How to Negotiate a Term Sheet, Part II

In this two-part series, columnist Tom Taulli defines key terms and sketches out common pitfalls for entrepreneurs negotiating a term sheet with venture capitalists

In my last column, I looked at some of the key issues of negotiating a term sheet and offered advice on how founders should handle them (, 8/15/08). In this week's column, I'll continue where I left off and cover the remaining terms.

Anti-dilution. This provision is meant to protect investors in the event of a down round. To understand how the anti-dilution concept works, consider this example: ABC has 5 million shares of common stock outstanding (owned by the founders) and an option pool to purchase up to 1 million shares (for employees). If the option is exercised, the valuation of ABC is $10 million. Having completed a Series A round, ABC issues 4 million preferred shares at $1 a piece. Over the next year, the company runs into trouble. As a result, in its Series B round—to raise $1 million—the share price has been reduced to 50¢. This means ABC will need to issue an additional 2 million shares and the valuation of the company will be only $6 million. Assuming no anti-dilution protection, the Series A investor will suffer a 40% loss.

No doubt, this is something that concerns VCs and so, in most cases, they require anti-dilution protection in a down round of which there are essentially three forms:

First, there is the "full ratchet," which means the Series A investor will get the same price as the Series B investor. Using our example, the Series A investor will get an additional 4 million shares.

Now, a less harsh approach is the "narrow weighted average calculation." With this, the Series A investor gets a new price on the shares that is based on the inclusion of the additional shares issued to the Series A investor (the formula is a bit long). This means that the Series A investor will get 400,000 extra shares.

Finally, there is the "broad based weighted average adjustment," which not only includes the shares for the Series A investor but also the options and warrants. In this scenario, the Series A investor gets 363,363 new shares.

Of course, founders should negotiate hard to avoid the highly dilutive full-ratchet.

Legal fees. In the negotiation with VCs, you'll spend much time with your attorneys. In fact, the fees can easily range from $25,000 to $50,000, which can be a big chunk for a small financing. Keep in mind that the legal work may include more than just term sheet issues but also corporate cleanup (such as correcting poorly drafted contracts, board minutes, and so on). The bad news: though you can negotiate a cap on the fees, the VC will require the company pay for all the fees Bum deal? It is.

No shop. This prevents you from actively seeking new investors. Essentially, the VC wants to lock in the company and not have to deal with renegotiations—or even losing the deal. A VC will probably not relent on the "no shop." However, you can limit the term, such as to 30 to 45 days. Interestingly enough, this should encourage the VC to work expeditiously on getting the transaction done.

Some things that don't matter. Most term sheets have a registration rights clause. This sets forth the procedures for making it possible for VCs to convert their preferred shares into common stock in the event of a public offering. But for an early-stage company, this clause does mean much.

The same goes for information rights. This clause allows the VCs to get access to internal company information (such as the financials, budgets, and so on). This is absolutely essential for VCs and as a result, is non-negotiable—unless the investor owns a small amount of shares (say below 1%).

Finally, a VC will have special voting powers for key decisions, such as for issuing new shares, selling the company (or buying one), firing officers, and expanding the board. While there are strategies to soften the impact of this (such as by lowering the voting thresholds), the fact remains that a VC will want to call the shots on these matters.

Yes, term sheets are tricky things. And, as we've seen, certain clauses can make a huge difference (such as the liquidation preferences and anti-dilution clauses). In other words, it's important to focus on some key areas, which should help keep up the momentum of the funding process.

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