Term Sheets and Cap Tables: The Basics of Startup Equity
A term sheet is a legal document that defines how much money you're raising, what it's worth, and what rights the investor gets.
Most founders:
- Don't read it carefully
- Don't understand it
- Don't negotiate it
- Sign bad terms
This guide explains term sheets so you DON'T.
The Key Terms in a Term Sheet
Term 1: Investment Amount
What it is: How much money the investor is putting in.
Example: "$2M Series A round"
Term 2: Valuation (Pre-Money vs. Post-Money)
Pre-money valuation: What the company is worth BEFORE this round of funding.
Post-money valuation: What the company is worth AFTER this round.
Example:
- Pre-money: $8M
- Investment: $2M
- Post-money: $10M
Formula: Post-money = Pre-money + Investment
Why it matters:
- Founder owns X% AFTER funding
- Founder's equity worth = X% × Post-money valuation
Example: If founder owns 70% post-money on $10M post-money valuation:
- Founder's equity = 70% × $10M = $7M (on paper)
Term 3: Liquidation Preference
What it is: If company sells, who gets paid first? And how much?
Example: "1x Non-Participating Preferred Stock"
Investor invested $2M at $10M post-money valuation. Company sells for $12M.
1x Non-participating = Investor gets their $2M back FIRST, then remaining $10M is split pro-rata between founder and other shareholders.
Result:
- Investor gets: $2M
- Founder gets: $10M × (founder stake %)
Term 4: Voting Rights
What it is: How much say the investor has in company decisions.
Example: "Investor gets board seat"
Means investor can influence strategic decisions.
Red flag: "Investors get veto rights over hiring" (too much control)
Term 5: Dilution (Anti-Dilution Clauses)
What it is: What happens to investor's ownership if you raise money at a lower price later?
Example: "Full Ratchet Anti-Dilution"
You raise Series A at $10M post-money (investor gets 20% = 2M shares / 10M shares).
You raise Series B at $5M post-money (lower price).
With "full ratchet," investor's share gets adjusted as if they bought at the $5M price. Founder gets diluted MORE.
Bad for founder. Avoid if possible.
Term 6: Board Composition
What it is: Who sits on your board?
Typical Series A:
- 1 founder
- 1 investor
- 1 independent (chosen together)
Term 7: Participation Rights
What it is: Can investor invest in future rounds?
Pro-rata rights = investor can invest in Series B to maintain their ownership %
This is normal. Not a dealbreaker.
Cap Table Basics
Cap table = Capitalization table
Shows who owns what percentage of the company.
Example:
| Holder | Shares | Total Shares | Ownership % |
|---|---|---|---|
| Founder (common) | 7,000,000 | 10,000,000 | 70% |
| Employee options (pool) | 1,000,000 | 10,000,000 | 10% |
| Series A investor | 2,000,000 | 10,000,000 | 20% |
| TOTAL | 10,000,000 | 10,000,000 | 100% |
What it means:
- Founder owns 70%
- Investor owns 20%
- Employees are allocated 10% (but haven't vested yet)
Understanding Dilution
Dilution = Your ownership % goes down with each round of funding
Example:
- Pre-funding: You own 100% (1M shares)
- Series A: Raise $2M, issue 2M shares to investor
- Post-funding: You own 33% (1M out of 3M shares)
Your 1M shares are worth the same. But company post-money is higher, so your equity is worth more (hopefully).
Red Flags in Term Sheets
Red Flag 1: Very Bad Terms on Liquidation Preference
"Investor gets 2x their money back before anyone else"
This means if company exits for $10M and investor put in $5M:
- Investor gets: $10M (2x their $5M)
- Everyone else gets: $0
Avoid this.
Red Flag 2: Full Ratchet Anti-Dilution
"If you raise at lower price, investor's shares adjust"
This disproportionately dilutes founder.
Negotiate for "weighted average anti-dilution" (less painful).
Red Flag 3: Participating Preferred
"Investor gets their money back + pro-rata share of remaining proceeds"
This means investor can "double-dip." Avoid if possible.
Red Flag 4: No Employee Option Pool
"We're not allocating shares for employee options"
Bad. You need to offer equity to attract great people.
Negotiate for 10-15% employee option pool.
Safe vs. Equity (Early Funding)
Equity round:
- Formal term sheet
- Valuation negotiated
- Investor owns stock right away
SAFE (Simple Agreement for Future Equity):
- No valuation today
- Converts to equity in next "Priced Round" (Series A)
- Simpler legal docs
- More common for seed rounds
When to use:
- SAFE: Seed funding (pre-PMF)
- Equity: Series A+ (proven PMF)
Example Series A Term Sheet
Raising: $3M Series A
Pre-money valuation: $7M
Post-money valuation: $10M
Use of funds:
- 50% to hiring
- 30% to marketing
- 20% buffer
Terms:
- 1x non-participating preferred
- 4-year vest for new shares (1-year cliff)
- Pro-rata rights for Series B
- Board seat for investor
- Anti-dilution (weighted average)
What this means:
- Investor gets 30% of company ($3M / $10M)
- Founder still owns 70% (diluted from earlier employees who got options)
- Investor has board seat but not veto rights
- Founder can recruit talent (option pool exists)
How to Navigate
Rule 1: Understand before you sign
Get a lawyer ($3-5k). Worth it.
Rule 2: Negotiate
Investors expect you to negotiate. Don't accept first offer.
Areas to negotiate:
- Anti-dilution terms
- Board composition
- Employee option pool
- Liquidation preference
Rule 3: Get advice
Talk to founders who've raised. Ask about terms they negotiated.
Connection to Fundraising
Term sheets are part of Series A fundraising.
Good terms = runway to scale. Bad terms = founder heavily diluted, investor has too much control.
Know What You're Signing
Term sheets aren't just standard. They're negotiable.
Get advice. Negotiate hard. Build a company you want to own.
Use Edmired to prepare for Series A fundraising and understand your terms. Join the beta.