Term sheet clauses founders most often misunderstand

A term sheet is short, and most of it is described as non-binding, so founders sometimes treat it as a formality before the real documents. In practice the definitive agreements almost always follow the term sheet closely, and a point conceded at this stage is very hard to reopen later. These are the clauses that most often turn out to mean something different from what a founder assumed.

Which parts are binding

Most of a term sheet sets out commercial terms that are not legally binding until the definitive agreements are signed. A few clauses usually bind from the moment the term sheet is signed, typically confidentiality, exclusivity (sometimes called no-shop), costs and governing law. Exclusivity matters most: it can stop a company talking to other investors for weeks or months, so its length and the conditions for ending it deserve attention.

Pre-money, post-money and the option pool

The headline valuation is usually stated as a pre-money figure. What founders often miss is where the employee stock option pool sits. If the term sheet requires the pool to be created or enlarged before the investment, its dilution falls entirely on existing shareholders, and the effective pre-money valuation is lower than the headline number.

It is worth modelling the cap table after the round, including the pool, before agreeing the valuation.

Liquidation preference

A liquidation preference decides who is paid first, and how much, when the company is sold or wound up. The common market position is a 1x non-participating preference: the investor receives either its money back or its share of the proceeds as if it had converted, whichever is higher.

A participating preference lets the investor take its money back and share in what remains. In a modest exit, that difference can move a large part of the proceeds from founders and employees to investors.

Anti-dilution protection

Anti-dilution clauses protect an investor if the company later raises money at a lower price. A broad-based weighted average adjustment, the more common form, adjusts the investor's conversion price in proportion to the size and price of the new round. A full ratchet resets it to the new, lower price however small that round is, which can be severe for founders in a down round.

Reserved matters and board rights

Investors typically ask for a board seat and a list of reserved matters: decisions that need their consent. Some are standard, such as changes to share capital or to the company's constitutional documents. A long list that reaches budgets, hiring, contracts above a low threshold or product decisions can make day-to-day management slow. The list should cover what protects the investment rather than how the business is run.

Founder vesting and transfer restrictions

Investors may ask founders to put some of their existing shares on a vesting schedule, so that a founder who leaves early does not keep a full stake. Term sheets also usually include a right of first refusal, tag-along and drag-along rights. Drag-along deserves particular care, because it can require founders to sell their shares on terms agreed by others.

Points specific to India

• Investment by a foreign investor must follow the pricing and reporting requirements under the Foreign Exchange Management Act, 1999. An unlisted company cannot issue shares to a non-resident below their fair value, as certified by a chartered accountant, a merchant banker or a cost accountant, and the allotment has to be reported to the Reserve Bank of India.
• Investors commonly subscribe to compulsorily convertible preference shares in place of equity shares, and the conversion terms carry the anti-dilution and preference provisions.
• Many investor rights have to be written into the company's articles of association to be enforceable against the company, not only into the shareholders' agreement. The Supreme Court held in V.B. Rangaraj v. V.B. Gopalakrishnan that a restriction on transferring shares which is not in the articles does not bind the company.

Before signing

Read the term sheet as a summary of the final documents, not a preliminary step. Model the cap table after the round, check which clauses bind immediately, and raise concerns now, while changes are still expected, and not during drafting of the definitive agreements.