Ask HN: Is there a good way to nullify a term sheet?
That is, how can a founder get out of a signed term sheet in a way that saves face / social capital?
Anyway, unless you have some non-standard term sheet, I do not think you have to worry so much as long as you are honest and up front. If you approach this properly it won't hurt you or your company, it is business not personal. Many, maybe most, investors would take a better deal in 3 seconds flat if they got one before the final docs were signed and money wired, founders have to remember that and look out for their company and their team. I have seen investors back out after docs are signed but before money is transferred. Could a startup sue them, sure, will they succeed? Probably not and it will waste a shit ton of resources and some investors have counted on that.
Just my 2 cents, but don't try to back out of a term sheet unless you already have a new one in place from someone else on more favorable terms. But also remember, the terms aren't the only factor, the quality and capabilities of the investor should also be considered closely. I'd take a lower valuation from a better investor who I know is more bought in on the success of the company than getting a slightly better valuation with an investor that doesn't have much to offer outside of cash and isn't as bought in.
Assuming this is just a common term sheet, you have to approach them and be up front, doing your best not to burn the bridge. Say something to the order, we appreciate you writing a term sheet and we've had some time to go back over everything with the team and our advisors (or whatever fits here) and while we are super appreciative we don't feel like it is the best situation for our company at this time... Notice I avoided the word "but" in that sentence, that helps because when you say "but" everyone's mindset shifts when you are discussing a deal etc. Hopefully that makes sense.
As in all deal type negotiations, they will likely want to pin you down to why, because if they see you as a valuable opportunity they'll want to try to fix something if they can. If they can't they'll walk. Just be aware, there are a range of reactions you can get, from the toddler being pissed and lashing out, to the professional being understanding and wishing you luck. Generally, from my experience/knowledge it errs more on the side of the professionals. If you get the toddler reaction then that shows they were not going to be a good partner in the first place and should help reinforce your reasoning to walk away.
I will just add this, make sure you have a solid reason to walk away from a fair term sheet. If you don't that can hurt you later on with other investors. This can happen if a new investor asks about any prior term sheets and what happened etc. You should never lie about the situation as the community is too small to get away with a lie for long, and if you have solid reasons it will actually make you a better partner for them, if you have flimsy reasons it may raise doubts or extra questions.
My disclaimer: there are other people that have more experience at this than I do, so my advice is based on what I have seen and what I know but I am not a lawyer nor have I done hundreds of these yet.
Good luck!