How do you design a term sheet that protects against dilution?

1 Understand the valuation

The valuation of your startup is the key factor that determines how much dilution you will face in each funding round. The higher the valuation, the less shares you have to give up to raise the same amount of money. However, you also have to be realistic and avoid overvaluing your company, which can scare away investors or lead to a down round later. You should do your market research, compare with similar companies, and negotiate with multiple investors to get the best valuation possible.

2 Choose the right investors

Not all investors are created equal. Some may offer more favorable terms than others, or have more value-added services, expertise, or connections. You should look for investors who share your vision, align with your goals, and can help you grow your business. You should also consider the stage, size, and structure of the investment. For example, seed-stage investors may take less equity than later-stage ones, convertible notes may have lower dilution than priced rounds, and syndicates may have less control than solo investors.

3 Limit the option pool

The option pool is the percentage of shares reserved for future employees, advisors, or consultants. It is usually created or increased before each funding round, and it dilutes both the founders and the existing investors. You should limit the size of the option pool to what you actually need to hire and retain talent, and avoid pre-allocating it before you have a clear hiring plan. You should also negotiate with the investors on who bears the cost of the option pool, and whether it is included in the pre-money or post-money valuation.

4 Use anti-dilution provisions

Anti-dilution provisions are clauses that protect the investors from losing value in their shares if the company raises money at a lower valuation in the future. They can be either full ratchet or weighted average, depending on how they adjust the conversion price of the preferred shares. As a founder, you should avoid or minimize the use of anti-dilution provisions, as they can increase the dilution of your common shares and reduce your motivation to raise more capital. If you have to accept them, you should prefer the weighted average method, which is less punitive than the full ratchet.

5 Monitor the liquidation preference

The liquidation preference is the amount of money that the investors get back before the common shareholders in the event of a sale, merger, or dissolution of the company. It can be either non-participating or participating, depending on whether the investors also share in the remaining proceeds after getting their preference. As a founder, you should prefer a non-participating liquidation preference, as it reduces the dilution of your common shares and increases your upside potential. You should also avoid multiple or stacked liquidation preferences, which can give some investors priority over others.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?