Negotiating Term Sheets: Focus on What’s Important when Raising Venture Capital

 By Martin Luenendonk| 2017-08-12T10:00:40+00:00 August 14th, 2017|

Congratulations!

If you’re reading this post because you’ve just been uttered the words “We should start negotiating a term sheet” by a VC, you’re doing great.

Even if you haven’t yet, you’ve come to the right place to prepare for the moment.

Term sheets are one of the most important concepts you need to understand as an entrepreneur. It is a huge guarantee of an investment deal and it can determine how well you’ll do financially in the later rounds and in the case of a sale.

A lot is on the line when it comes to negotiating a term sheet.

So, what does it mean?

Here’s a look at the key concepts, terms and issues you need to focus on when negotiating your startup’s investment deal.

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Term sheets in a nutshell

Term sheets are easy to understand in the sense that they are exactly what the name would suggest them to be: a sheet with specific terms laid down for the investment.

It is essentially a piece of paper outlining the conditions for the investment.

Sometimes a term sheet is referred to as Letter of Intent (LOI) or Memorandum of Understanding (MOU).

A term sheet will include information such as:

  • Company valuation (and whether it is pre- or post-money valuation)
  • The price per share for the investment
  • The economic rights of the new shares

Here’s a look at an example term sheet:

Now, you and the investor will need a term sheet as the investment process progresses further.

If you use the analogy pitching to an investor is like dating, then when term sheets get in the picture things are getting from the proposal point to marriage.

With the term sheet, you agree on the size of the investment and the economic and control rights it will provide.

However, you should also remember a term sheet is generally not legally binding. It isn’t yet the official agreement that will finalise everything.

Indeed, the agreement is more about the confidentiality and it often implies that you as the startup and the investor are going to agree not to talk to others.

Indeed, although the document is often not legally binding and might not result in an investment, you can come face-to-face with a “no shop” clause.

What this means is that you’re not allowed to talk to other VCs as you are negotiating the term sheet.

Therefore, don’t just rush into negotiating the term sheet – be sure you are happy with the VC!

As I mentioned, it’s almost like the engagement preparing you to get married.

But just like you could call off an engagement without much hassle, you can leave empty handed even if you have a term sheet.

So, once you get names into a term sheet, don’t celebrate yet – the road to full investment will continue with due diligence.

The most important thing for a successful negotiation: Know what you want

So, what do you need to know when negotiating a term sheet?

Well, the most important thing you need to start with is something you need to know when you negotiate anything in life: your objective.

You can’t really negotiate if you don’t know what you are looking for from the other person.

How will you know if the negotiating is going well or badly?

You need to start by knowing what you want from the negotiations. What is a term sheet that looks like a good outcome?

You might be thinking you can just wing it based on the VC and their interest.

Perhaps you’re used to negotiating where to go on a date with your girlfriend –and hey, VC relationship was like getting married, right?

No.

Investor readiness checklist

You need to focus because you are dealing with seasoned professionals.

VCs want to invest in order to make a hefty return. This means they want terms that are the most favourable for themselves – terms that give them more guarantees of returns.

You can be sure the VCs know exactly what they want – if you don’t, they’ll probably end up getting a better deal than you.

Furthermore, remember what negotiating is all about.

It’s about compromises.

You won’t be able to win every battle during the negotiations. You won’t receive a term sheet that’s magnificent for your startup (i.e. all the money you need with very little equity lost and no hard repayment mechanisms).

For this reason, you need to know the battles you really want to win and those you’re prepared to give in more easily.

You need objectives – this gives you focus and it speeds up the process.

You know what things you’re willing to concede or the areas you want to discuss in a little more detail.

So, how to set objectives for term sheet negotiations? According to Luissenlabs, you need to figure your Optimum, Desirable and Essential objectives:

Optimum, desirable, and essential outcomes in term sheet negotiations

Your focus should, first and foremost, be in the two main things negotiated in a term sheet:

  • The amount of capital you want to raise, and
  • The amount of equity you are willing to give away.

Once you are aware of the three objectives in terms of the two main issues, you can start focusing on the more nitty gritty aspects – clauses such as drag along and liquidation preference.

It’s not just about you: Understand the VCs perspective

However, you’re not going to be the only one sitting at the table.

As I mentioned earlier, the VCs know what they want from your business.

They’ll probably have a term sheet in mind before they even hear your pitch. Indeed, VCs probably negotiate one to two term sheets every month.

The question then becomes: do you know what they want?

Being aware of what the VC wants will help you in negotiating.

You’ll not only be prepared to understand the desirable objective, but also to prepare yourself better in terms of getting what you want.

Indeed, you can understand your leverage over the VC when you think carefully what they are looking to have.

For example, you might find the sweet spot by comparing the past investments – you’ll learn the kind of equity they want to have for what price. Knowing this could help you pushing up the valuation or increase the investment to the maximum possible point.

Remember, you want to create a good relationship with the investor.

Therefore, the ability to show the VC you understand where they are coming from with their demands and being willing to find common ground will ensure you’re viewed favourable.

You’ll seem like one of the good guys – an entrepreneur that’s skilful and able to negotiate.

A VC doesn’t want a pushover – how can you succeed in the competitive business world if you’d do everything the VC says?

On the other hand, a VC won’t appreciate anyone who’s being unreasonable and unwilling to compromise – you need to be able to show humility; after all, you do need the money to grow, right?

A term sheet negotiation is a great point in showing trustworthiness, talent and business acumen.

Hire a lawyer: But don’t rely on them only

Like all good relationships (read with sarcasm), your marriage with the VC requires a few third wheels.

These are lawyers and they are an integral part of negotiating term sheets.

Your VC will have a lawyer to turn to at each stage and when you start closing in on the investment, you should have one in your corner too.

You want to find a lawyer that’s experienced in term sheet negotiations. If you’re new to the process, you don’t want the lawyer to be!

Now, it’s important to find a trustworthy lawyer – someone who can give you honest advice.

You don’t want to agree to anything the VC proposes without running it through your lawyer. You want to have an expert opinion – a guarantee that you’re not being cheated.

Remember, the VC won’t mind you checking with your lawyers; it shows them professionalism.

Now, when you are hiring a lawyer don’t just pick one randomly.

You’re dealing with seasoned VCs and therefore, you want an experienced lawyer, well accustomed to the world of VC jargon.

While you’ll want to hire law to help you out, you do need to remember one important thing: don’t shift responsibility to the lawyer.

You should know what term sheets are (good you’re reading the post!) with its different terms and concepts.

Ultimately, the lawyer is not responsible for getting the best term sheet for you – you are.

You need to know what your objectives are, what a good and a bad term sheet look like, what different terms mean and what are the pitfalls you want to avoid.

This isn’t just important in terms of preparing you to negotiate the best possible term sheet.

Doing the hard work and learning about term sheets will help you keep the costs down. Hiring a lawyer is not cheap and therefore, by talking to investors directly and getting the lawyer involved only in terms of the finalisation process will help you save money.

Indeed, it is often faster and more cost-effective to deal with issues directly with the VC rather than having your lawyers send the term sheet back and forth.

If there’s an issue you want to talk about, have an honest conversation with the VC about it.

Be on top of the vocabulary: Learn the key terms

So, the above will help you understand how to prepare yourself for the negotiations and what you want to achieve with the term sheet negotiations.

But what about the terms and concepts you need to understand?

There are essentially two important terms: economic and control terms. Below is a chart for the key words you must learn about.

Economic terms

The economic terms refer to the financial side of the term sheet. It’s about concepts that discuss the size of the investment and the possible schedule and the size of the returns.

TERM

DEFINITION

WHO DOES IT BENEFIT AND HOW?

AN EXAMPLE

Price/Valuation The size of the investment and the valuation of the startup:

Notice the difference between pre- and post-money valuation.

Beneficial for both parties, depending on the size of the investment and valuation. You could agree a pre-money valuation of $500k, with an investment of $300k and the post-money valuation of $800k.
Liquidation preference The return the investor receives if the company is sold, merged or in the event of bankruptcy. Protects the investor in case the majority shareholder wants to sell the company or the company is forced into bankruptcy.

Liquidation preference can be hurtful for the startup owner, so you need to pay attention to this clause.

Generally 1x of their investment.

If they invested $50 million for 50% in a $100 million post-money valued company and the company sells for $75 million, the VC will get over 50% of this money.

They’ll first get their investment $50 million. Then they’ll get 50% of the remaining $25 million.

Option pool The size of the equity reserved for future team hires. This will protect the startup, as it gives it an option to lure in talent with the help of employee shares, for example.

Ensures some shares are set aside for making new hires and ensuring the investor doesn’t get all the equity.

An example would be to set aside 20% of equity as an option pool for future employees.
Anti-dilution Provision that protects investors in the event the startup is valued at a lower valuation than in the previous round. Protects the investor because it ensures they don’t lose out in terms of lowering valuations in the future. Another clause that can be hurtful for the startup. Term sheets outline the kind of conversion price that’s used for calculating the price the investor gets in terms of the lower valuation.

Calculation includes full-ratchet, broad-based and narrow-based weighted average.

Dividends The sum of money the startup pays regularly to its shareholders out of profits or reserves. Will benefit any shareholder, as they will gain from the dividends. Can technically be problematic for startup if the size of dividends is not set correctly. An example statement in a term sheet could promise cumulative dividend to the shareholders of the specific round to receive dividends at the rate of 8%.

Control Terms

Control terms focus on the ownership of the startup and the rights both the majority and the minority shareholders have in decision-making and management of the startup.

TERM

DEFINITION

WHO DOES IT BENEFIT AND HOW?

AN EXAMPLE

Participation rights The right of first refusal by the investor to invest in the future financing rounds. Gives the investor the option to choose whether they want to invest in the following round or not – to increase their equity or to ensure another competitor doesn’t invest. In the term sheet, the investor tends to receive an additional pay-out when liquidation preference has been used.
Board of Directors The makeup of the governance of the company. Naturally, a proper board of directors is needed for both.

Generally, the focus is on creating a composition that doesn’t give either party a clear majority and that neutral members are included in the board.

As a rule of thumb, a good set-up would reflect the actual cap table.

A typical example would be to have a three-person board after initial equity round – one investor representative and the two co-founders.
Voting Rights A right of approval for investors over actions the startup might take and which might be harmful for the investor. Protects the VC more and guarantees they are able to have a say if the startup would make a decision which could directly affect the rate of return. Outlining when the investor has the right to vote – either as a member of the board or due to the nature of the issue being discussed.
Information rights The right to receive certain company information, including financials, performance metrics and so on. Ensures the investor knows how the company is doing.

In order for the company to protect itself from providing sensitive information, the information rights tend to require a minimum amount of purchased shares.

Similar to the above, it’s added to outline the specific situations under which the investor can obtain information from the company.
Drag along Assures that in the event of the majority shareholder selling his stake, the minority shareholders are forced to join the deal (with pre-fixed price). Can help guarantee the company is sold when there’s a lot of fragmentation. The clause generally just agrees that the stock holders or founders agree to a sale or liquidation if the round’s majority investor wants it to happen.

In terms of the most important focus points, you should pay extra attention to negotiating and understanding the following points:

  • The valuation,
  • The liquidation,
  • The set-up of board of directors,
  • The protective provisions,
  • The anti-dilution protection, and
  • Any mentions of exclusivity

On the other hand, topics you must understand, but not pay as much attention to include:

  • The information rights,
  • The dividends,
  • The rights of first refusal, and
  • The tag-along rights.

Focus on your strengths: Always negotiate with leverage

When you’re thinking about your desired objectives, you should also focus on thinking about your strengths.

You ideally want to enter discussions about term sheets after you’ve pitched to a few different investors and you’ve understood what investors love about you.

Furthermore, talking to a number of VCs will help you focus on leverage – you can negotiate a much better term sheet when you know you’re not relying on this single VC to invest.

Indeed, VCs will want to seal the deal quick before competition, which could mean you attract better terms.

If the investor feels like they need urgency in sealing the deal (and they love your passion and product), they might be able to give you more concessions than the other way around.

Remember the famous saying: don’t put your eggs in a single basket.

As an interesting thing to keep in mind, take note of what the entrepreneur and VC Mark Suster wrote when talking about his unique way of negotiating a term sheet.

He and his co-founder teamed up for a day in a room to draft the term sheet together to avoid delays. During the unique negotiations, the VCs used the following line:

“In all the 50 deals we’ve seen in our portfolio we’ve never seen this term approved.”

This to Suster is a line you need to take with a grain of salt. He writes:

“Please don’t fall for that line. Either the point makes sense or it doesn’t. I have seen VCs hide behind this “we’ve never done it before” line many times”

Final word of advice

Term sheets can be rather complicated.

You do want to spend a bit time on understanding the concepts.

Spending time leaning the above concepts and browsing template term sheets will help you prepare for the negotiations.

What are the most important concepts for your business? Do you think there’s something you don’t quite understand?

You can ask questions here, contact lawyers or talk with other startup entrepreneurs to enhance your knowledge.

The key thing you need to remember is that both you and the VC want to come out with a good deal – the fact an investor has offered you a term sheet means they are serious.

You’ve not yet landed the investment, but you will after a successful negotiation.

Therefore, maintain a positive attitude throughout the process. Focus on the important points for you, keep communicating with the investor instead of outright rejections and don’t be afraid to ask help.

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