Why All Term Sheets Aren’t Created Equally

If you frequently read business websites or the business section of a newspaper, you have likely read about private companies that have recently closed on a new round of equity financing. More often than not the article headlines with two pieces of information: how much was raised and on which pre-money valuation.

If you frequently read business websites or the business section of a newspaper, you have likely read about private companies that have recently closed on a new round of equity financing. More often than not the article headlines with two pieces of information: how much was raised and on which pre-money valuation. For example, ABC Co. has raised $10 million on a $90-million pre-money valuation. These two numbers are very important data points, but without the full story given in a term sheet, they could imply a myriad of things.

Term Sheets

A term sheet is document presented to a company by an investor or venture capital firm, indicating intent to invest (counsel should always be consulted whenever dealing with term sheets). Within the document lies the blueprint of the proposed investment. It presents terms the investor expects the company to abide by in the event the investment proposal is accepted. Term sheets can be as simple and short as a single page or much more detailed and in depth. Term sheets lay out the specifics of two main areas:

Both areas have great impact, but in this article, I will be exploring the financial terms specifically. They dictate who gets what financially during the life of the business as well as in an exit scenario.

The first component that warrants attention is the pre- and post-money valuation. In conjunction with the amount of money invested, these items determine how much of the company the new investors will own. The pre-money valuation is the company’s valuation prior to investment. The post-money valuation is the aforementioned pre-money plus the amount invested.

If the valuation of the company is set at $90 million and the investment amount is $10 million, then the post-money is $100M. Investor ownership in this example would be calculated as follows:

Investors strive to maximize the percentage of the company acquired, which founders and management desire to limit. The goal with the valuation should not be to arrive at the largest possible valuation; it should be to arrive at a fair valuation that aligns the long-term goals of the investor with those for the company. If the bar is set excessively high in early rounds and that bar is not met prior to the next round, then the company might need to raise a flat or down round, which reflects badly on them. At the end of the day, the valuation is step one in a term sheet, so it’s best to set it at a level that presents a win-win scenario for all parties involved.

Aside from the valuation, liquidation preferences bear scrutiny as well. These rights are regularly included in the term sheet. Equate them to an insurance policy—you never want to be without one, but you hope you never have to use it. Investors desire the company to do well, so their money is worth more than when initially invested, but in the event that the company fails, liquidation preferences will protect them.

The most standard provision is a multiple-liquidation preference (1x invested capital, 2x, 3x, etc.). In most companies I see, the liquidation preference is 1x invested capital. In the event the company is sold or wound down, investors receive an amount equal to that which was invested before junior classes of stock received any economic benefit.

The key thing to look for in the language is that 1x the original purchase price is what is being promised. Anything greater would be considered less favorable terms for the company. A 2x liquidation preference would be akin to having an insurance policy that covers an asset and allows for a scenario in which that asset is destroyed and the beneficiary receives more than the value of the asset. Now, we would all want that policy, but no sane insurance company would provide it.

When an investor receives preferred stock in exchange for an investment, they typically request a conversion clause. This clause allows the preferred shares to be converted to common shares. Typically, you would expect this ratio to be 1:1—1 preferred share for 1 common share. Much like liquidation preferences, any other ratio (for example, 1 preferred share for 2 common shares) favors the investor and dilutes ownership and founders’ returns in an upside-exit scenario.

With liquidation and conversion covered, this brings us to one of the trickiest provisions found in term sheets: participation rights. There are three possible scenarios with participation rights.

So what is participating preferred stock? Participating preferred stock gives investors two benefits: a return on their investment before any other investors (liquidation preference) and a percentage of whatever is left.

In the case of participating preferred stock, the investor has the best of both worlds. The investor gets the liquidation preference and then is able to participate as common and is paid out in accordance with its percentage ownership. To limit this provision, the participation rights might be connected with a cap.

In the case of participating preferred stock with a cap or non-participating preferred stock, the owner of the shares have the option to forego their liquidation preference and convert to common prior to the event, if converting to common would result in a higher economic benefit.

To illustrate, in this example, we will assume a $20M Series A investment at an $80M pre-money valuation, resulting in Series A owning 20% of the company. No additional shares have been issued following the Series A investment. The company is sold for $160M.

Hopefully this helps illustrate the economic impact of participation rights. In scenario 1, preferred investors receive $32M, leaving $128M for the common shareholders. In scenario 2, preferred investors receive $40M, leaving $120M for common shareholders. In scenario 3, preferred investors receive $48M, leaving $112M for common shareholders. In this theoretical example, a $16M difference of money available to be allocated to common shareholders exists strictly due to participation and non-participation rights.


Another provision that can have grand impact on the economic distribution is dividends. Similar to how a publicly traded company will distribute earnings to shareholders, private companies will occasionally do the same thing. Most term sheets will have a section dedicated to dividends, but the language of the term sheet could render them effectively pointless.

Dividends will usually be expressed as a percentage, typically 5% to 15%. They are designed to provide an additional return to the preferred investors. The most typical language involves the phrase, “when and if declared by the board of directors” and the word noncumulative. If those two portions are included, the economic impact is minimal. It declares that if the board decides to pay dividends, then preferred shares have the first right to these divided payments, but until that point, nothing is paid out or owed.

If the word is cumulative, an alternate scenario occurs. Cumulative dividends favor the preferred shareholders. Dividends accrue as a percentage on the original issue price from the inception of the investment. The dividend is calculated every year, and if the company cannot or does not pay that amount, then it rolls over (accumulates) to the next year until it is paid, essentially stacking more money on top of the agreed-upon liquidation preference.

Dividends are usually paid out in cash, but in some cases, they can be paid out in stock. If this is the case, you will read a provision “paid in kind,” or the acronym PIK. PIK dividends are a compounding issue, as the dividend value is paid out in preferred stock. This, in turn, would increase the liquidation preference while simultaneously diluting other shareholders, the impact increasing as time passes.


As we explore the details of these various provisions, I hope it becomes evident that term sheets are not a simple headline of $10 million on a $90 million pre-money valuation. The detail and differences that can be contained within term sheets are numerous.

If the headline, or amount and valuation, is the façade of a theoretical house, the terms are the house’s foundation and internal structure. Before making a home purchase, I would hire an inspector to assess the structural integrity to ensure I do not put myself in the position of buying property that is a poor fit for my needs. The same idea should be applied to term sheets. The valuation and amount of money being offered are the façade, but without knowing the foundation and internal structure of the presented term sheet, one can never truly assess the implications of moving forward. Every founder or management team should understand fully the implications and agreements contained within the term sheet.

My goal with this article is to present some of the major components commonly contained within equity financing term sheets specifically relating to the economics. As a company enters a phase in which equity fundraising is necessary, there are some key points to consider:

At the end of the day, focus on what is important to you in this process. Educate yourself as best as possible, and when in doubt, consult with trusted advisors or counsel. Decide what you can and cannot live with, and keep those things in mind during negotiations.

For more information, follow Scalar on LinkedIn, Twitter, Facebook and  Instagram. If you need valuation services,  or call us at 385.831.1010.

This article is purely informative, and Scalar does not accept any responsibility for action taken based on the content of this article.

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