The AI Founders Simple Guide to Understanding Term Sheets

We've all been there, staring at that dense document, the term sheet, feeling like we need a translation layer just to grasp the basic economics of our own creation. As engineers and builders, we're focused on the technology, the architecture, the next iteration of the model, but ignoring this piece of paper can lead to architectural flaws in the business structure itself. It's not meant to be opaque, but the language used often feels deliberately designed to obscure rather than clarify the distribution of control and capital.

I spent a good chunk of last week poring over a recent pre-seed agreement, trying to map the preferences back to the cap table structure, and it struck me how much of the future valuation hinges on decisions made right here, in these initial, seemingly administrative, clauses. Let's strip away the legal jargon and look at what actually dictates who gets paid what, and when, because understanding the mechanics of liquidation preference is non-negotiable for any founder serious about their equity.

Let’s pause for a moment and reflect on the liquidation preference. This clause dictates the waterfall—the order in which capital is distributed if the company is sold, especially if the sale price is modest. Most standard agreements feature a 1x non-participating preference, meaning the investor gets their initial investment back before common stockholders (the founders and employees) see a dime. If the company sells for exactly the amount the investors put in, the founders get nothing, which seems harsh, but that's the baseline protection for early capital deployment risk. Now, things get trickier with participation rights attached. Participating preferred stock means the investor gets their 1x back *and then* shares in the remaining proceeds pro-rata with the common stockholders. That effectively doubles their take in a low-to-mid range exit scenario, severely diluting the return pool for the team that actually built the product. I’ve seen founders agree to 2x participation simply to close a round quickly, only to realize later that this structure makes achieving a meaningful outcome on a $50 million exit nearly impossible for them personally. We must treat the participation structure not as a footnote, but as a fundamental determinant of our eventual payout profile.

Another area demanding close scrutiny is the structure of control provisions, specifically board composition and protective provisions. Board seats are often allocated disproportionately early on, reflecting the capital provided, but we need to look critically at what veto rights the preferred shareholders gain. Protective provisions list specific corporate actions—like selling the company, taking on substantial debt, or amending the charter—that require the preferred shareholders' separate approval, often needing a supermajority vote of just the preferred class. If the investor group holds a majority of the preferred shares, they effectively control the company’s fate, regardless of the common share count. This isn't about malice; it's about risk mitigation for the capital source, but founders must ensure they retain operational autonomy to pivot or hire key executives without constant external interference. Furthermore, pay close attention to anti-dilution provisions; full ratchet mechanisms are excessively punitive, protecting the investor against any future financing round priced lower than the current one, effectively wiping out the value of subsequent option pools if a down round occurs.