The Term Sheet!

Red or Blue Pill?

Congratulations! You Got the Term Sheet. Now What?

A term sheet hits your inbox. You’re buzzing with excitement and nerves—finally, someone believes in you and is ready to invest in your vision. It feels like you’ve crossed the finish line, but in reality, the race has just begun. I’ve been through this process a few times myself and picked up a few lessons along the way. At its core, a term sheet outlines the conditions under which someone is willing to fund your dream. Now you’re at a pivotal moment: You can only choose one path—will you take the blue pill or the red?

Let’s step out of the Matrix for a minute and break down why this decision is so crucial before you get carried away. This is the start of a series of critical decisions about your company’s future. A key factor to understand? Liquidation Preference and Preferred Stock.

What is Liquidation Preference?

In simple terms, liquidation preference determines who gets paid first if your company faces an exit—whether through a sale, acquisition, or liquidation. Investors who hold preferred stock typically get this perk, ensuring they receive a specific amount before common shareholders (like founders and employees) see a dime.

This can affect what founders, employees, and early shareholders walk away with, so it’s crucial to understand.

How Does it Work?

Let’s break it down with an example:

Imagine your company sells for $10 million, and you’ve raised $2 million from investors with a 1x liquidation preference. This means those investors get back their $2 million before common shareholders receive anything. If your company sold for only $2 million, your investors would take the full amount, and common shareholders would walk away empty-handed.

But what happens in a larger exit where the company sells for more?

The Founder’s Nightmare: Big Exit, Zero Payoff

Here’s a real-world use case where founders can walk away with nothing, despite a large exit:

Let’s say you raise $10 million in funding, but the investors negotiate a 2x participating liquidation preference. This means they’ll get 2x their money back—$20 million—before common shareholders (you, the founders) see any proceeds.

Now, imagine your company is acquired for $25 million. Sounds like a win, right? Not exactly.

1. The investors will first get their $20 million due to the 2x liquidation preference.
2. That leaves just $5 million for everyone else.
3. But since these investors have participating preferred stock, they’re also entitled to a share of that remaining $5 million alongside the common shareholders.

In the end, they may take a large portion of the remaining proceeds too, leaving you and your team with barely anything after what appears on the surface to be a big win. Despite a $25 million exit, the founders and employees could walk away with close to zero.

The Key Types of Liquidation Preferences:

1. 1x Liquidation Preference: The most standard, meaning investors get back their original investment. For example, if they invested $1 million, they get $1 million before anyone else.
2. Participating vs. Non-Participating:
3. 2x or Higher Liquidation Preference: In some cases, investors negotiate for more than they put in—like a 2x preference, where they receive double their investment before others get paid. Be cautious here; this can significantly reduce the pool available for founders and employees.

Why Does This Matter?

The structure of liquidation preferences can dramatically alter your financial outcome in an exit. Understanding these terms—and negotiating them well—can mean the difference between a fair reward for your hard work or walking away with little. Founders often focus on valuation, but liquidation preference is just as important. Even with a high valuation, a hefty liquidation preference could mean investors still take most of the pie in an exit.

Preferred Stock and Control

When investors purchase preferred stock, they typically gain special rights beyond just financial preference. These might include:

• Voting rights on key business decisions (such as selling the company)
• Anti-dilution protection that ensures their percentage ownership doesn’t drop in future funding rounds
• Board seats, giving them a say in strategic decisions

Understanding how much control you’re giving up is crucial. While preferred stock can bring in much-needed capital, it can also shift decision-making power.

How to Navigate the Term Sheet

As exciting as a term sheet can be, don’t rush through it. Take time to understand liquidation preferences, preferred stock rights, and how these terms might impact your future financial outcomes. Involve your legal and financial advisors—they’ve seen this before and can help ensure you’re not agreeing to something that could limit your upside later on.

Final Thoughts

Receiving a term sheet is an exciting milestone, but it’s just the beginning of negotiations. Pay close attention to liquidation preferences and preferred stock terms—they can have a huge impact on your eventual payout and control. Make sure you're negotiating for more than just a high valuation. A strong deal is one that balances investor incentives with founder success.

Congratulations again on hitting this huge milestone—now let’s make sure it’s the right deal for your future!

Mo