Securing an investment offer from a venture capital firm can feel like a significant milestone, especially following a challenging journey to that point. But it’s critical to understand that the headline valuation on the table is not the number that will end up in your bank account.
Glen Waters, head of early-stage tech and life sciences banking at HSBC Innovation Banking UK, notes that a venture capital term sheet contains far more than just pre- and post-money valuations.
“VCs are minority investors. It is typical for an investor to want preference shares, which allow them to assert a level of control over the company as well as limit financial exposure,” he says. “They allow the investor to be paid first on a liquidity event when proceeds are being distributed — and if things don’t go well, this class of shares means the VC will at least get their money back before ordinary shareholders see anything.”
Founders, meanwhile, are typically issued ordinary shares.
“The key economic rights attached to preference shares should be set out in the term sheet,” says Waters. “This allows a founder to model out the ‘waterfall’ payout structure so called because of how distributions spill over from one class of shareholder to another, down the cap table.”
This payout hierarchy can have stark consequences.
“Depending on the company’s valuation in a liquidity event, some shareholders may receive a larger return than others — and if a founder hasn’t done their waterfall modelling, doesn’t know what to look out for and hasn’t appreciated the risks embedded in the deal structure, then that can leave a founder receiving a payout far less than they expected,” adds Waters.
The type of preference shares offered can also vary — and early terms often set the tone for all future fundraising. Later investors tend to build on the framework already established, rather than creating new rules from scratch.
This is why, after the valuation, the liquidation preference attached to the waterfall is the most important economic term in the term sheet. It can be considered the other side of the coin to valuation. So what should founders look out for?
Understanding payout structures and best practice
Earlier this year, HSBC Innovation Banking released its Venture Capital Term Sheet Guide 2025, an analysis of 588 term sheets issued to startup and scaleup founders in 2024. These represented 33% of UK deal volume and 40% of UK deal value, according to Pitchbook.
If a founder hasn’t done their waterfall modelling, doesn’t know what to look out for and hasn’t appreciated the risks embedded in the deal structure, then that can leave a founder receiving a payout far less than they expected.
The report lays out the main components of preference shares. There is the participation and the liquidation multiple. The participation element can be divided into the following:
Non-participating. On a liquidity event, the investor has the option of:
- the amount invested multiplied by the liquidation multiple, plus any unpaid dividends or
- to convert the preference shares into ordinary shares and participate as an ordinary shareholder.
Participating (preferred). On a liquidity event, the investor receives the amount they invested multiplied by the liquidation multiple before anything is available for distribution to the ordinary shareholders. Then the investor receives their pro-rata distribution of the remaining proceeds alongside the ordinary shareholders. This is known as the ‘double dip’: the investor gets their money back through the liquidation preference, then also shares in the upside with ordinary shareholders — meaning founders only see their share once both payers are satisfied.
Liquidation preferences have a multiple attached. For example, 1x or 2x. This means the preferred shareholder — usually the VC — gets their original investment at that multiple before the shareholders below them in the priority stack — the order in which the preferred shareholders get paid out.
What to watch out for
Waters says founders should be ultra-wary of term sheets that give participating preferential share stock to the VC and should try to avoid them.
“Apart from the real risk to founders, especially at seed or Series A, of ending up with a very small return, being locked into a preference stack of participating shares at various multiples can kill morale, as your employees will realise their options are not worth very much,” he says. “Share options can be a good tool to attract top talent — and equally put them off if the structure you’ve agreed is unattractive.”
For founders who are lucky enough to receive a few different offers, create a table of the key economic and participation clauses in each term sheet and compare them side-by-side for clarity.
Chris Smith, managing partner at London VC fund Playfair, which focuses on pre-seed investing, agrees: “Founders shouldn’t be agreeing to a deal with a waterfall structure of anything other than 1x non participating preference in the term sheet. This is fair to the VC and keeps things straightforward for the founder.
“The way I think about it is this: founders are driven by their mission and passion. I want the founders I invest in to be going to sleep at night dreaming of the payout they will receive one day upon the sale of their business or IPO. How can they have those dreams if they need a spreadsheet to calculate this because their waterfall model is so complex? This is not how VC is meant to operate.”
The good news is that 1x non-participating preference is the market standard. HSBC Innovation Banking’s Venture Capital Term Sheet Guide 2025 shows that 87% of term sheets analysed featured preference shares that were non-participating, and the 1x liquidation multiple was the most common multiple for both non-participating and participating structures.
Smith adds: “Founders can get excited by high valuations not realising that a VC may be inserting a structure to ensure their returns are acceptable. I’d generally advise founders to consider a lower valuation with a simpler structure that is more likely to lead to better long-term returns or even leave the deal on the table and go back to bootstrapping rather than get tied up in knots.
To scaleups looking for funding, keep your head and try to keep away from any term sheet that has a deal structure not aligned with your interests.
“For founders who are lucky enough to receive a few different offers, create a table of the key economic and participation clauses in each term sheet and compare them side-by-side for clarity.”
Waters advises founders to make sure that the term sheet includes a cap table and to get their lawyers or advisers to create a waterfall analysis that takes the cap table and evaluates the distribution of proceeds to the different shareholder classes, different liquidation preferences and priority stake during a liquidity event at different exit scenarios.
For example, Carta has created a free exit simulator tool for the UK market, which is available here.
“Our latest term sheet guide shows that actually later stage deals are being executed on more structured, investor-friendly terms than at seed stage, where investors are competing to get a piece of the AI action — and so I’d say to scaleups looking for funding, keep your head and try to keep away from any term sheet that has a deal structure not aligned with your interests,” says Waters.
Read more about the latest term sheet practices, negotiation strategies for founders and UK VC fundraising trends in HSBC Innovation Banking’s Venture Capital Term Sheet Guide 2025 here.
