Term Sheet Negotiations Done Right

Quick note on the importance/definition of a term sheet

A term sheet is a document that describes how much will be invested in your company, and under which conditions. While term sheets vary for different companies, investors, and even between rounds, there are a few essentials to keep in mind every time you are negotiating a fundraising round.

1. Why you should negotiate with your investors

Each business relationship is also a partnership. Both sides of the table want a reliable and competent partner, as well as someone who will help them achieve their goals. When you negotiate with VCs, you have to keep in mind that they are looking for a good partnership.

How can you show that you’re the best partner for them? In part, by careful negotiation. If you accept the presented terms at face value, you may lose credibility (Do you not value your startup enough to negotiate?). On the other hand, picking apart every detail of your term sheet can make you look inexperienced, and you’ll be losing precious time – time when you could already be working together.

To avoid wasting time and appearing inexperienced, be informed, focus on what’s important, and speak out when something is wrong. Show the VC that you are knowledgeable. Show them that you will stand up for the important issues.

The VC knows which talking points are important, and will not be surprised if you raise them. Just make sure that your positions are fair.

Note: If you’re uncomfortable with the situation and you feel like you’re being taken advantage of, talk with your advisor or lawyer. Clear up the situation first and then decide if you want to proceed with the investment or not.

2. Can you do it alone or do you need a lawyer?

Founders like to save money and avoid high legal fees, but there is a reason lawyers still have jobs. In a word: experience – nothing can beat experience. Startup lawyers have been involved in fundraising, mergers and acquisitions, and other liquidity events. They know what to expect if negotiated rights are exercised.

Lawyers can also help you navigate dense legalese, which can sometimes appear to say one thing, but actually mean another.

When you are wondering later whether the terms for your term sheet are legally binding, a lawyer can help guide you – this is particularly true when dealing with local laws. Bottom line, if you can find yourself a good startup lawyer, don’t let them go.

3. What does a good term sheet look like?

While no one term sheet will be identical to another, there are many common term sheet formats. These include equity financing, convertible loans, and newer convertible loan variations that are used mainly in the USA, such as KISS, SAFE and Convertible Equity.

We looked at our data and discovered some interesting patterns about convertible loans, which you can read here.

For equity financing rounds, your term sheets will have different content than for loan rounds. You can see an example of an equity round term sheet from Y Combinator below.

If you’re a founder, it’s important to know what a good term sheet looks like. Y Combinator has done an excellent job explaining why the term sheet shown above is good for you.

4. Focus on the important provisions

If you are feeling overwhelmed by all of the terms, focus on these 6 first. They are often the most crucial and, importantly, negotiable.

The basics of the investment (who and how much)

When choosing an investor, pick one who shares your values. They will become a part of your (business) life, and have a great impact on your company. An important question to ask yourself is: Are they better than a bank loan? Can and are they willing to help me and give me advice?

Fun fact: In the United States, the average founder-investor relationship lasts as long as the average marriage (1)

How much should you ask for? A good rule of thumb is to estimate your expenses until your next meaningful milestone. For a small company, this might be your beta launch. For a more seasoned company, it could be launching a new mobile app that accompanies your main product. Be sure to include new hires and growth in your estimate.

Statistics fact: The standard equity in return for investment is between 10% and 25%. (2)

Option pools

Option pools are shares that are set aside for a specific purpose – typically for employee incentives. This might not seem like an important negotiation point in a pre-seed round, since option pools probably won’t even exist yet. However, pools can impact valuation and dilution, so it’s important to consider them now.

Pay attention if investors want to consider the fully diluted cap table in negotiations. This would mean that option pool shares that haven’t been issued yet are still included in the calculation of total shares. For the investor to own 10% of your company with option pools included, you have to give her more shares. This dilutes your holdings as a founder. Make sure you understand the basics of pre- and post-money option pools (examples included in the link).

Liquidation preference and participation

Liquidation preferences determine how much money the investor receives before anyone else is paid in a liquidation event (e.g. acquisition, mergers). Pay attention to anything above the standard 1x liquidation preference.

For example, a 2x liquidation preference on a €1M investment would mean the investor receives €2M before anyone else - even the founders.

A 2x liquidation preference on a €1M Seed investment may not seem like much. However, it will be extremely unfavorable if this clause is later carried out on a €50M investment in Series C. That’s bad for you and for other early investors, who won’t see any return until the Series C investor receives €100M.

Participating liquidation preference rights are the double-dipping of the startup world. In short, an investor first receives the guaranteed liquidation preference and then an additional percentage of the proceeds proportional to her ownership.

Let’s say an investor invested €1M with 1x participating liquidation preference for 10% ownership. The company is sold (without any additional diluting events) for €2M. The investor first receives the €1M back (liquidation preference) and then, because she had the additional 10% ownership, she would receive another 10% of the €1M that’s left (participating liquidation preference), for a total payout of €1.1M. Meanwhile, you, with 90% ownership (if you’re the only one holding all remaining shares in a fully diluted capitalization) would receive €900,000, which is just 45%, or half of what you’d expect if you looked at just company ownership.

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Protective provisions

One of the most typical protective provisions for protecting investors is anti-dilution provision. It’s important that you understand how different types are calculated and which one is the fairest and best option for your startup. You can learn more about anti-dilution provisions here.

Another form of protection is the right to veto certain corporate actions. First, avoid giving veto rights to single investors – encourage them to work together by giving them veto rights as a group. Similar to option pools, some veto rights seem trivial in early stages, but they can include well-disguised traps. Consult your lawyer about the consequences of certain veto rights, like future financing.

Accruing dividends

Dividends are to be expected and are often not worth negotiating. The exceptions are accruing dividends. These represent a future additional payout obligation to the preferred stockholder, which will, in turn, reduce funds available for common stockholders.

Accruing dividends allow the startup to delay the dividends payments. However, the accrued amount needs to be paid later at the liquidity event. The accrued value is added to the investor’s total payout amount. If you’re wondering how accrued dividends are calculated you can read more about it here.

Control terms/Board of directors

Control terms relate to the formation of the board of directors. C-executives are a big part of the day-to-day operations, while the board is more concerned with the general oversight of the corporation. For example, the board’s approval is required in order to sell the company or to set up an employee participation plan.

It’s important to strike a good balance between the number of investor and founder board seats. There are usually 3 seats in the beginning. Typically, this means 2 seats for the founders and 1 for the investor representative. It gets more complex when you start adding independent board directors (who don’t hold any equity).

The earlier the stage of the company, the more your board seat distribution should look like your cap table.

The only binding part

Exclusivity or no-shop policy is the only binding part of the term sheet. It means that after signing the term sheet, you shouldn’t go around and talk to other investors while the VC is starting to spend money on lawyers to perform due diligence on your company. It’s usually capped at 45 days.

Note: Just because we say focus on the important things, it doesn’t mean you shouldn’t read the rest of the term sheet.

All in all, the most important things to keep in mind are: inform yourself and choose your investors wisely. No one can predict the future and term sheets are just one of the helpful tools in battling unpredictable and unplanned situations - both good and bad.

Our next post will be an inerview with our investors, keep an eye out for the announcement. And, good luck out there!

Sources

1. Brad Feld & Jason Mendelson, Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist
2. How to raise a seed round
3. CooleyGo

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