Episode Summary
Executive Summary: In this episode of 'This Week in Startups,' host Jason Calacanis and Becky DeGras, a partner at Wilson Sonsini, discuss the importance of term sheets in startup fundraising. They cover the purpose of term sheets, the seriousness of signing one, the typical due diligence process, common deal-breakers, and key economic vs. control provisions. The conversation emphasizes that term sheets are sacrosanct, good governance is essential, and founders should get legal counsel early to avoid costly mistakes.
Main Topics: Purpose of a Term Sheet (Priority: 5/5): A term sheet outlines the key terms of an investment, such as valuation, investor rights, and board seats. It serves as a preliminary agreement to align expectations before expensive legal documentation begins. Sanctity of a Signed Term Sheet (Priority: 5/5): A signed term sheet is considered highly binding in the startup ecosystem. Walking away without a valid reason damages an investor's reputation and can sink a startup. Exceptions exist when major undisclosed issues are discovered during legal due diligence. Due Diligence Process (Priority: 4/5): Due diligence has two phases: business diligence (product, team, customers) conducted by the investor, and legal diligence (IP, contracts, cap table) often done by lawyers post-term sheet. Legal diligence can uncover cleanup items but rarely kills a deal unless fraud or a major lawsuit is hidden. Common Deal-Breakers in Diligence (Priority: 4/5): True deal-killers are rare (about one every five years for series A). Typical deal-breakers involve fraud or significant undisclosed lawsuits. Cleanup issues like missing IP assignments are common and do not stop deals. Economic vs. Control Provisions (Priority: 5/5): Founders should focus on understanding the fully diluted cap table rather than just the pre-money valuation. Control provisions like board composition are important but should be balanced; for early-stage companies, a three-person board (two common, one investor) is typical. Importance of Legal Counsel and Hygiene (Priority: 5/5): Getting a lawyer involved early is crucial to understand term sheet implications and build a pro forma cap table. Good governance practices, including regular board meetings from the start, prevent future lawsuits and make companies more attractive to investors.
Key Arguments: A term sheet is a simple document that establishes a meeting of the minds before legal costs escalate. Signing a term sheet is a serious commitment; investors rarely back out (less than 1% of cases), and doing so harms reputations. Startups should disclose major issues (e.g., lawsuits) upfront to avoid appearing fraudulent during due diligence. Founders should unpack the pre-money valuation to account for option pools and convertible notes—use a pro forma cap table. Good governance via an odd-numbered board (e.g., 3 members) is recommended from the start to avoid deadlock and build skills. Using cap table software (e.g., Captable.io) helps founders become better negotiators. Legal spend early on (a few thousand dollars) can save millions later by avoiding structural mistakes.
Data Points: Legal cost to originate a term sheet: hundreds to low thousands of dollars - Cost incurred by the investor before signing. Likelihood of a signed term sheet not closing: less than 1% - Estimated by Calacanis for reasons other than fraud. Diligence cost for a Series A deal: $10,000 to $15,000 - Legal diligence costs incurred by the investor after the term sheet. Frequency of deal-killing issues in Series A: approximately once every 5 years - According to DeGras's experience as a lawyer. Early-stage board size recommendation: 3 members (e.g., two common, one investor) - Prevents deadlock and is simpler than adding an independent director too early.
Pivotal Quotes: "If you don't have a meeting of the mind at the term sheet stage, and you start paying more money to actually put the documents in place, it's going to cost you a whole lot more." — Becky DeGras: Explaining the value of a term sheet as a cost-saving alignment tool. "When you have a term sheet in front of you, you should get a lawyer involved... a couple of thousand dollars in legal work could save you millions to tens of millions to hundreds of millions of dollars down the road if you did it wrong." — Jason Calacanis: Emphasizing the importance of early legal counsel despite cost concerns. "If you start getting that reputation among founders, I think you're going to have a hard time actually getting a term sheet signed and getting folks interested." — Becky DeGras: On the reputational damage to investors who back out after signing a term sheet.
Implications: Founders must treat term sheets as binding commitments and engage legal counsel early to avoid costly mistakes. Cleaning up governance and cap table hygiene from the start increases credibility and reduces friction during future funding rounds. A balanced approach to control provisions (e.g., 3-person board) fosters trust without sacrificing founder autonomy.
About This Week in Startups
Jason Calacanis covers startups, tech, markets, media, and all the hottest topics in business and technology. He also interviews the world’s greatest founders, operators, investors, and innovators.