Negotiating Term Sheets: Focus on What’s Important

Focus on what’s important, negotiate and resolve the important points early, get the deal closed as quickly as possible and get back to growing the company.

When you receive a term sheet from a VC for a full preferred stock financing, the abundance and variety of terms might seem overwhelming.  It can be difficult to understand what terms are really important when you don’t have experience living with those terms across long time periods and across many companies and situations.  This is where professional advisors like lawyers can come in handy.  The purpose of this article is not to get too deep on specific terms that might appear in a term sheet, but rather to give a broad overview of the types of terms that are more important. This context will help you focus on the things that really matter, so deals can move quickly and people don’t get bogged down on smaller points, wasting time and legal fees.

A Rule of Thumb – Follow the “Rule of 3”

What is the Rule of 3?  Simple — focus your energies on 3 issues to negotiate.  Sure, there might be more (or less), but in my experience there are most often about 3 issues in any term sheet worth arguing about. Of course you may identify more than three issues that are important to you, but the takeaway here is to work with your advisors and teammates to identify the things that are really important, and focus on those things.

Why follow this advice?  If you accept the term sheet “as is” and don’t negotiate the important issues, you may lose credibility with the VC.  How a founder acts during this phase can have a significant impact on the relationship going forward.  Show the VC that you will stand up for the important issues.  The VC knows what issues are important, and will not be surprised you are raising them if your positions are fair.  On the flip side, if you argue endlessly about every point, many of which are largely not material, you will look inexperienced and the parties will lose focus on what really matters.  Show the VC that you will stand up for the important issues, and that you actually know what the important issues are.

This doesn’t apply in all transaction types – for example, in a complicated M&A negotiation or commercial deal the parties engage in many tactics such as throwing up red herring issues to detract from more important ones.  However, an investment transaction is fundamentally different from an M&A deal because the parties must work together, usually intensely, after closing, and an alignment of interests is critical.  Therefore, focus on the key points and get them resolved quickly, and close the deal so you can focus on building the company.

If you’re not comfortable with the terms, work with a trusted advisor or an experienced startup lawyer to help weed out the most important issues.  You can also read the latest Cooley report on venture financing trends.

What are the important issues?

Here is a list of some of the most common terms that are worthy of negotiation.  This is not intended to be an exhaustive list of all term sheet provisions – there are many great resources on the web describing in detail the various term sheet provisions (for example, Brad Feld’s term sheet series).

1. Valuation/Dilution.  This is obviously one of the most important issues, although not a legal one.  Much information is available on the web.  Make sure you understand the effect of including the option pool in the fully diluted pre-money valuation. Always think about valuation in the context of the particular investor.  A lower valuation from a great investor may be better than a higher valuation from a bad investor.
2. Liquidation Preference.  This is usually the next most important business issue, although it is often mistaken for a legal issue and sometimes glossed over (at your peril).  The liquidation preference defines the return that an investor receives in a sale of the company, and it can have a significant impact on the founder’s return.  Be sure to model out expected exit values so you understand the actual dollar differences between the liquidation preference formulas.  Please also keep in mind that terms put in place in the Series A often carry over to the Series B and beyond, so be careful what you agree to here even if it seems relatively harmless at this stage.  The fact that Series A terms carry over into later rounds (and sometimes negatively affect the Series A investors in later rounds) can often be used as leverage to resist their inclusion.  For example, a “participating preferred” for a small seed round might not result in a meaningful extra return for the investor at exit (at least in absolute dollar numbers), but it will be painful to the founders if all future rounds include participating preferred stock.
3. Makeup of the Board of Directors.  The makeup of the Board of Directors and governance of the Company going forward is very important.  A typical arrangement following an initial equity financing would be a three person board with one investor representative and two founders as representatives of the common stock. As you might imagine there are many variations on the theme, and in some cases companies have one or more independent directors (meaning directors that don’t hold any of the company’s equity and don’t have any other material interest in the company), which adds complexity to the “balance of power” analysis.  One decent rule of thumb for early-stage boards is that the investors’ and common holders’ representation on the board should reflect the relative control of the cap table. Make sure to have a constructive discussion with the VC about board makeup to ensure that everyone is aligned on the governance of the company going forward.  Control of the Board can also affect the thinking on other issues, such as vesting.
4. Protective provisions. It is typical for the investors to have a set of “protective provisions” (commonly referred to as “veto rights”) over specified corporate actions. Some of these are less controversial (particularly in the early stages of a company’s growth and financing) – like a veto right on the declaration of dividends or the modification of the rights of the stock issued to the investors – and some are more likely to be important, like veto rights on future financings or sales of the company. It’s worthwhile to examine these closely, and discuss them with your lawyer or other advisor, as these contain traps for the unwary. One example is a veto right on future financings. The relevant right does not say “no financings without our approval” – it says something like “no creation of a new series of stock without our approval” or even “no amendments to the certificate of incorporation without our approval.”
5. Founder Vesting.  This is a critical area to review and understand from the founder’s perspective.  Much has been written about founder vesting and we won’t spill too much ink here on the subject.  Important things to understand are (i) on what date does vesting commence, (ii) does vesting accelerate upon termination without cause, and (iii) does vesting accelerate (in whole or in part) upon a change of control or upon a termination of employment without cause within some period of time after (and sometimes before) a change of control (so-called “double trigger” acceleration).
6. Antidilution Protection.  Nearly all VC deals in the United States have some form of antidilution protection to protect the VC from future sales of preferred stock at a lower valuation.  The variations in the types of antidilution protection define the extent to which the VC is protected.  If it is “broad-based antidilution protection” then move on.  If you see the phrase “full ratchet“, talk to your lawyer.
7. Exclusivity.  It is common for the only binding part of a term sheet to be a restriction that you don’t talk with other investors for some period of time after you sign the term sheet.  This is a reasonable request, as the VC is going to be paying lawyers to draft documents and perform due diligence on your company.  But be sure the time period is not too long – 30 to 45 days is plenty of time to finalize a VC investment in almost all cases.

Many of the other provisions in the term sheet are either harmless or have become so customary that it’s not worth spending any time negotiating them.  There are always exceptions and special situations, so do talk to your own counsel, but here are some of the things that you can largely de-prioritize in most cases:  dividends (except for accruing dividends), information rights (unless you are really concerned about sharing), conversion rights, registration rights, standard conditions to the investment, rights of first refusal, and co-sale or tag along rights.  Certainly these and other similar boilerplate provisions are relevant, but I would not advise any of my clients to spend any significant time talking about them unless they are so “out of market” that it might harm the client to accept them.  Even if one of these terms does become important later, you probably won’t be able to anticipate it at the time you’re negotiating the term sheet.