Let’s say you’re a first-time entrepreneur and you’ve hit on an idea that is getting some traction and attracting the attention of VCs. You do some research online to familiarize yourself with customary terms and finally get a term sheet from a reputable VC at a valuation you think is fair. Next comes the fun part – negotiating the term sheet. Negotiating term sheets should be straightforward, but sometimes when you combine first-time entrepreneurs with inexperienced counsel, the results can be toxic.
One of the contributors to the problem has been the explosion of information available to entrepreneurs on blogs about starting companies, getting funded and other matters, much of which is legal-related. Although this is a welcome development, I have found in talking to my current and prospective clients that this wealth of information has caused a situation akin to Medical Students’ Disease. Many first-time founders can become overwhelmed by the various lengthy and “legalese heavy” provisions in a term sheet and don’t know what to negotiate because they don’t have appropriate context. They sometimes feel the need to optimize every individual provision in the term sheet according to the guidelines found online. For example, a founder recently expressed his shock to me that a VC wanted an 8% non-cumulative dividend preference on the preferred stock given the historical lows of current interest rates. He didn’t realize that dividends in fast growing companies are almost never paid, thus making this provision essentially irrelevant and just a relic of past practice. Even if the dividend preference was “out of market” at 10%, it probably wouldn’t have mattered. Context helps.
This abundance of information combined with lack of context can lead to the toxic result of arguing about things in the term sheet that frankly won’t likely matter in most situations. This unnecessarily slows deals down, raises (and wastes) legal fees and negatively affects the founder’s reputation with the VC going forward. One of my partners enjoys telling the story of representing a VC investing in a company started by a first time founder using his father (who was not a startup lawyer) for legal counsel. My partner wasted a week convincing the father that liquidation preferences in preferred stock were not only legal but also customary. The founder was not well-served in this situation, and he paid the price dearly since the VC’s legal fees are paid by the company.
A Rule of Thumb – Follow the “Rule of 3”
It shouldn’t be a surprise that I recommend that you get counsel that does these types of deals day in and day out. But I will share what I tell many founders that I represent – follow the Rule of 3.
What is the Rule of 3? Simple — focus your energies on 3 issues to negotiate. Sure, there might be more (or less), but in my experience there are most often about 3 issues in any term sheet worth arguing about.
Why follow this advice? If you accept the term sheet “as is” and don’t negotiate the important issues, you will lose credibility with the VC. How a founder acts during this phase can have a significant impact on the relationship going forward. Show the VC that you’re not a pushover and that you will stand up for the important issues.
I’ll share an example. One of the founders I am advising recently received a term sheet that was pretty reasonable, except that the terms of his vesting contained no acceleration for termination without cause. In other words, he could be fired at any time and lose his unvested stock. When we pushed back on the VC, the response from the VC was “We’re all in this together, and we really need you to help build this company. We would never terminate you without cause, that would destroy our investment thesis.” This founder thought that was a reasonable response and was not inclined to push back because he needed the money. However, I told him what everyone reading this already knows – that even though what the VC said is probably true, things often change and founders are terminated all the time and he could end up with very little of the company he started. He won that particular battle because the VC knew it was a reasonable request, and the VC learned that this founder was willing to stand up for himself when it was the right thing to do.
On the flip side, if you argue endlessly about 10 points, 7 of which are largely not material, you will look inexperienced and the parties will lose focus on what really matters. Show the VC not that only will you stand up for the important issues, but that you actually know what the important issues are.
This doesn’t apply in all transaction types – for example, in a complicated M&A negotiation the parties engage in many tactics such as throwing up red herring issues to detract from more important ones. However, an investment transaction is fundamentally different from an M&A deal because the parties must work together, usually intensely, after closing, and an alignment of interests is critical. Therefore, move quickly, focus on the key points and get them resolved quickly, and close the deal so you can focus on building the company. Think of the 8% dividend and liquidation preference examples I talked about above. I’m confident that neither of these situations left the VC feeling very confident about the founder or the quality of his legal representation.
If you’re not comfortable with the terms, work with a trusted advisor or an experienced startup lawyer to help weed out the 3 important issues.
What are the important issues?
Here is a list of some of the most common terms that are worthy of negotiation. This is not intended to be an exhaustive list of all term sheet provisions – there are many great resources on the web describing in detail the various term sheet provisions (for example, Brad Feld’s term sheet series).
- Valuation/Dilution. This is obviously one of the most important issues, although not a legal one. Much information is available on the web. Make sure you understand the effect of including the option pool in the fully diluted pre-money valuation. Think about alternatives to simply changing the valuation, such as using warrants.
- Liquidation Preference. This is usually the next most important business issue, although it is often mistaken for a legal issue and sometimes glossed over (at your peril). The liquidation preference defines the return that an investor receives in a sale of the company, and it can have a very significant impact on the founder’s return. Be sure to model out expected exit values so you understand the actual dollar differences between the liquidation preference formulas. Please also keep in mind that terms put in place in the Series A often carry over to the Series B and beyond, so be careful what you agree to here even if it seems relatively harmless at this stage. The fact that Series A terms carry over into later rounds (and sometimes negatively affect the Series A investors in later rounds) can often be used as leverage to resist their inclusion. For example, a “participating preferred” for a small seed round might not result in a meaningful extra return for the investor at exit (at least in absolute dollar numbers), but it will be painful to the founders if all future rounds include participating preferred stock.
- Board of Directors/Voting Provisions. The makeup of the Board of Directors and governance of the Company going forward is very important. One typical arrangement is one director appointed by common stock, one director appointed by the Series A stock and one independent director, although there are many variations on the theme. Make sure to have a constructive discussion with the VC on board makeup to ensure that everyone is aligned on the governance of the company going forward. Control of the Board can also affect the thinking on other issues, such as vesting.
- Founder Vesting. This is a critical area to review and understand from the founder’s perspective. Much has been written about founder vesting and I won’t spill much ink here going through them. Important things to understand are (i) on what date does vesting commence, (ii) does vesting accelerate upon termination without cause, and (iii) does vesting accelerate (in whole or in part) upon a change of control (so-called “single trigger”) or upon a termination of employment without cause within some period of time after (and sometimes before) a change of control (so-called “double trigger”).
- Antidilution Protection. Nearly all VC deals in the United States have some form of antidilution protection to protect the VC from future sales of preferred stock at a lower valuation. The variations in the types of antidilution protection define the extent to which the VC is protected. If it is “broad-based antidilution protection” then move on. If you see the phrase “full ratchet”, talk to your lawyer.
- Exclusivity. It is common for the only binding part of a term sheet to be a restriction that you don’t engage with other VCs for some period of time after you sign the term sheet. This is a reasonable request, as the VC is going to be paying lawyers to draft documents and perform due diligence on your company. But be sure the time period is not too long – 30 to 45 days is plenty of time to finalize a VC investment in almost all cases.
Most of the other provisions in the term sheet are either harmless or have become so customary that it’s not worth spending any time negotiating them. There are always exceptions and special situations, so do talk to your own counsel, but here are some of the things that you can largely de-prioritize in most cases: dividends (except for accruing dividends), information rights, conversion rights, customary protective provisions (i.e., special voting rights), registration rights, standard conditions to the investment, rights of first refusal, and co-sale or tag along rights. Certainly these and other similar boilerplate provisions are relevant, but I would not advise any of my clients to spend any significant time talking about them unless they are so “out of market” that it might harm the client to accept them. Even if one of these terms does become important later, you probably won’t be able to anticipate it at the time you’re negotiating the term sheet.
One of the best parts of my job is telling a first-time entrepreneur overwhelmed by the 10-page term sheet that he or she does not need to worry about most of it. Of course, one of our jobs as lawyers is to make sure the client understands what the terms are so they are comfortable signing up. But does your typical entrepreneur care how many S-3 registration rights the investor has? They should not.
Wrap up: focus on what’s important, negotiate and resolve the important points early, get the deal closed as quickly as possible and get back to growing the company.