When an entrepreneur decides to raise venture capital funds, it is both a patient process and a sprint to the finish line at the same time. One stage in the cycle is term sheet negotiation. Due to the excitement, and sometimes need to keep the lights on, we’ve watched entrepreneurs nosedive into signing term sheets with bad terms. Our goal is to save you from making the same mistakes.
First things first, what’s a term sheet? A venture capital term sheet is a document that expresses the agreed upon terms and intent of both parties (startup and investor) for the financial investment.
Typically, since entrepreneurs are not as versed in making deals as the VCs at the table, the bargaining power may become slightly off balanced. That is why it is very important to have a knowledgeable lawyer that you trust at the deals table with you. Don’t let yourself (or your lawyer) make these six mistakes:
1. Do not agree to off market terms
From time to time, investors that may ask for terms that are off-market. Your lawyer and other advisors can help you identify whether a deal term is off-market. Some terms that should make you raise your eyebrows include the following:
Participating preferred liquidation preferenceFull-ratchet anti-dilution protectionAccrued dividendsSuper pro rata rightsOversized option pool
2. Do model the terms
How can you decide if a deal is good, if you don’t model the financing and understand the possible effects? Bingo. You can’t!
Make sure your lawyer builds out a capitalization table to model the financing and walks you through the various scenarios. If there is something you don’t like in the modeling, you probably won’t like the effect in reality, either. Use the cap table to negotiate your preferences at the deals table.
3. Do not agree to a “No Shop Clause”
A no shop clause is a provision in the term sheet that stipulates a time period where the startup cannot seek or speak with additional investors for a certain amount of time. Although we are not fans of no shop clauses, we understand that sometimes they serve a purpose. At the very least, do not agree to a provision that locks up your ability to speak to other investors for a long period of time. If you’re comfortable with the investment size and are okay with taking a hiatus from venture capital meetings, then discuss the situation with your lawyer.
Typically, we advocate against these provisions because who is to say that a bigger investment isn’t around the corner…the last thing you want is a no shop clause in your way!
4. Do not give away board seats left and right…
Board seats equal control. Most VC investors will ask for at least one seat on the board. Once you hand off a board seat, you can’t put the toothpaste back in the tube. If you allow too many investors to gain management control, and they do not like your performance, you risk losing your own seat and being fired. Choose carefully who you want and trust on the board.
5. Don’t play the ‘Option Pool Shuffle’ game!
Don’t let your investors determine the size of your startup’s option pool. Why? When you’re negotiating about the size of the option pool to be adopted, you’re also negotiating the company’s valuation.
If you see a provision like:
“The $X million pre-money valuation includes an option pool equal to X% of the post-financing fully diluted capitalization.”
STOP IT IN ITS TRACKS. By including an option pool equal to a percentage of post-financing fully diluted capitalization, the term is actually adding in new options to achieve the higher pre-money valuation. Thus, this term further dilutes your shares.
For more on the option pool shuffle, read Venture Hack’s article.
6. Do stay due diligence ready, always!
Due diligence follows term sheet negotiation. Do not scramble to be due diligence ready because time kills all deals. A company’s ability to quickly and completely respond to due diligence requests increases the likelihood that the deal at hand will close on favorable terms (or close at all).
Ensure you’re due diligence ready, always, with our simple checklist.
We hope these dos and don’ts help you secure the best terms for your startup! For more information regarding term sheet provisions, like vesting shares, NDAs, or how to hire a lawyer, <= click those links!