What are the top 5 things we should pay attention to when negotiating a term sheet with VCs?

Ethan Stone

Ethan Stone

Question: My startup is now going out for its first round of venture financing. What are the top 5 things we should pay attention to when negotiating a term sheet with VCs?

Answer by Ethan Stone, Stone Business Law

First, a quick caveat: I’m not your lawyer and this answer doesn’t establish an lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site.

Now to the question: I’m going to cheat a bit and combine some things that tend to appear as separate line items on a term sheet into general categories. But here’s my top five.

1. First, focus on the binding provisions. I greatly prefer to use a separate non-disclosure agreement as a binding contract and leave the term sheet completely non-binding. Many people like to combine a non-binding term sheet with some binding provisions, however. So you need to focus on what is actually going to bind you. The most common binding provision is an agreement to negotiate exclusively with the VC for some period of time (a “no-shop”). There are good reasons VCs ask for this, but its generally in your interest to avoid it. So if there’s a lot of VC interest in your company, you should try very hard to reject it. You should give in only if you’re sure the VC asking for it is serious and brings much more to the table (not just money, but compatibility, stature and credibility etc.) that the others who are expressing interest. If there isn’t a lot of interest, you might as well give the VC a no-shop but keep it short or you may find yourself off the market for longer than you’d like.

2. Leaving aside binding provisions, valuation is the key provision. I’m sure the basic valuation won’t escape your notice, but there’s one key item to look out for here: the option pool. VC term sheets will often require you to set aside shares for an option pool (say 10% of the company) and provide that the “fully-diluted” pre-money valuation of the company includes the option pool. The result is to decrease the price per share.

Think of it this way. The term sheet provides for a $1 million investment on a $3 million pre-money valuation. If that’s all it says, the founders will end up with 75% (3/4) of the company and the VCs with 25% (1/4). If the pre-money valuation is on a fully-diluted basis, including a 10% option pool, however, the calculation changes. Now shares worth $400,000 (10% of $4 million) have to come off the top. So the founders end up with 65% of the company (2.6/4), the VCs still have 25% (1/4) and the rest sits waiting to be issued to your new hires.

Now VCs have a legitimate interest in specifying an option pool and taking it into account in pricing the round. Issuing options to employees typically does not trigger the VCs’ anti-dilution rights, so any employee options will dilute them between rounds of investment. That should play a role in pricing the round. So a good approach is to try to figure out a realistic number for the option pool (given your specific hiring plans), agree on that, and then negotiate price you both think is fair, with that option pool as a given. If you start with the valuation and then think about the option pool, someone is going to feel ripped off.

3. The third most important item is any contingencies the VCs want to place on the founders’ stock. The VCs will usually ask the founders sign an agreement to forfeit part of their stock (or sell it back to the company at a low price) if they leave early. Depending on your negotiating leverage (e.g. how much VC interest there is in the round), you may be able to resist this entirely. If not, try to keep the contingency period short, the shares at risk limited and the price of a buyout on exit high. You might also try to limit the contingency to situations in which you decide to leave (without being pushed) or they kick you out for a good reason (e.g. you embezzle). Bear in mind, however, that there are very good reasons not to want a bunch of non-employee common stockholders milling around pre-IPO, especially if they’re disgruntled former employees. It makes for trouble. So if you can work out a fair and clean exit formula, that’s sometimes best for everyone.

4. A fourth important topic is the control rights of the VCs. These fall into three broad categories. The first, and least important, is formal voting power. It’s least important because very few things are really going to be done by a competitive vote. But if there are multiple VCs, it is worth thinking carefully about who would have to gang up (include different founders in this calculation) to reach a majority. If some of those scenarios are problematic, you can try to limit it by a voting agreement. The second category is board representation. VCs have a legitimate desire for board representation and you should want them on your board. If you don’t, think hard about why you’re letting them into your company. What you want to avoid is too many representatives of different funds on the board, since it makes for difficult board meetings and board relations. If there’s only one or two VCs, that’s not an issue. If there are more, you need to figure out a way to keep the number of people down. Finally, the term sheet will typically give the VCs a veto power over certain actions, either by requiring a board or stockholder vote high enough to require their consent or by providing for a separate vote of the preferred stock. There’s usually a fairly long list and many of them are uncontroversial, but you need to pay attention and make sure that nothing on the list is going to be too troublesome. For example, if sales and licenses of assets require consent, you may want to qualify that in ways that give the managers some freedom to do day-to-day deals (e.g. by requiring approval only for deals over a certain dollar amount or by exempting “ordinary course” transactions).

5. The fifth category is a bit of a fudge (I’m running out of categories), but here it is. There are a number of provisions in typical term sheets that try to force minority shareholders to go along with the majority on key issues. The preferred stock is usually subject to mandatory conversion to common in an IPO and sometimes certain sale transactions. There are also typically “drag-along” rights to allow the majority to bring the minority along in a sale. Sometimes there are “pay to play” provisions, penalizing investors who fail to take part in subsequent rounds of financing. These provisions (other than pay to play) will almost always bind the founders. From the founders’ perspective, they should also bind the VCs. If you have to go along with them, it’s better to make sure that they have to go along with you and each other. That said, it’s worth thinking through these provisions very carefully, bearing in mind the specific types of stock, percentages and voting rights each stockholder will have. As with other control rights, think through the various combinations and make sure you’re comfortable with who can make decisions that bind you and who could hold up decisions that might be important to you.

So those are five. There are, of course, many other provisions in the typical term sheet that merit very careful consideration. For good reason, entrepreneurs often prefer to have lawyers out of the picture when they’re negotiating a term sheet. That doesn’t mean you have to do without advice. A good approach is to take the first draft and pass it by counsel to get comments and advice in thinking through your reaction. Then leave the lawyer in the background as you go back to the VC to negotiate the things that matter to you.

Comments & Advice:
  1. Negotiating with a VC over anything in a term sheet is difficult because the VC almost always has the advantage of asymmetric information. The VC can compare the prospect to anything in its current portfolio and negotiate from a position of strength if it has an accurate picture of the startup’s chances. Very few startups have the luxury of being courted by multiple VCs.

    That option pool might dry up pretty quickly if the startup scales up rapidly and hires to fill its needs. Maybe that’s a good problem to have if it means a big exit.

  2. I would add one major bullet point to Ethan's very thorough answer: Liquidation preference. For many exits ranging from modest to relatively successful, the investors' liquidation preferences can have a tremendous impact on the value the founders and employees ultimately receive, so I'd put it second right after valuation in terms of importance.

    Most entrepreneurs try to avoid participating preferred if at all possible, but if you have to give on that point, at least negotiate a cap on the participation — although this creates strange incentives in certain scenarios. Brad Feld wrote an excellent blog post on this subject at http://www.feld.com/wp/archives/2004/08/to-participate-or-not-participating-preferences.html

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