A term sheet negotiation is a non-binding business agreement between a start-up company and a potential investor. While a term sheet itself does not solidify a business partnership, it is widely considered the most important step towards creating a binding agreement. Term sheets negotiations are long and complex processes, and there are many specific financial and legal issues that must be agreed upon between the company and the investor.
The 8 steps outlined below will cover the best processes and tactics for successfully negotiating a term sheet:
- Take the Time to Woo Multiple Investors
- Do Your Due Diligence When Finding Investors
- Raise the Necessary Capital in Case of a Mishap
- Understand Term Sheet Market Terminology
- Hire a Good Lawyer to Assist You
- Prioritize the Non-Negotiables of Your Term Sheet
- Be Prepared to Negotiate with Your Investor
- Watch for Red Flags
As a new start-up or emerging company, it can be frightening to put part of the future of your business in someone else’s hands. If you’re unfamiliar with term sheet negotiations and the implications they will have for your company, this 8-step guide to negotiating a term sheet will give you the tools you need to begin growing your company.
How do You Negotiate a Term Sheet?
Successfully negotiating a term sheet requires a company CEO or entrepreneur to have a solid understanding of the basic market terminology outlined within a term sheet. Knowing how to politely and assertively negotiate these issues with a trustworthy and experienced investor will ensure a win-win situation for both parties.
Take the Time to Woo Multiple Investors
Although it may seem a daunting enough task to get just one investor involved, it’s in your best interest to be wooing multiple investors simultaneously. If a potential investor knows that they compete, they will be more amenable to agreeing to your terms and conditions. If you’re about to begin a term sheet negotiation process, make sure you have multiple interested parties lined up before you get into the nitty-gritty.
Do Your Due Diligence When Finding Investors
It’s completely normal to allow the excitement of landing your first investor to make you anxious to get a deal underway. However, working with an investor involves a far more complex relationship than just passing money from one hand to the other. A quality investor will play a major role in the growth of your business, and it’s important to do your research to ensure that your potential investors have the proper credentials and experience to help your business achieve success. The better the relationship between you and your investor, the more successful your business will be in the long run.
Raise the Necessary Capital in Case of a Mishap
The first round of funding a company receives from investors will have a huge impact on continued success and growth – but most investors will not be willing to invest funds in a company that has not been capable of raising them on their own. Furthermore, sudden unanticipated market changes could leave your company struggling to reach their first round of fundraising goals despite contributions from investors.
To avoid this potential scare, companies should have enough funds raised to keep themselves afloat for 12-18 months should a financial crisis ensue or if a potential investor unexpectedly backs out. It is never a bad idea to have a solid financial cushion before entering into term sheet negotiations.
Understand Term Sheet Market Terminology
When negotiating a term sheet, it’s important to have a good understanding of the most common market terms that will make up the brunt of the contract. Below is a list of the most important terms that will be laid out in a term sheet negotiation and why they are so important in making a binding and successful contract for yourself and your investor.
- Money Raised
- Money Valuation
- Preferred Stock vs. Common Stock
- Liquidation Preference
- Anti-Dilution Provisions
- Pay-to-Play Provisions
- Board Representation
During the negotiation, an investor should identify a specific amount of money they need your business to raise before they provide funding. Before you move forward with your negotiation it’s important to agree upon an amount of money that is approved by your investor but is also feasible for your organization to raise in a realistic time frame.
Valuation refers to a company’s worth or value. A company’s valuation will ultimately determine the percentage of the said company that the investor will gain ownership of for their investment. A company’s valuation can be determined in two different ways.
- Pre-Money Valuation – This is the estimated value of your company before an investor’s added contribution. While this type of valuation is more common, it can sometimes be more complicated to determine due to outside variables that can make the value fluctuate.
- Post-Money Valuation – This number is the value of your company after money and investments have been contributed by the investor.
When discussing valuation, both the company and the investor must be on the same page regarding whether they will be determining investments and equity using pre-money valuation or post-money valuation formulas. It is generally encouraged to stick to one or the other to avoid difficulties that may arise due to miscalculations if both are used.
The valuation will likely be one of the most contested topics of a term sheet negotiation. Many start-up companies are too aggressive with their valuation requests and have difficulty nailing down investors. Similarly, if an overly high valuation is approved and received from an investor, it can lead to intense pressure to live up to their financial expectations. This can set companies up to lose out on additional financial support in later funding rounds. Be realistic about your valuation demands and be prepared to negotiate substantially on this subject.
Preferred Stock vs. Common Stock
The most common method for a company to attract investors is to issue them money and ownership value in the form of stocks. Stock can be issued to investors in two ways:
- Preferred Stock – Investors are paid a pre-determined dividend that is independent of the company’s growth. Investing in preferred stock mitigates the risk of losing money if the company does poorly, but it does not give investors any voting rights on corporate issues.
- Common Stock – Investors are paid depending on the success of the company. Common shareholders generally will receive very little money back if the company goes bankrupt, but they are given voting rights on corporate issues.
While investing in common stock is a riskier move, it can result in significantly more profit than preferred stock if the business is successful. When negotiating a term sheet, companies and investors need to be on the same page about how they will issue stock and what liberties this will give investors. This will also play a big role in decisions about liquidation preferences, as explained below.
Liquidation preference is a protective provision for investors if a company is liquidated and ends their business at a lower value than was expected or calculated. Liquidation of a company can occur through:
- Company Acquisition
A Liquidation Preference ensures that investors, or the “preferred shareholders”, receive their money back before the company owners/employees, or “common shareholders.” Liquidation Preference is commonly laid out in two different ways within a term sheet:
- Non-Participating Liquidation Preference – In this scenario, investors can choose whether or not they want to get all of their money back before the common shareholders or if they want to convert their shares into common shares and receive their funds based on their percentage of ownership of the company at the time of liquidation.
- Participating Liquidation Preference – In this scenario, an investor will receive additional “participation” funds on top of their initial liquidation preference. These funds are based on the investor’s ownership percentage.
Companies should negotiate for a non-participating liquidation preference, as the latter choice will always mean more liquidation funds will be going to the investor and less towards the common shareholders in the event of a liquidation. Even though liquidation preference refers to a “what if” situation, it’s important to include it in your term sheet and ensure that common shareholders will be protected given a liquidation scenario.
Anti-Dilution Provisions are protective clauses in a term sheet that protect investors from losing money via the company selling their stock at a lower price than the investor initially paid. If these provisions are not included in the agreement, the investor can legally regain their initial percentage of ownership without paying additional money.
While anti-dilution provisions protect investors, the pay-to-play provision seeks to protect the company by requiring that investors must continue to invest in the company over time to hold onto their preferred stock.
Generally, an involved and committed investor will request a seat on a company’s Board of Directors. It’s important to lay out the terms and conditions of this appointment so that neither party feels that they have been given too much or too little power.
Hire a Good Lawyer to Assist You
Hiring a lawyer can seem like a serious money and waste of time, but having a professional on your side throughout the negotiation process will ultimately be worth it if you aren’t well-versed in the market terminology. A lawyer who is practiced in investor relations will be able to give you support and a second opinion will protect you from falling victim to an experienced investor who may be looking to take advantage of your lack of expertise.
Newer entrepreneurs can run into the problem of sitting back too much and letting their lawyers take over the brunt of the negotiations. While your lawyer should be there to provide you with knowledge and insight, do not allow them to take the reins. Once you’ve found the right lawyer, establish ground rules regarding what exactly you are looking for from them before and during negotiations.
Prioritize the Non-Negotiables of Your Term Sheet
Both you and your investor will undoubtedly come to the table with some non-negotiables that could make or break your relationship. Bring these issues immediately to the table, and don’t move on to less important matters until each issue has been resolved. Straying away from the more important discussion topics can signal to your investor that you’re lacking confidence or commitment, which can leave you in a position to be taken advantage of.
Be Prepared to Negotiate with Your Investor
This may seem like a no-brainer, but many new entrepreneurs lose ground with potential investors by either refusing to budge on too many non-negotiables or by letting the investor take control of the meeting. A term sheet negotiation should ultimately result in a win-win for you and your investor, and that will undoubtedly mean that provisions on both sides will need to be adjusted. Understanding that both sides will need to make adjustments will help you come into an investor meeting with your eyes open to things that need to be negotiated.
One of the easiest ways to narrow down the most important topics that need to be negotiated is to follow the “rule of 3.” Going into your term sheet negotiation choose 3 issues that you are committed to negotiating about. Having a game plan and moving right into the important issues will show your investor that you are knowledgeable about the issues at hand and that you’re unafraid to back down on subjects that are important to you. Gaining credibility with your investor early on will make a world of difference down the road.
Watch for Red Flags
No matter how competent you feel going into a term sheet negotiation, there is still the potential for certain provisions or lack thereof to slide under the radar and not be recognized until it’s too late. Knowing what the most common red flags in a term sheet can help you identify them before they become solidified and you’re unable to go back and make revisions. Below is a list of the most commonly seen red flags you need to look out for during a negotiation.
- Review Period
- Undisclosed Change in Management
- Guaranteed Exit
Some term sheets may include a “review period,” which allows potential investors to pull out of the term sheet penalty-free, even after the term sheet has been signed. While a term sheet is technically a non-binding agreement, good investors will generally not sign a term sheet unless they are confident about moving forward with the agreement. Seeing a “review period” in a term sheet is a sign that the investor is anticipating the deal going not through, which is a sign that you need to re-think your choice of investor.
Undisclosed Change in Management
It’s unlikely that a change in management will be written into a term sheet since a company’s Board of Directors can replace a CEO regardless. However, you should be concerned if your investor includes a change in management term without prior discussion regarding its inclusion. If you see a change in management term that you did not previously agree upon with your investor, make sure that it is removed.
If you’re given a term sheet that guarantees your investor a return on their contribution within a pre-determined period, you should think twice about who you’re going into business with. An investor who includes a guaranteed exit term is looking to ensure that they don’t lose out if the company goes bankrupt, which is a sign that they don’t have the company’s best interest at heart. Make sure any mention of a guaranteed exit is removed from your term sheet, or you could find yourself in an unnecessary power struggle with your investor.
Some investors may request to provide additional funding based on certain milestones achieved by the company, which are called “trenches.” If your investor requests milestone funding, be wary – this may indicate that they don’t trust your company’s estimated growth trajectory or may be wishy-washy about fulling committing to an investment. If your company is currently well-established and seeing positive growth, avoid taking this route with potential investors.
With so many moving parts to a term sheet negotiation, it can be easy to overlook small details or potential red flags. However, as long as you’ve identified your most important points of negotiation and are confident with the investors that you are bringing on, you will be on the right track to successfully negotiating a term sheet and exponentially growing your business.
How do I Gain the Upper Hand in a Term Sheet Negotiation?
If you’re concerned about “coming out on top” in a term sheet negotiation, the first thing you need to do is throw your ego out the window. While you need to be assertive and vocal about the needs of your company, you also need to be sympathetic and open-minded when working with your investor. At the end of the day, a successful term sheet negotiation will result in a happy company and a happy investor that will lead to a positive and mutually beneficial long-term business relationship.