Term Sheet 101: How to negotiate a term sheet
Term sheets usually sound more complicated than they really are. In other articles on our blog, we have touched upon the various terms used in a term sheet. Many entrepreneurs often ask me strategies on how to negotiate a term sheet. In this article on term sheets, we are going to see exactly that – how to negotiate a term sheet.
In this article we take a two part approach towards negotiating term sheets. Let’s jump right in!
How to negotiate a term sheet – Part 1 – The approach
- Retain a lawyer who understands VC terms: One of the top mistakes is to retain a lawyer who doesn’t have domain expertise in the world of angel and VC funding. While you may save some money by hiring your friend, the long-term impact could be disastrous. A lawyer needs to help you in the negotiation process. He needs to understand the difference between a “full-ratchet” and a “broad based weighted average” and so on.
- Drive the negotiation: As the entrepreneur, you should be driving the negotiation directly with the investors. You may use your lawyer as a sounding board, but own up the negotiation! When the investor comes onboard, you are likely to have tougher discussions down the road. The ability to have open and honest conversations is crucial.
- It is important to understand the investor’s interest level: Most professional investors are genuine when it comes to term sheets. They negotiate more term sheets every year, than you do the entire lifetime. But it is important that you understand the investors’s interest level. The worst thing that can happen to you is to sign a term sheet, and then realize that the investor has dropped out. Remember, term sheets are often non-binding!
- Unwarranted negotiations: Younger lawyers are usually aggressive on the negotiation, because they are keen in proving their value to you. But ensure that you do not lead the investor into a negotiation war. Realize that you may not get everything you want, nor will the investor. It is important to prioritize what you fight for and keep the negotiation wars to the minimum.
How to negotiate a term sheet – Part 2 – The technicalities of a term sheet
Knowing how to negotiate a term sheet is an important skill. This skill is not complete without understanding the technicalities of a term sheet. This list is not exhaustive, but should give you an idea on the most critical items of a term sheet.
- Valuation: One of the most debated and widely discussed item is the valuation. Make sure you understand the valuation terms and the impact of option pools in the fully diluted pre-money valuation. Remember, in early-stage startups, valuation is more an art than a science!
- Anti-dilution: Most term sheets have anti-dilution provisions in the term sheet. If you find a “broad based weighted average” anti-dilution clause, then move on. If you find a “full-ratchet” anti-dilution, then talk to your lawyer.
- Liquidation Preference: The liquidation preference determines the value an investor gets in case of sale of the company. This could have a significant impact on the founder’s return. Be sure to get things right by charting out the various exit possibilities. Ensure that the early-stage term sheets get these issues right. Later rounds (such as Series B, C and so on) usually carry over the terms from the earlier funding rounds.
- Founder Vesting: Founder vesting is an important aspect of the term sheet that many founders fail to understand. Much has been written about founder vesting. The key is to understand (i) date of commencement of vesting, (ii) vesting cliff, (iii) vesting acceleration when there is a change of control, and (iv) double trigger acceleration.
- Exclusivity: Having investor level exclusivity is quite common in term sheets. This means that you cannot talk to another investor once a term sheet is signed. Be sure that you get the time limit right. Anything less than 45-60 days is reasonable.