Investment Terms: What You Must Understand Before Signing

This article explains the core concepts in direct language. It doesn't replace legal counsel — it makes your conversation with counsel shorter and more useful.

1. Three instruments

The convertible instrument (SAFE). An agreement under which the investor pays an amount today in exchange for the right to receive shares at a future priced round. It defers the valuation negotiation, making it fast and inexpensive — hence its popularity at early stage. It isn't debt in origin: no interest, no maturity date.

The convertible note. Similar in purpose but different in nature: it is actual debt, carrying interest and a maturity date, and repayment may be demanded if no conversion event occurs. Heavier on the company and more protective of the investor.

The priced equity round. Agreeing a valuation today and issuing shares directly. More complex and costly, and the standard form in larger rounds.

2. Valuation cap and discount

A convertible instrument typically carries one or both mechanisms:

• Valuation cap: a ceiling on the valuation at which the early investor's money converts, rewarding them for entering early if the next round prices above the cap.
• Discount: a percentage reduction on the next round's share price.

Where both exist, whichever is better for the investor usually applies. The founder should calculate the actual number of shares that will be issued on conversion rather than looking only at the amount raised — accumulating several instruments with low caps can produce sudden, substantial dilution at the priced round.

3. Pre-money and post-money

• Pre-money: the company's value before the investment.
• Post-money: pre-money plus the investment amount.

Investor's stake = investment ÷ post-money valuation. Confusing the two in a verbal agreement is a recurring source of later dispute — make sure which is meant is written explicitly.

4. Dilution

Every new share issuance reduces your percentage. This is normal and not necessarily harmful: a smaller share of a much larger company beats a larger share of a small one.

Watch two sources of dilution that are frequently overlooked: the employee option pool, which investors sometimes require be created or expanded before the round — meaning existing shareholders absorb its effect alone — and the conversion of prior instruments. Always calculate ownership on a fully diluted basis rather than on outstanding shares.

5. Liquidation preference

The clause determining who recovers their money first when the company is sold. The standard, moderate form is a 1x non-participating preference — the investor chooses either to recover their investment or to convert and share in the distribution, but not both.

Heavier forms — a multiple preference, or a participating preference where the investor recovers their money and then shares in the remainder — change the exit outcome fundamentally in their favour, and can leave founders with very little even in a sale that looks successful. This is the single most important non-price clause in any term sheet.

6. Other significant rights

• Anti-dilution protection: protects the investor if a later round prices lower. The broad-based weighted average formula is the common and more balanced version; full ratchet is harsh on founders.
• Protective provisions: a list of decisions that cannot be taken without investor consent (selling the company, issuing a new share class, changing the business). Review its length carefully — a long list means a genuine block on management.
• Information rights: an obligation to report periodically. Normal and useful to both sides.
• Board seat: deeper control. Customarily begins as observer rights at early stage.
• Pro-rata rights: preserve the investor's percentage through additional participation.
• Tag-along and drag-along rights: govern what happens when large stakes are sold, and prevent a minority blocking a sale.
• Founder vesting: typically required by investors, and in the interest of the remaining founders as well.

7. How to read a term sheet

Read it in order of impact rather than order of pages: liquidation preference first, then protective provisions, then anti-dilution, then valuation and amount. Then model two scenarios — an excellent exit and a modest one — and see what remains for each party in both. That simple calculation reveals the effect of these clauses better than any explanation.

Common mistakes

• Focusing on valuation and neglecting terms. A high valuation with a participating preference is worse than a moderate one with clean terms.
• Ignoring the cumulative effect of convertible instruments.
• Accepting a long list of protective provisions that blocks day-to-day decisions.
• Overlooking who bears the creation or expansion of the option pool.
• Relying on a template without specialist legal review.

Pre-signing checklist

• Instrument chosen with its nature understood
• Cap and discount clear, with their effect calculated numerically
• Explicit statement of pre- or post-money
• Ownership calculated on a fully diluted basis
• Liquidation preference and its type reviewed
• Length of the protective provisions list reviewed
• Anti-dilution formula understood
• Two exit scenarios modelled
• Independent legal review

FAQ

Is a convertible instrument better than a priced round?
Faster and cheaper at early stage, but accumulating them without modelling produces unexpected dilution.

What is the most dangerous non-price clause?
Liquidation preference in its participating or multiple form.

Are terms negotiable?
Yes, particularly the non-price ones. Interest from more than one party improves your position more than any argument.