Congrats, You Got a Term Sheet

You have done the hard part and you now have a term sheet from a VC in hand.  While you are not funded just yet, you should be congratulated because this is a real validation of your business.  As it should be, the term sheet itself is non-binding on either the VC or your company as to the obligation to close, so, even if you sign it as drafted, neither your company nor the VC are required to close the deal. That closing will be subject to coming to agreement on full “definitive” contracts and whatever due diligence the VC wants to continue to do on the company (and what you may elect to do on the VC firm). That does not mean the contents of the term sheet are insignificant.

The term sheet outlines the many key terms of the investment deal. It is not intended to cover everything that will arise in the actual binding contracts, but it should have all the “major” items included. The signed term sheet is the map for the attorneys to use in drafting the contracts. To the extent that a major issue comes up later in the deal that was not addressed in the term sheet, or there is a material change in terms after the term sheet has been signed, one party or the other is probably going to be a bit perturbed.  So the point is, it is in everyone’s best interest to get the term sheet right now so problems do not arise later. Stated differently, don’t expect to sign the (mostly) non-binding term sheet and then raise big issues or changes later. This will quickly create “deal fatigue” and either kill the deal or create bad feelings with your new shareholder. Negotiate the major terms before you sign the term sheet.

What VC Terms are Not Negotiable?

So if you must negotiate the major terms now–before you sign the term sheet, what terms are really negotiable? It is easy to find an “expert” or lawyer that says “everything is negotiable” and in some theoretical world, that may be true (if your company is a “unicorn”). However, in the real VC world, many terms are simply non-negotiable realities of accepting VC money. With very, very few exceptions, if you are taking money from a real VC,

• if your company is not already structured as a corporation for state law purposes and a “C Corporation” for tax purposes, you will need to convert
• the stock issued will be preferred, not common
• there will be a liquidation preference
• assume board representation for the preferred class
• assume the company will be required to indemnify the board designee and obtain D&O insurance
• assume defined “major decisions” will require the consent of the VC
• assume that founders will need to sign noncompetes where enforceable and other documents in favor of the company
• you will need to enter into a Management Rights Agreement with the VC

This is clearly not an exhaustive list but merely examples.  If you do not enter the negotiation understanding certain realities, you will look amateurish and have less chance of successfully negotiating the items that are negotiable. Further, there is no reason not to be aware. If you have a term sheet from a traditional VC for “Series A” preferred stock, look at the annotations for the NVCA’s template term sheet. If you do not understand those annotations, find an advisor that does. If your advisor or attorney does not know what a Management Rights Agreement is when you ask them, find another advisor. A lawyer that does not even know what a Management Rights Agreement is may be a fine lawyer, but they by definition do not know VC deals and cannot properly advise you as to market terms. Representing many investment funds, I cannot tell you how many times I encounter lawyers that are advising company founders on VC deals but they have no background to properly advise their own clients on what to expect and which terms are “market.” The outcome is that the founders end up worrying about issues that are not particularly important and the transaction becomes more expensive because it extends lawyer time wasted on arguments you will never win. The result will be the same, and you will have simply wasted money, stress and time in the interim.

It does make it a bit more difficult that some firms have their own “third rail” issues that are non-negotiable for that particular firm. Do your research on the VC firm on the Internet. In conducting your own due diligence on the VC, ask them for references in the form of management contacts from companies in their current and former portfolios. While they will naturally provide those with the best relationships, ask those founders what terms were and were not negotiable with that firm. In my experience, they will share this intel.

Alright, So What is (or should be) Negotiable?

There is a list of terms, some of which have real economics behind them, that should always be fair game in my mind for negotiation. These include:

• Valuation (within reason but if you are nuts on valuation, that probably would have been flushed out by the VC before the term sheet stage)
• Liquidation preference multiple (if it is anything except 1x, negotiate!)
• Participation (participating or not, caps?)
• Vesting schedule for founders (if it is being imposed or extended, its is negotiable at least as to time)
• Dividends (any, amount, cumulative?)
• Registration Rights (at least as to type)

In summary, do your own research, use knowledgable advisors and attorneys and get the major terms fully negotiated before you sign the term sheet without raising things that will never be successfully changed. It will make your deal more likely to actually close and will start your relationship with the VC off on the right foot.