Term Sheets Explained: Key Clauses, Common Traps, and Negotiation Tips for Startups

When you’re raising capital for your startup, one of the first formal documents you’ll encounter is a term sheet. This serves as the bridge between initial investor interest and the legally binding investment agreements that follow. Whether you’re raising a seed round or preparing for Series A through C, the term sheet lays out the key commercial and legal terms of the proposed investment.

It might only be a few pages long, but a term sheet plays a decisive role in shaping the deal-and your business’s future. Understanding term sheets, what they contain (and what’s excluded) can help you make smarter decisions, avoid costly mistakes, and negotiate better terms.

In this article, we explain what a term sheet is, walk through the key clauses, highlight common traps, and share tips to help founders handle the negotiation process with confidence.

What is a Term Sheet?

A startup term sheet is a short agreement that outlines the basic terms and conditions of an investment offer. It determines the key terms of the proposed investment, such as the amount of capital being invested, the company’s valuation, the type of shares being issued, and investor rights, such as board seats or veto rights. It’s usually the first formal step once an investor has indicated they’re serious about coming on board.

Although it’s usually not legally enforceable (except for a few specific clauses), a signed term sheet serves as a blueprint for the legally binding documents that follow. Investors and lawyers generally treat matters covered in it as closed to negotiation once completed, so entrepreneurs should never sign one without understanding the key terms and conditions to include.

You might sometimes see people using a different name for this type of document – for example: heads of agreement (HOA), memorandum of understanding (MOU), letter of offer (LOA), letter of intent (LOI) or non-binding indicative offer (NBIO). All of these documents are just variations of the same concept.

Why Term Sheets Matter for Startup Founders

Startups looking for cash injections must have properly drafted term sheets for the following reasons:

• It locks in the key commercial terms of the deal, thus framing the negotiation and future relationship with your investors.
• Determines how much equity you’re giving up – and on what terms;
• Can affect your ability to raise further funding down the line;
• Impacts your control over the business; and
• It may affect your exit options through potentially restrictive terms.
• Entrepreneurs often sign term sheets too quickly, without fully understanding the long-term implications. Don’t rush. Take the time to understand the details.

Key Clauses to Understand & Include in a Startup Term Sheet

Here are the main sections of a typical early-stage term sheet, especially in Australian startup funding rounds.

1.  Valuation and Investment Amount

This section spells out how much the investor is putting in, what they’re getting in return, and how the valuation is determined (to assess share prices). 

The company’s valuation can be either:

• Pre-money valuation – the company’s value before the investment is added.
• Post-money valuation – the company’s value after the investment is included.

Why it matters: The investment amount and valuation are important for obvious reasons – they specify how much cash the company receives and how much equity is given up in return. They are the key commercial terms of the deal.

Whether the valuation is pre- or post-money determines who bears the dilution if the company raises additional funds (besides the investor signing the term sheet) as part of this round. A pre-money valuation means that additional funds will result in the investor diluting their stake. A post-money valuation means the investor is protected against dilution, and the founders/existing shareholders will bear all dilution if further funds are raised in this round.

Trap: avoid agreeing on a post-money valuation – all it does is create headaches for you in case circumstances change. Insist on a pre-money valuation. 

2. Type of Shares or Instruments

Investors might be offered:

• Ordinary shares
• Preference shares (which come with extra rights, such as liquidation preferences, anti-dilution, conversion rights, dividend preferences and more), or
• Convertible securities like notes or SAFEs.

Each has different implications for voting rights, dividends, and what happens if the company is sold or wound up. Most Australian Series A (and later) rounds use preference shares with some customised rights.

UX Law Tip: Do not volunteer preference shares unless the investor specifically demands them. Many investors, even veteran angels, will agree to ordinary shares on many occasions. It will be a tougher sell with institutional investors, though, who usually demand preference shares.

3. Capitalisation Table (Cap Table)

This sets out who owns what, before and after the investment, and considers dilution and vesting (for instance, you may have issued some options to an employee that will vest and ‘convert’ into shares down the line). It should include:

• Founders and current members,
• New investors,
• Any employee share option pool (ESOP).

4. Board Structure

While investors might not want to run your business, they typically wish to oversight and some veto power over key decisions. But too much investor control can undermine founder leadership and flexibility. Remember that the board of directors runs the company, and board control is extremely important. Your goal should be for the founder group to maintain a majority on the board for as long as possible. Some broad guidelines for board structures are below:

• Try to avoid giving away any investor board seats in earlier rounds, such as Pre-Seed and Seed.
• try to restrict investor board seats to only investors who hold over 10% or even 15% of equity.
• set up good mechanisms to resolve deadlocks – such as a casting vote to the chairman (who should be a founder) or an independent director (more common in more advanced startups)

Remember that an advisory board is not the same as the board of directors. 

UX Law Tip: Remember, board voting is usually simply 1 vote for each director. Founders who hold large equity chunks (especially sole founders) may need to specifically mention that their appointed director has extra votes, to ensure they maintain board control.

5. Decision Making

Some term sheets aim to set out the company’s decision-making framework. Generally, the company’s decisions require a simple majority vote of the board. Still, specific significant actions may require elevated approvals – for example, shareholder approval, a supermajority board approval, or the agreement of specific directors (such as a founder director or investor director). Investors will often push for many decisions to require their consent, whereas founders will typically want to limit investor veto powers over most matters. In general, these special approvals should be limited to genuinely significant issues so that day-to-day operations remain under normal board control. Examples of common problems that require investor approval include:

• related party transactions
• payment of dividends
• materially changing the nature of the business
• capital expenditure or borrowing above an agreed threshold
• founder salaries, and employee remuneration, above an agreed threshold
• selling or shutting down the business

UX Law Tip: Keep special approvals to a minimum and avoid shareholder-level approvals where possible, as they can be slow and procedurally cumbersome to obtain. Avoid giving investors a blanket veto right over new capital raises or share classes.

5. Liquidation Preferences

Many investors will insist on receiving preference shares with a liquidation preference. A liquidation preference protects an investor by ensuring they receive a minimum return in the event of a sale or the company’s closure.

The most common form is a 1x non-participating liquidation preference, which gives the investor the greater of:

1. Their original investment amount, or
2. What they would receive based on their equity percentage in the company.

This protects them where the exit price is lower than what they originally invested – they get to take out what they originally invested, even though it is higher than what their equity would otherwise entitle them to.

By contrast, a participating liquidation preference lets the investor take both:

1. Their original investment back, plus
2. What they would receive based on their equity percentage in the company.

This “double dip” means participating preferences can substantially reduce what founders receive on exit. 

UX Law Tip: Non-participating preferences are far more balanced. Participating preferences heavily favour investors – push back unless the investment size or stage genuinely justifies it. Be aware of how this impacts your cap table – it will mean the investor’s investment must be deducted from the purchase price before the balance is divided according to everyone’s equity percentage.

6. Anti-Dilution Protection

If the company raises money in the future at a lower valuation (a “down round”), anti-dilution provisions protect earlier investors from losing too much value.

There are two main types:

• Full ratchet: The investor’s conversion price is adjusted as if they had invested at the new, lower price (this is the most aggressive form and is relatively rare in Australia)
• Weighted average: The adjustment is more moderate, taking into account both the new share price and the number of shares being issued

Anti-dilution protection is typically achieved in practice by issuing additional shares to the protected investor so that their effective ownership or conversion price is adjusted to reflect the down round. For example, under a weighted average provision, the formula recalculates the investor’s conversion price based on the ratio of old shares to new shares and the price of the new shares. In effect, the investor receives additional shares at no extra cost, partially offsetting the dilution from the lower-priced round.

For Example:

An investor buys 1,000 shares at $10/share. Later, the company raises a down round at $ 5 per share.

• Full ratchet: The investor’s conversion price is reset to $5 per share, effectively doubling their shares to 2,000 without additional investment. This maximally protects the investor but can heavily dilute founders.
• Weighted average: The conversion price is adjusted proportionally based on the number of new shares and the lower price. Using a simple formula, the latest conversion price becomes $7.50/share, and the investor receives extra shares, partially offsetting dilution.

7. Information and Reporting Rights

Investors usually want regular updates – monthly or quarterly financials, annual budgets, and the right to inspect books or ask questions.

Common investor requests include:

• Quarterly financial statements
• Annual business plans and budgets
• Right to inspect company records
• Ad hoc updates on material events

These rights are reasonable, but they should be balanced with your stage of growth and internal resources. Founders should avoid agreeing to overly frequent or burdensome reporting requirements – especially if the investor holds a small stake.

UX Law Tip: Founders should offer transparency, but not commit to overly burdensome admin obligations at an early stage (for instance, push back on monthly reports unless your business already operates this way internally). Include a provision requiring confidentiality for all investor-shared information. 

8. Founder Vesting or Clawback

Founder vesting is a mechanism to ensure key team members remain committed to the business post-investment. Even if you and the other founders already hold your shares, investors might ask for a vesting arrangement – meaning shares are “earned” over time (typically 3–4 years with a 12-month cliff).

If a founder leaves early, a portion of their shares may be “clawed back”, repurchased or transferred to someone else, usually for $1. This is designed to ensure key people stay on to build the business.

Vesting is more common at the earlier stages of a startup’s lifecycle. However, many investors in later rounds will seek to fully or partially reinstate vesting periods for founders to ensure they remain committed. Founders who have already invested significant time (or cash) in a business should negotiate shorter (or no) vesting periods.

UX Law Tip: If you are a sole founder, then vesting only operates against you. Do not volunteer it unless you need to police other founders. If you do include it, ensure the mechanism states that, if a founder exits, their unvested shares are distributed to the other founders.

9. Drag-Along and Tag-Along Rights

These clauses kick in during a full or partial sale of the company.

• Drag-along allows majority shareholders to force minority shareholders to sell their shares if an outside buyer is seeking to acquire the entire company. 
• Tag-along rights give minority shareholders the right to join a deal if the majority decide to sell their shares, ensuring they are not left behind in a partial sale. 

Both sets of rights are standard features for startups. The key is usually in the parameters that surround them. The primary parameter is the threshold which triggers the activation of the rights. For example, a threshold of 70% will mean shareholders holding 70% of the shares need to agree to sell before either of the rights is activated. 

Founders must keep these thresholds front of mind when negotiating with investors, as they typically seek to ensure they maintain sufficient ownership to meet the drag-along threshold even after future funding rounds dilute their stake. In practice, this means when drafting the term sheet, you should calculate thresholds based on fully diluted shares (including options, convertible notes, and other instruments) to ensure the intended parties retain control over drag or tag rights, regardless of future dilution.

UX Law Tip: Some investors will add additional parameters around drag-along, for example, that drag-along rights are triggered only if the sale price is at least 3x (or some other multiple) of the valuation the investor invested. It is best to try to avoid those parameters where possible.

10.  Exclusivity Provisions (No-Shopping)

Exclusivity provisions prevent the startup from talking to other investors for a set period (usually while the interested investor conducts due diligence and the parties negotiate the long-form document). As a founder, you want to put a reasonable window without locking yourself into a too-long period. It would be prudent to consider your current runway and burn rate, and factor in the possibility that the deal could collapse and that you may need to return to the market.

11.  Confidentiality

Confidentiality, naturally, is another legally binding provision that is essential to be included to protect founders. A well-drafted confidentiality provision will provide mutual protection for both parties, continue beyond execution, and may even outline the circumstances under which confidentiality is breached. 

12.  Costs

Typically, each party cover their own costs of the agreement, and this should be drafted into the term sheet so there can be no claims for expenses by either party. Some venture capital firms (particularly overseas ones) require founders to pay for the firm’s legal fees. 

UX Law Tip: If a VC firm insists on the payment of legal fees, you should at least try to negotiate a reasonable cap on those fees, and no payment if the VC voluntarily withdraws. 

Common Traps for Founders

Trap 1: Misunderstanding Dilution

Founders often underestimate how much equity they’re giving up, especially when factoring in ESOPs and multiple rounds of financing. Use a detailed cap table and run scenarios for future rounds and exit values to avoid giving away too much equity.

Example: Let’s say you raise $1 million at a $4 million pre-money valuation with a 10% ESOP carved out post-money. You might think you’re giving up 20%, but after adjusting for the ESOP, your actual dilution is closer to 27%.

UX Law Tip: Build a detailed cap table model that includes future funding rounds, ESOP expansions, and different exit scenarios. Tools like Cake Equity or Carta are helpful, or work with your accountant or lawyer to simulate cap table outcomes. We can also provide you with cap table tools. 

Trap 2: Agreeing to Overly Investor-Favourable Terms

Some term sheets include investor-friendly provisions such as high liquidation multiples, veto rights over basic decisions, or significant board control, even for modest investments. These can hinder the business later. These can reduce founder flexibility, deter future investors, or lock the company into an unfavourable governance structure.

Remember that most of the templates available online were prepared for investors, not founders (even if they claim to be founder-friendly). You can usually get much better terms than those in the online documents.

UX Law Tip: Know what you can get away with! Do not volunteer preferential rights, as many investors will accept ordinary shares. Push back on terms that are excessive or “off-market” for your stage, and ensure you have a clear understanding of the rights you are giving investors. Do not accept terms as ‘market’ simply because they exist in a document you downloaded online.

Trap 3: Not Planning for Future Rounds

Some founders structure their first raise without thinking about future ones. Terms that are too generous to early investors – such as full anti-dilution or aggressive preferences – can make later rounds unappealing to new investors.

Example: A seed investor with a complete anti-dilution clause might get a massive repricing in a down round, heavily diluting founders and demotivating future funders. 

UX Law Tip: Negotiate terms that leave room for follow-on investment and are seen as fair by later-stage investors. Make sure your early round doesn’t block your Series A. 

Trap 4: Rushing Into a Deal and Signing Without Proper Advice

A common mistake is signing the first term sheet an investor offers out of excitement or urgency. But the wrong terms, even in a non-binding document, can set your company on a difficult path.

UX Law Tip: Always take the time to review with a trusted legal and financial advisor. A well-negotiated term sheet builds trust, sets the tone for your investor relationship, and protects your business. The legal fees you may pay for peace of mind pale in comparison to the worst-case scenario horror stories of investors muscling into your business and tearing things apart. 

Negotiation Tips for Founders

1. Do Your Homework

Understand what’s “market standard” for deals at your stage in Australia. Speak to people in your network and ask them what they managed to negotiate. Speak to lawyers, and read this guide carefully!

2. Get Legal Help Early

Even though most of a term sheet is non-binding, once signed, it heavily influences your Shareholders’ Agreement and other final documents. A startup-focused lawyer can help you spot red flags and negotiate better outcomes. 

3. Know Your Bottom Lines

Before you negotiate, get clear on what matters most to you:

• Minimum acceptable valuation
• Your role and board representation
• How much control are you comfortable sharing
• The amount of dilution to your equity stake you can accept

Knowing this upfront prevents rushed or emotional decisions. 

4. Negotiate With Confidence

Investors expect founders to negotiate agreements. Even first-time founders can respectfully challenge terms. Please don’t feel pressure to agree on the spot; most VCs prefer thoughtful partners who understand their own boundaries. Be firm on key issues but open to compromise where it makes sense. 

5. Build a Cap Table Model

This is your most powerful tool in any negotiation. A well-built cap table lets you:

• Model ownership at each round
• Visualise different exit waterfalls
• Show how terms like liquidation preferences affect outcomes

It helps you argue from data, not guesswork. Use tools like Cake Equity, Carta, or a good spreadsheet model to test different funding and exit scenarios. This helps you see the real-world impact of preferences and dilution. 

Special Considerations in Australia

Raising capital in Australia comes with its own regulatory nuances. Make sure your term sheet and final documents account for:

• ASIC compliance: Unless you’re willing to issue a prospectus (hint: you’re not), your capital raise needs to qualify under one of the disclosure exemptions in the Corporations Act 2001 (most commonly, you will be relying on the 20/12 rule or the sophisticated investors exemption).
• FIRB approval: If your investor is a foreign person, you may need approval from the Foreign Investment Review Board before the investment is completed.
• Tax and ESOP: If you’re offering equity to employees, make sure your ESOP complies with Australian tax rules, especially after the 2022 ESS reforms.

 Final Thoughts 

Term sheets may seem short and informal, but they’re one of the most important documents a startup founder will sign. They shape your company’s ownership, control, and future funding options. Take the time to understand them, get good advice, and negotiate terms that support your long-term success.

If you have any questions about term sheets or capital raises or need any advice on business matters, get in touch (Schedule free consultation) with our experienced lawyers. Reach out to us today for practical, founder-friendly legal advice.