Term Sheets Decide Outcomes Long Before Exits

Lou Schwartz, Esq., Managing Member, Schwartz & Associates

Most financing disputes are not about fraud or broken promises. They are about math.

Specifically, how math embedded in a term sheet allocates outcomes when performance does not match projections. By the time a company exits below expectations, the operative economics are no longer intuitive. They are mechanical.

Liquidation preference is usually the first fault line. A seemingly modest preference can consume the entire exit in a sub-optimal outcome. Multiple-of-capital provisions and stacked preferences often determine whether common equity participates at all.

Participation rights compound the effect. Participating preferred can recover capital and then share in the remainder, effectively double-dipping before common sees value. Non-participating preferred aligns incentives earlier, but shifts risk back to the investor.

Anti-dilution provisions operate earlier in the lifecycle. Full ratchet protection can dramatically reprice ownership after a down round, transferring dilution almost entirely to founders and employees. Weighted-average formulations soften the blow but still materially alter cap tables.

Pro rata rights shape control over time. They determine who can maintain ownership and who is diluted out of influence. In later rounds, these rights often dictate who sets terms and who accepts them.

Drag-along rights resolve conflicts at exit, but they also concentrate power during negotiations. Minority holders may be forced into liquidity events they did not choose, under economics they cannot change.

By the time common equity participates, it is downstream of every clause above it. Founders and employees often discover too late that their outcome was structurally constrained years earlier.

Courts rarely intervene in these disputes. The terms are usually clear. The disappointment is not legal. It is economic.

The practical lesson is simple. Term sheets should be read as outcome models, not fundraising documents. They describe who bears downside, who controls timing, and who survives divergence from the plan.

Most exits do not look like the deck.
They look like the term sheet.