Here’s a common set of angel-investor questions regarding a standard seed round term sheet for a tech company:

1. Why are the shares divided into preferred and common?
2. Why does the preferred stock have a limited “1x” return?
3. What will happen with liquidation preferences in future rounds?
4. What will happen with dividends?
5. Does the preferred stock have to convert to common to get more than its money back? Why? How?
6. Don’t these restrictions make preferred shares seem less “good?”

The short answer is that this is a standard seed round term sheet that balances all the issues in a reasonable industry-standard way that won’t hamstring follow-on rounds. What that means is that venture investors, and also their lawyers, expect to see companies with a structure that is within the normal variation of such things. The standard, as I’ve written before, is to see a Delaware C-corp with a reasonable division of equity among the founders, some sort of vesting, a clean balance sheet, and a reasonably clean cap table overall. Complications on any of these points can arise, and some variation is certainly common, and some variation is actually meaningful, purposeful, and beneficial to the company.

Of course there are two positions on each of these kinds of issues, but if you think about contracts as mechanisms for transferring risk from one party to another, then some structures make less sense because they’re economically inefficient by  not assigning a risk of loss to the person best able to prevent that loss.

Here are some longer and more precise answers:

1. Preferred and common shares — this is the traditional structure for venture-financed companies. The two classes of stock help fine-tune the relationship between the investors and the founders in light of the risk/rewards appropriate for each. Preferred stock allows certain holders, i.e., the investors, to receive their investment back before any return accrues to the other holders, i.e., the founders. This is the general practice. The use of preferred stock also provides other high-level protections to investors even if they own less than a majority of the company, which would not be the case if they only held common stock; there are similar protections for founders holding common stock even if the preferred stock holders own a majority of the company on a fully diluted basis.
2. The upside on the preferred shares is not limited. It is a 1x non-participating preferred. This means that the preferred stock holders have an option in the event of a liquidation event of some kind: (a) take their money back or (b) convert to common stock. The choice means that holders of preferred stock will, in the event the company is sold very early, not face a situation where they lose money and the founders make money.
3. It is the company’s goal, and standard in the tech industry for venture-financed companies, to maintain the 1x non-participating preferred structure. Whether those terms would vary in the future for a round of venture financing with particular investors cannot be determined. But the protections of current preferred stock holders to approve certain additional issuances of preferred stock generally acts to prevent unfair future sales of stock.
4. It is the company’s goal, and standard in the tech industry for venture-financed companies, to not actually declare and issue dividends. The basic assumption is that at the discount rates implicit in angel and venture valuations, it makes more sense for the relatively small amount of cash that dividends would represent to remain invested in the company for a far greater return. Also, since few early stage companies are producing cash, dividends are generally not distributions of free cash flow but just a deduction from cash on the balance sheet. That’s a very different corporate finance strategy, one that most startup CFOs would not suggest. The same points as it #3 regarding future rounds apply here except that dividend provisions rarely change; liquidation preferences are more likely to be different from round to round.
5. Yes, conversion to common is generally deemed to occur immediately prior to the closing of the liquidity event, e.g, a merger or IPO. The specifics are spelled out in the transaction documents; the general format can be seen in the Series Seed documents linked below.
6. Preferred shares are always thought of as better because they are protected on the downside. See Fred Wilson’s example in his post linked below for the basic scenario in which preferred stock investors are protected. As a general rule of thumb, in the absence of particularized 409A valuations, common shares are thought to be “worth” approximately 10% of the value of preferred shares; this ratio reflects the partial protection against downside risk that is the preferred return.

Some links:
Series Seed documents

Fred Wilson of Union Square Ventures discussing the liquidation preference: he discusses the point often on his blog; it could be helpful to read his comments.