Close the deal quickly, negotiate and settle important points in advance. Here's what Vakilsearch has to say about term sheet negotiations.
It can be overwhelming when you receive a term sheet for a full preferred stock financing from a VC. When you are unfamiliar with the terminology, you don’t have experience living with it over long periods of time as well as across multiple companies and situations. Professional advisors like us can help here. This article aims not to go into detail about specific terms that might appear on a term sheet negotiation. Instead, it provides a general overview of the types of terms that are more relevant. You will be able to focus on the important points so that deals can move more quickly, and people will not get bogged down on minor points, wasting time and legal fees.
What Is a Term Sheet?
A term sheet is a legal document that outlines the terms of a deal between two parties. It is usually signed between an investor and a company they are interested in helping finance. Still, it can also be used by parties looking to attract other investors or potential partners (more on this later). A term sheet is a concise legal document that explains how much money the investor is willing to invest in your company. The amount can vary depending on several factors, such as your company’s growth and the investor’s perception of its viability. Terms and conditions can cover everything from how your company will be managed going forward to how much equity the investor is willing to provide and what happens if your business doesn’t meet expectations. The most important aspect of a term sheet is that it lays the foundation for a strong working relationship.
How to Create a Term Sheet?
The first step to creating a term sheet is understanding your ideal investor. You can use several resources to get this part right, but the easiest method is to ask. You can also use industry research to understand your ideal investors and what questions you need to ask to court them successfully. You can tailor your questions to the type of investors you want to meet.
Still, we recommend looking into the general questions:
- Where do you see your company in five years?
- What are your top three goals?
- What is your biggest competitor?
- What are your biggest challenges?
- What’s next for your business?
- What’s your Target market?
- What makes your business appealing to investors?
Critical Skills for Negotiating Term Sheets
Many people think of Term sheet negotiation as a one-on-one deal between the two parties. Still, in reality, most deals are mediated by a team. You’ll likely be working with lawyers, financial experts, and other executives who will all have a say in the final terms of a deal. If you want to get the most from your Term sheet negotiation, you need to learn to play nicely with others. That’s where key skills like negotiating with leverage come into play. With leverage, you can play against the other side and make them overpay or settle for less than you’re worth. If you can’t win on your own, you need to find someone who does so you can partner up and share the spoils.
Following the ‘Rule of Three’ Is a Good Rule of Thumb.
How Does the Rule of 3 Work?
Focus your energy on three issues for Term sheet negotiation. There might be more (or less). There are generally three issues worth arguing about in any term sheet. However, you may identify more than three issues that are important to you. It would be best to work with your advisors and teammates to identify the critical things and then focus on those.
What Are the Reasons for Following This Advice?
You may lose credibility with the VC if you accept the term sheet negotiation ‘as is’ without negotiating the important issues. Founders’ actions during this phase can significantly impact the relationship in the future. Prove to the VC that you will stand up for the important issues. If your positions are fair, the VC will not be surprised that you raise important issues.
Conversely, suppose you argue endlessly about every point, many of which are primarily unimportant. You will appear inexperienced, and the parties will lose focus on what really matters. Demonstrate to the VC that you will stand up for the important issues and that you are knowledgeable about the important issues.
For example, in a convoluted merger and acquisition negotiation or commercial deal, the parties engage in tactics such as bringing up red herring issues to keep attention away from more important ones. In contrast, an investment transaction is fundamentally different from a merger and acquisition transaction in that the parties must work together intensively after closing, and an alignment of interests is essential. So, focus on the key points and resolve them quickly, and close the deal so you can focus on building the company.
Consult a trusted advisor or lawyer who understands startup issues if you’re not comfortable with the terms. Read the latest articles of Vakilsearch for a better understanding of the process.
What Are the Important Issues?
Here are some of the most common terms that are worth negotiating. This is not intended to be an exhaustive list of all term sheet provisions. There are a lot of helpful resources on the web that describe in detail the various term sheet provisions (for example, How long does it usually take to make a term sheet).
- Valuation/Dilution: Obviously, this is one of the most important issues, although it is not legal. There is a lot of information available on the Internet. Be sure to understand the impact of including the option pool in the fully diluted pre-money valuation. Consider valuation in the context of the investor. In some cases, a lower valuation from a great investor may be better than a higher valuation from a lousy investor.
- Liquidation Preference: A legal issue is often mistaken for a business issue and is often glossed over (at the risk of your business). An investor’s liquidation preference defines the return they receive when the company is sold. It can significantly affect the founder’s return. Model out the expected exit values to understand the actual dollar differences between the liquidation preference formulas. Also, remember that terms in series A often carry over into series B and beyond. Therefore, you should be careful what you agree to here, even if it seems relatively harmless at this stage.
As a result of the fact that series A terms carry over into later rounds (and sometimes negatively affect series A investors in those rounds), they can often be used as leverage against their inclusion. An investor might not realise a meaningful additional return at the exit with a ‘participating preferred’ for a small seed round (at least in absolute dollar terms). Still, it would be painful to the founders if all future rounds included participating preferred stock.
- The makeup of the board of directors: Governance of the company and the composition of the board of directors will be important going forward. A typical arrangement following an initial equity financing would be a three-person board with one investor representative and two founders serving as representatives of the common stock. As you might imagine, there are many variations on the theme. Some companies have one or more independent directors (meaning directors who do not own any equity in the company or have any other material interest in it), making the analysis of the ‘balance of power more complex.
For early-stage boards, it’s a good idea to have investors’ and common holders’ representation reflect the relative control of the cap table. It is vital to have a constructive discussion about board composition with the VC to ensure that everyone is aligned on the company’s governance going forward. Control of the Board can also affect thinking about other issues, such as vesting.
- Protective provisions: Investors usually get a set of ‘protective provisions’ (also called ‘veto rights’) over certain corporate decisions. Some of them aren’t as controversial (especially early on in a company’s growth and financing) – like a veto right on dividends or modifying the rights of the stock issued to the investors – and some are more important, like veto rights on future financing or sales. You should carefully study these and talk to your lawyer or other advisors, as there are traps for the unwary. For example, a veto right on future financings. In the relevant right, it does not say ‘no financings without our approval’ – it says something like ‘no new series of stock without our approval’ or even ‘no amendments to the certificate of incorporation without our approval.’
- Founder Vesting: Understanding this area is critical from the founder’s perspective. A few essential points to understand include
(i) when vesting commences,
(ii) does vesting accelerate upon termination without cause, and (iii) whether vesting accelerates (in whole or in part) when there is a change of control or termination of employment without cause within a specific period of time after (and sometimes before) a change of control (so-called ‘double-trigger’ acceleration).
- Anti Dilution Protection: Most VC deals in the United States include anti-dilution protection to protect the VC from future sales of preferred shares at a lower valuation. The types of anti-dilution protection determine the degree to which the VC is protected. Move on if it is ‘broad-based anti-dilution protection’. Talk to your lawyer if you see the phrase ‘full ratchet’.
- Exclusivity: It is typical for the only binding part of a term sheet to be a restriction on talking to other investors for a certain period of time after signing it. The VC will be paying your lawyers to draft documents and perform due diligence on your company, so this is a reasonable request. But be sure the period is not too long – 30 to 45 days is usually plenty of time to finalize a VC investment.
What Can Go Wrong When Negotiating Term Sheets?
As with most things in life, there are dangers and risks when negotiating term sheets. One of the most significant risks is miscommunication. If one party is unclear about the other party’s expectations, the negotiation will be long, challenging, and unsuccessful. Miscommunication can occur in a few different forms and can happen at any stage of negotiations.
Here are a few examples: The other party doesn’t understand the terms you’re using. The other party doesn’t seem to understand the terms you’re using. The other party is trying to get more out of the deal than you’re willing to share. The other party asks you to do things you haven’t already agreed to do.
Negotiating term sheets: takeaways
If you’re reading this, you’re probably an experienced negotiator and already know how to set the table in your negotiations properly. But just in case, let’s look at what term sheets are and how they can help your startup grow its business. A term sheet is a legal document that outlines the terms of a deal between two parties. It is usually signed between an investor and a company they are interested in helping finance. Still, it can also be used by parties looking to attract other investors or potential partners (more on this later). Terms are the key to any negotiation, and when establishing terms, you’ll want to make sure both parties are on the same page. If one party is unclear about their expectations, the term sheet negotiation will be long, hard, and unsuccessful.
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