Understanding term sheets: key terms and pitfalls

Even though it is not legally binding, it is advisable to draft a term sheet with the utmost care and sufficient detail, as it sets the tone for subsequent contract negotiations and thus carries considerable strategic weight.  

What should be included in a term sheet?  

A typical term sheet contains provisions on the following aspects:  

• Valuation and investment amount: The pre-money and post-money valuation, as well as the amount of the investment and the resulting share of the investor. 

• Liquidation preference: This clause regulates the order and amount in which investors are paid out in the event of an exit (e.g., sale or IPO). A 1x non-participating preference is standard market practice – but there are variants that can be disadvantageous for founders.  

• Vesting provisions: Founder shares are often subject to vesting, which ensures that they remain in the company for a certain period of time. Four years with a one-year cliff is typical. 

• Anti-dilution protection: These clauses protect investors from dilution in future financing rounds at lower valuations (“down rounds”). The “weighted average” mechanism is particularly common, while the “full ratchet” is significantly more investor-friendly.  

• Tag-along rights and drag-along obligations: These govern the conditions under which investors or founders must or may sell their shares jointly.  

• Board composition and control rights: Investors often secure seats on the advisory board or special approval or veto rights for strategic decisions, such as capital measures, budget approvals, or exit decisions. 

What is the legal significance of a term sheet and what are the typical pitfalls? 

Although a term sheet is often largely non-binding, it regularly contains legally binding clauses – for example, on exclusivity, confidentiality, or cost allocation. These are legally enforceable and should therefore be reviewed with the same care as a final investment agreement.  

A common mistake on the part of founders is to focus too early on valuation without understanding the long-term implications of liquidation preferences or anti-dilution clauses. The governance structure is also often underestimated – who will hold decision-making authority in the future? Here, seemingly insignificant wording in the term sheet can have a major impact on corporate control. 

It should also be noted that the term sheet often serves as the basis for subsequent due diligence and contract drafting. Imprecise or one-sided wording can prove to be a stumbling block in later negotiations. 

Conclusion 

A well-negotiated term sheet creates clarity, trust, and a solid basis for further cooperation. A poorly negotiated term sheet, on the other hand, can lead to long-term conflicts and economic disadvantages. It is therefore crucial to seek legal advice at this early stage – not only for review, but also for strategic planning.  

Are you planning a financing round or about to sign a term sheet? Talk to us – we will support you with our many years of experience in VC consulting.