Term sheets usually sound more complicated than they really are. We have, in other articles on our blog, talked about 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 dive right in!
How to negotiate a term sheet – Part 1 – The approach
Retain an attorney who understands VC terms: The top mistakes are retaining an attorney who doesn’t have domain expertise in the world of angel and VC funding. While you 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: Directly as the entrepreneur you should be driving the negotiation with the investors. You may use your lawyer as a sounding board; however, own up to 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 very important.
Understand the interest level of the investor: Most professional investors are serious about term sheets. They do more term sheets in a year than you probably do in a lifetime. But it’s equally important that you understand the interest level of the investors. The last thing you want is to ink a term sheet and have the investor disappear on you. As I said, term sheets are usually nonbinding!
Unwanted negotiation: Aggressive negotiation is usually witnessed in young lawyers as they try to prove their worth to you. However, be sure that you do not take the investor into a negotiation war. Keep in mind that you may not have it all, neither will the investor. Know what you should fight for and do not wage too many wars on negotiation.
How to negotiate a term sheet – Part 2 – The technicalities of a term sheet
Knowing how to negotiate a term sheet is a good skill, but it is incomplete without knowing the technicalities of a term sheet. Obviously, this list is not comprehensive, but it gives a view of the most critical items of a term sheet.
Valuation:
Probably the most debated and most spoken-about item is valuation. Be sure to understand the terms of the valuation and the impact of option pools on the fully diluted pre-money valuation. Keep in mind that when it comes to early-stage startups, valuation is more of 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:
It’s what an investor gets back if the company sells. This impacts the founder’s return significantly. Get it right by charting out the different possibilities of exit. See to it that the early stage term sheets get these issues correct. Later rounds, Series B, C, etc., just carry over the terms from the earlier funding rounds.
Founder Vesting:
Founder vesting is one major area of the term sheet that most founders fail to understand. A lot has been written about founder vesting. The key would be to note (i) commencement date of vesting, (ii) vesting cliff, (iii) acceleration on change of control, and (iv) double trigger acceleration.
Exclusivity:
Having investor level exclusivity is quite common in term sheets. This basically means 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.
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