A term sheet is a non-binding business agreement between a startup company and a potential investor. It is all a part of the dating process: the term sheet is an agreement to agree. It is a bit like engagement is an agreement to eventually marry. Here we discuss how to negotiate a term sheet.
A term sheet itself does not bind a business partnership; it is an important step towards creating a binding agreement. Term sheet negotiations are long, complex, and can be very annoying at the seed/angel level.
At this stage, you often deal with investors and entrepreneurs who don’t have a lot of experience negotiating term sheets. At the same time, there are many specific legal and financial issues to sort out.
So, how do you negotiate a term sheet?
The seven steps outlined below 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
- Negotiate A Term Sheet Better by Understanding the 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 startup or emerging company, it can be scary to put part of your business’s future 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 to raise money and build your company.
Take the Time to Woo Multiple Investors
Although it may seem a daunting enough task to get just one investor involved, it is in your best interest to simultaneously build relationships with multiple investors.
There are many reasons for this.
First, you may find that you need a group of investors rather than just one, so courting a group of investors may serve you well from a purely financial perspective.
Second, investors move in herds. As much as we work against this, it is true: once you start to get momentum with some investors, it is easier to get the next one to invest. (If you are an investor reading this, be aware of this tendency, you do want others to invest in the venture, but you don’t want to invest just because others are investing.)
Finally, if a potential investor knows that they are competing with others, they will be more amenable to agreeing to your terms and conditions.
Now, do NOT overplay the competition card: we had one startup tell us that he had plenty of options, and if we didn’t agree to his terms, he would walk. We immediately showed him the door; his business no longer exists.
Let this play out subtly and in the minds of the investors. Just remember: 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 is 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 another.
A quality investor will play a major role in the growth of your business. You want to work with investors who can provide advice as well as money. So, it is essential to do your research to ensure that your potential investors have the proper credentials and experience to help your business succeed.
It boils down to this: The better the relationship between you and your investor, the more successful your business will be in the long run.
Negotiate A Term Sheet Better by Understanding the Terminology
When negotiating a term sheet, it is important to understand common terms that will make up the contract.
So here are some of the most important terms that you will come across in a term sheet negotiation:
- Money Raised
- Money Valuation
- Preferred Stock vs. Common Stock
- Liquidation Preference
- Anti-Dilution Provisions
- Pay-to-Play Provisions
- Board Representation
Money Raised
Money raised is the money you are raising. The key here is to ensure that you are clear about how much you are raising and how much each investor contributes.
The challenge with the money raised is almost always not raising enough. Be clear about you need for 12-18 months of runway for your company. Communicate the needs of your business to investors and don’t raise less than you need. The desire to finish the negation can lead to bad decisions, so fight against that.
If you don’t have the money, you need you will fail, and that benefits nobody.
Money Valuation
Valuation refers to a company’s worth or value. Valuation determines the amount of equity that an investor acquires for their investment. Often in negotiating the term sheet, we talk about pre-and post-money valuations.
- Pre-Money Valuation – This is the estimated value of your company before an investor’s added contribution.
- Post-Money Valuation – This number is your company’s value after money and investments have been contributed by the investor.
If you have a $1,000,000 pre-money valuation and your investor contributes another $1,000,000, the post money value is $2,000,000.
When discussing valuation, both the company and the investor must be on the same page. Be sure you are both using either pre- or post-money valuation terms, or you can be in for some last-minute surprises.
The valuation will likely be one of the most contested topics of a term sheet negotiation. Many startup companies are too aggressive with their valuation requests and have difficulty nailing down investors.
But a high valuation can lead to intense pressure to live up to expectations. Getting the valuation wrong can set companies up to lose out on additional financial support in later funding rounds.
Be realistic about your company’s value and keep your eye on the final prize. A smaller percentage of a much larger company is much better than a larger share of a much smaller company.
Preferred Stock vs. Common Shares
Often as you start to raise money, you will create different categories of shares. Each class has specific rights and obligations. So you will often have preferred shares and common shares:
- Preferred Shares (preferred equity) – These shares come with specific rights that can include additional voting rights or specific dividend terms.
- Common Shares (common equity) – these are standard shares with no special rights.
Negotiating the rights of preferred shares can become a part of your term sheet negotiation.
Ultimately the rights conferred on preferred shares can also limit the upside potential: nothing is free. So while common shares have fewer rights, they may be the more lucrative investment.
When negotiating a term sheet, companies and investors must agree on how they will issue stock and the rights they gain.
This will also play a significant role in decisions about liquidation preferences, as explained below.
Liquidation Preference
You may negotiate liquidation preference, but it often is not an issue at the angel investment stage. At this stage, the company is so new and so risky that liquidation preference is a non-sensical conversation.
However, you should know the term:
Liquidation preference is a protective provision for investors if a company ends its business at a lower value than expected. Liquidation of a company can occur through:
- Mergers
- Company Acquisition
- Bankruptcy
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.
Ideally companies should negotiate for a non-participating liquidation preference. This means that more liquidation funds go to the investor and less towards the common shareholders in the event of a liquidation. Investors, obviously want the opposite.
Anti-Dilution Provisions
Dilution happens when another round of investment increases the number of shares or changes the valuation.
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.
Pay-to-Play Provision
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.
Board Representation
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. This is also why it is so important to do your investor due diligence and work with people who will support you.
Hire a Good Lawyer to Assist You to Negotiate Your Term Sheet
Hiring a lawyer can seem like wasted money and time, but having a professional on your side will ultimately be worth it throughout the negotiation process.
A lawyer who is practiced in investor relations will give you support, and a second opinion will protect you from contract terms that won’t serve you. Most investors are not out to take advantage of you, but they likely have more experience and know better what they are looking for. That difference of experience combined with the emotional need to finish the negotiation can lead to a bad deal. A lawyer can help with both the experience and emotional attachment.
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 lack 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 in a Term Sheet Negotiation
Knowing 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
- Milestones
Review Period
Some term sheets may include a “review period,” which allows potential investors to pull out of the term sheet penalty-free, even after signing the term sheet. 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.
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. And it can mean nothing. Discuss this, and understand why the provision is in place.
Undisclosed Change in Management In a Term Sheet Negotiation
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 management term change without prior discussion regarding its inclusion. If you see a management term change that you did not previously agree upon with your investor discuss this, understand it and make sure you agree with the provision.
Guaranteed Exit In a Term Sheet Negotiation
If the term sheet guarantees your investor a return on their contribution within a pre-determined period, stop. You can’t guarantee a return on investment. A guaranteed return is unrealistic. Worse, it can make raising future rounds impossible.
Milestones
Some investors may request to provide additional funding based on certain milestones achieved by the company, which are called “tranches.”
Milestones are fine: but be sure to understand the terms, be very clear about each milestone, what you need to do to achieve them and what happens when you don’t.
Know this: your plan is wrong. Your company will not develop or grow the way you think it will. Your investors should understand this. So be wary of over-committing.
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 negotiation points and are confident with the investors you are bringing on, you will be on the right track to successfully negotiating a term sheet.
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, stop. The first thing you need to do is throw your ego out the window. You should stand up for your rights and your business, but also recognize the needs of the investor. The term sheet should help you design a fair deal for everyone involved.
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.
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