Legal Checklist: Term Sheet Pitfalls Every Founder Should Avoid

Term sheets signal intent, but their provisions can have long-term implications far beyond headline valuation. This checklist focuses on common pitfalls founders encounter and provides practical negotiation guidance. While not a substitute for legal counsel, these checkpoints will help founders recognize red flags and ask the right questions during diligence.

1. Liquidation Preferences and Participation

Founders often overlook the long-term impact of liquidation preferences. A 1x non-participating preference is common and reasonable — shareholders get their money back first, then the remaining proceeds are split. Avoid participating preferences that allow investors to take their preference and then participate pro rata in the remaining proceeds; these can severely reduce founder upside in exit scenarios.

2. Pro-Rata and Anti-Dilution

Pro-rata rights allow investors to maintain ownership by participating in future rounds. While common, excessive pro-rata can complicate cap table dynamics when many small investors hold rights. Anti-dilution protections, particularly full-ratchet clauses, are highly punitive to founders and should be avoided. Weighted-average anti-dilution is a more balanced compromise.

3. Board Composition and Protective Provisions

Board seats are governance levers. A board dominated by investors can impede strategic flexibility. Founders should be wary of excessive protective provisions that require investor consent for routine operational decisions (e.g., hiring/firing executives, approving budgets, or changing business lines). Limit protective provisions to material changes like further fundraising above a threshold or fund dissolution.

4. Vesting Cliff and Acceleration

Standard four-year vesting with a one-year cliff remains typical for founder equity. Founders should negotiate for double-trigger acceleration in M&A contexts — acceleration upon acquisition plus termination without cause — to avoid being locked out of equity value post-acquisition.

5. Option Pool Carve-Outs

Investors may ask for an enlarged option pool to be created on a pre-money basis, effectively diluting founders before the new capital arrives. Push to have option pool expansion negotiated on a post-money basis where reasonable, or agree on a clear plan for hires and associated assumptions to justify the pool size.

6. Information Rights and Reporting Burden

Investors often request periodic financial reporting, which is reasonable; however, overly granular or frequent reporting requirements create operational overhead. Define a reasonable reporting cadence (e.g., monthly KPIs and quarterly financials) and avoid ad-hoc audit rights.

7.Founder Lock-Ups and Key Person Clauses

Some term sheets include founder lock-ups that restrict sale or transfer of shares for extended periods. Also watch for key person clauses that treat departure of a named founder as a default event enabling investor remedies. These should be narrow and time-bound.

8. Drag-Along and Majority Sale Terms

Drag-along provisions enable a majority to force minority shareholders to sell. Reasonable drag-along terms protect the company’s ability to close strategic exits; however, founders should ensure minimum thresholds and fair-price protections are included to avoid coerced disposals at low valuations.

9. Founder Loans and Capital Mechanics

Founders sometimes convert personal loans into the company as bridge financing. Clarify whether those loans convert into equity at a discount or are repaid and how they factor into the cap table. Ambiguity here can complicate eventual rounds.

10. Jurisdiction and Governing Law

Standardize on a jurisdiction that aligns with your legal counsel and investor base. For US-headquartered startups, Delaware law is common; cross-border terms must explicitly address tax treatment, employee options, and local compliance considerations.

Negotiation Tips

• Start with a clear list of non-negotiables and a set of desirable but flexible items.
• Bring a term-sheet-savvy lawyer early and budget for legal costs; early counsel often saves negotiation time and capital later.
• Use precedents from your investor’s portfolio to propose fair language — investors often accept language consistent with their past deals.

"The best term sheets are transparent about expectations and leave both founders and investors incentivized for long-term growth."

Term sheets crystallize expectations. Founders who understand these common pitfalls and approach negotiation with clarity and professional counsel protect not only ownership but also strategic optionality. When in doubt, push for simplicity and alignment; complex protections today can become operational headaches tomorrow.