This post is the third in a series discussing term sheets and fundraising processes. In the prior two posts, we provided an introduction to the negotiation of term sheets and interviewed our investor Cédric Köhler about his experience on this topic. This post will tackle why term sheets exist, alongside a Q&A with our investor Andreas Goeldi, from btov Partners.
Why use a Term Sheet?
It turns out there is no law that requires you to use a term sheet. The Venture Deals book reminisces about deals where the VC and startup would agree on a valuation, board seats, and employee pool size over email.
This approach may look attractive to the startup and VC, but nowadays the reality is that the investors behind the VC fund would not agree to giving money away without legal documents protecting their investment. What’s more, these other legal documents will need to be created, regardless of whether a term sheet is a part of the deal.
Legal documents are a part of the startup life so we thought it might be helpful to point out some good reasons for why contracts exist.
As we discussed in the first part of the series, both the investor and startup strive to be good partners in the relationship – be it for the sake of a business partnership, monetary incentives, etc.
However, good intentions alone can’t legally ensure that the parties behave in each other’s best interest. This is why contracts were introduced. They enforce good behavior, even if something goes wrong.
For example, let’s look at employee equity plans in an acquisition. Every party involved (investors, employees, and founders) will have very different interests. Something that benefits the investors will result in less favorable terms for everyone else involved. If the investors want more equity ownership, everyone else ends up with less. It’s important to deal with this upfront and agree on the terms beforehand.
In some situations the founders’ and investors’ motivations don’t align. When this happens, if there are no legal documents in place that describe what to do, the easiest thing for both parties to do would be to disregard one another.
There are terms in the term sheet that can help alleviate this conflict, such as adding a board seat for the investor, or requiring an odd number of board members. These measures can facilitate decisions in case of disagreements, with the goal of enforcing collaboration and aligning motivations.
Without a good contract in place from the beginning, there’s a good chance that there will be a lot of additional contracts in the future trying to fix the initial one. It’s important to realize that it is not only going to cost you money, but time as well, the most precious resource you have.
Andreas is an internet technologist, serial entrepreneur and startup investor with over two decades of experience. He joined btov in 2019 as a partner. Previously, he co-founded and helped build several successful technology startups in e-business services, social media analytics, video marketing and online content in both Europe and the United States.
Question 1: How long does it typically take to negotiate a term sheet?
Andreas: It depends on the stage and complexity of the deal, as well as the competitiveness. Somewhere between one day and two weeks is fairly typical.
Question 2: How can a startup prepare for the due diligence process?
Andreas: You should start early preparing a virtual data room with all the important documentation. Pulling all documents together can be very time-consuming, so it's best to go into fundraising with already most of the documentation ready for due diligence. There will always be changes and additions, but founders should spend their time during a fundraising period talking to investors, not chasing paperwork.
Question 3: Who usually pays the legal fees associated with writing up the term sheet?
Andreas: Usually, most seed investors write their term sheets themselves, i.e. adapt a template the fund has set up with a law firm. This means that there are rarely legal costs in these early-stage transactions before actual contract negotiations.
In larger transactions, the venture capital fund sometime uses external counseling. The fees will be paid for by the company in case the deal comes to a signing. As a VC, you have to agree with the company about a certain limit of fees you are allowed to deduct. If the term sheet is not signed or you get over the agreed-upon level, the investor will pay for external counseling himself. Some funds have an internal legal counsel helping with the documentation at new investments.
Question 4: A scenario: Two VC firms are considering an investment, one of them asks for details of the other’s term sheet. What should a startup do?
Andreas: It depends on what case we're talking about: If both VC firms want to collaborate on a shared round, the lead investor either defines the term sheet and the other VC joins it, or they develop the TS together. In both cases, the terms will be transparent.
But if we're talking about a competitive situation (you got a TS from VC A, but VC B wants to do the round and asks you about the terms you got), it's a risky situation. This is often called "term sheet shopping" — a startup gets a term sheet and then uses it as negotiation leverage with other VCs. This is typically not a good idea. Term sheets are almost always confidential, so if you disclose these terms towards other investors without permission, you're risking legal exposure. It's also considered bad form and you have to expect that other VCs won’t trust you if you previously betrayed the trust of another investor. Founders have to be very careful with this because deals can easily fall apart over such confidentiality issues.
Question 5: What can be reasons for which VCs pull term sheets?
Andreas: It could be any material change to the information the VC had when they provided the term sheet. For example, a founder reference might not have checked out; maybe the startup exaggerated its traction, or new technical problems became obvious. There are also cases when a founding team might want to renegotiate terms after the term sheet was already issued, and that's rarely a good sign. However, pulling term sheets is never a positive thing and can cause reputational damage for both sides, so most experienced VCs will only issue a term sheet once all important terms are clearly negotiated and informally agreed upon.
Question 6: What are the most absurd terms you’ve seen in a term sheet?
Andreas: We once saw a 5x liquidation preference in a seed round. There often are also excessive downside protection clauses that are rarely helpful. Good investors optimize for the upside, not the downside. You should also be careful about investments that are bound to business milestones, particularly in early-stage rounds when the business model is still evolving.
Question 7: What small mistake in a term sheet turned out to be a disaster later in M&A?
Andreas: No practical cases to report, but you should be very careful about understanding liquidation preferences properly. In a less than stellar M&A case, this can make a huge difference for founders and early investors alike. There are still founders who optimize for high valuation numbers at the expense of steep liquidation preferences, and that can come back to bite you in a mediocre exit. Furthermore, it's important to have proper tag-along and drag-along clauses to protect the interests of all investors in an M&A case.
Question 8: How do veto rights on future investors play out in real life (the protective provisions a VC gives to a startup in a term sheet)?
Andreas: This really depends on the case. Most VCs will be happy to accept any reputable investor for a future round. If the startup really needs the money quickly and there are not many options to pick from, most likely no competent VC will veto a reasonable offer from another investor. However, there are cases where vetoes might be justified and in the best interest of the company. For example, if the startup is considering investment from a strategic corporate investor that might generate competitive issues with the rest of the market, it's normally a good idea to reconsider.
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