How to Negotiate a Term Sheet, Part I
A term sheet is a document prepared by venture capitalists that sets forth the key terms of a proposed investment. The temptation for the entrepreneur is to focus mostly on the overall valuation of the transaction. But this can be fatal. Keep in mind that a term sheet has a variety of protective clauses for the VC that can significantly reduce the valuation for the entrepreneur. As a result, it's imperative to have an experienced attorney negotiate a term sheet with you.
To get a sense of the negotiation process, imagine yourself in the following scenario. After months of pitching VCs, you finally get a term sheet for your Series A round of funding (for a company we'll call ABC Corp.). The amount is for $5 million, and the post-money valuation (BusinessWeek.com, 8/8/08) comes to $10 million. The term sheet is only seven pages, but it is complicated and even mysterious. You can find a sample term sheet at the National Venture Capital Association's Web site and see some real-life examples at TheFunded.com.
A term sheet is a conditional offer. The VC will perform further due diligence and negotiate key contracts, such as employment agreements, the option plan, registration rights, shareholder agreements, and so on, before you see the complete the deal. The process can easily take several months.
What are the key terms and common potential traps of term sheets? Let's take a look:
Preferred Stock. When a company is created, the founders will get common shares, which represent ownership in the venture. These are also referred to as founder's shares. VCs don't want these shares; instead, they want preferred stock. These securities have a variety of protections—such as liquidation preferences and voting rights—that provide VCs with downside protection and control. However, there is virtually no way to get rid of the preferred stock. Although, you can certainly negotiate some of the underlying protections (which we will talk about below).
Liquidation Preferences. VCs have a broad definition of "liquidation," which includes an acquisition, bankruptcy, and the sale of much of a company's assets. For the most part, a VC wants to get as much capital back on such events. As the name implies, a liquidation preference means that a VC gets the first money out of a deal.
Consider this example: ABC Corp. has a 1X liquidation preference in the term sheet. This means that—upon liquidation—the investor will receive up to $5 million. In other words, if the company sells for only $5 million, then the VC will get all the money. Interestingly enough, there are 2X and 3X preferences (and even higher, depending on the riskiness of the company). But this is uncommon and definitely worth negotiating over.
What if ABC Corp. sells for, say, $7 million? What happens to the additional $2 million?
Well, if there is participating preferred stock, then the VC will get an extra $1 million (which is based on the percentage of ownership). In fact, this is often referred to as "double dipping." This would obviously be a tough outcome for founders, so I suggest you negotiate away the participation feature. And, if this doesn't work, you can attempt to put a limit on the participation (maybe no more than 3X the VC's investment).
Dividends. This is an annual return on the preferred stock, which can range from 5% to 15% (payable in either stock or cash, which is usually at the option of the company). Of course, you should try to negotiate for the lower amount. If the preferred is cumulative, it means dividends that are not paid will be added up. If this happens over five or six years, the impact can be substantial, so try to negotiate a clause that makes the dividends noncumulative.
Reverse Vesting. When entrepreneurs learn about this concept, the reaction is usually shock or anger. With reverse vesting, the founders set aside their common shares and then earn them over time (the standard is four years). Simply put, VCs want to make sure the founders stay around.
But there are ways to mute the impact of reverse vesting. First, you can try to get immediate vesting for a portion of the shares (say a quarter or a third). After all, you have already put a lot of work into the company. Next, you can shorten the vesting period (perhaps to two or three years).
Drag-Along Rights. This means that minority shareholders must agree to a sale or liquidation of a company. For the most part, this is triggered when the proceeds are less than the liquidation preference, which means that the founders will get nothing.
Yes, this sounds harsh. Then again, this is a situation where the company didn't live up to its expectations. So why should the founders get a return? Essentially, that's the main argument from VCs. A drag-along right is normally tough to negotiate away. Save your energy for other terms, such as liquidation preferences and reverse vesting.
As you can see, there are many nuances to a term sheet. And we're only about half-way through the main provisions of a standard version. While the clauses sound harmless and somewhat dull, they can nonetheless have a big impact on your return. In my next column, I'll take a look at the remaining clauses of term sheets.