We received a term sheet from an angel investor. Now what?

How did the founders get down to only 40% in the first place?

Dissolve your "startup" and try again. This time try understanding equity/angel/venture funding. 40% ownership after a seed round is laughable. Heavy handed investing in the first two rounds (seed, A) will kill a company before it even starts. You messed up, research more next time.

While I don't know what sort of legal agreement you have with your original investors, generally speaking once you've taken money from someone and used their money to build out your idea you can't simply liquidate the company and start it over again with a new name as a means to reset your ownership. It's essentially fraud and if it were that easy to do you'd have a lot of entrepreneurs trying to screw seed investors.

Rather than beat you up over a decision made early on, let's focus on understanding your options:

1) You can ask existing investors to refresh your ownership as a condition of liquidity for them. They want liquidity. You have leverage. Tell them a deal can't be reached unless they give up some of their equity to the founders as new investors think the current structure doesn't adequately incent you to perform.

2) Ask for a refresh as a condition of the new money. If the new money really wants in they will want to make sure interests are aligned and may refresh your options a bit.

There are probably other options as well but these two were top of mind. Good luck.

You said it's fraud to liquidate and start over, but I watched the primary investors in Lineo in Utah put it up for auction and then bid for it, screwing all the other investors out of every dime they put in.

No one else would/could bid because they would be holding nothing if they got it.

It's dirty business and I'm not advocating it, but I don't see anyway to stop that, do you?

Other companies have done something similar to this to jettison toxic waste sites from their company.