What to Look for When Negotiating a Term Sheet for Venture Capital Financings

Apr 17, 2017 by

What to Look for When Negotiating a Term Sheet for Venture Capital Financings

What is a term sheet and why is it important to an entrepreneur?  In short, a term sheet is a formal document that spells out the initial agreement reached between an entrepreneur and a venture capitalist. It is the primary document attorneys use to draft the final agreement between the parties and resolve any disputes. It is typically the product of high stakes, emotional negotiations between the founders of a company and venture capitalists. For the unwary entrepreneur, a term sheet that seemed like a great deal at the time it was signed could later prove to be a bad deal.  This is why it is so important to understand the impact of a term sheet and how a favorable result from negotiations could lead to the success of a new company.  The financial “bottom line” of the term sheet is only a part of what should be considered in these negotiations (albeit an important part).  Non-monetary issues, such as support from the venture capitalist, control over the company and anti-dilution protection are all important to the term sheet and future life of the company as well.

Some of the common language used in term sheets is defined in this article.  However, the entrepreneur must be aware of which of these terms are negotiable, and which ones are important enough that the entrepreneur should negotiate over.  This article identifies six specific terms that are important enough that the entrepreneur should negotiate them.  They are:  valuation, board of directors, liquidation preference, protective provisions, and anti-dilution protection.

Valuation.  This is one of the biggest issues when it comes to a term sheet, but should not be considered exclusively of the other provisions in the term sheet.  For example, one venture capitalist may bring more to the table in terms of experience and offered assistance, so an entrepreneur might consider a lower valuation from that venture capitalist.  It is also necessary to understand the importance of the option pool as it relates to the fully diluted pre-money valuation.

Board of Directors.  Who sits on the Board of Directors and runs the company can be critical to the long-term life of the company.  The Board’s make up and structure can take a variety of forms, depending on the particular entrepreneur and venture capitalists involved.  A common make up includes two board members from the entrepreneur’s side of the table and one board member from the venture capitalist side.  However, depending on the size of the investment, the venture capitalist might seek greater control over the Board, and therefore the company as it moves forward.  An entrepreneur should have a frank discussion about the control and direction of the company with the venture capitalist, to ensure there is an understanding about control over the future of the company.

Liquidation Preference.  This is language that identifies and protects the venture capitalist’s money by identifying the return of money via preferred (versus common) shares of stock.  There are a variety of potential liquidation preference formulas that an investor might use, depending on the triggering event (sale, bankruptcy, merger, etc.)  Additionally, some liquidation preferences will “carry over” from Series A to Series B funding, so a long term understanding of the impact of these preferences is important for the entrepreneur to have.

Protective provisions.  Most venture capitalists will seek to include protective provisions, or veto rights, over some specific company actions.  These veto rights could range from small matters, such as on declaring dividends, up to large matters, such as the sale of the company.  These protective provisions could be a trap for the unwitting entrepreneur, so make sure you understand the full implication of any protective provisions the venture capital seeks to include in the term sheet.

Anti-dilution protection.  Dilution refers to the concept of a shareholder’s decrease in ownership percentage due to an increase in the number of outstanding shares, leaving the shareholders (investors) with a smaller piece of the corporate pie.  Anti-dilution provisions protect against a later issuance of stock at a price that is lower than the preferred issue price (a “down round”) by adjusting the price at which the preferred stock converts into common stock.  The provisions are generally designed to protect the venture capitalist’s investment, so the entrepreneur needs to understand the impact of any proposed anti-dilution provisions in the term sheet.

Most term sheets will also include the monetary and non-monetary language identified below. (This language is generally less important to the negotiation than the terms identified above, but still important to the future of the company.)

Monetary Terms

Type of Security.  Investors usually receive preferred stock, which will often result in receipt of the proceeds of an exit before holders of common stock.

Conversion. A conversion transforms preferred stock into common stock.

Pay to play.  This requires the venture capitalist to invest a certain amount in later rounds or suffer penalties such as forced conversion to common stock, loss of anti-dilution protection, and/or the loss of various control rights.

Dividends.  Dividends are sums of money paid by a company to its shareholders out of its profits or reserves.

Warrants.  A warrant is a security that gives investors the right to buy stock at a certain price within a certain timeframe (usually at a low/nominal price).

Option pool.  An amount of shares reserved for future hires.

Non-monetary Terms

Exclusivity.  This prevents an entrepreneur from speaking with other investors for a specified period of time after signing the term sheet.  This allows the venture capitalist time to perform due diligence without worrying about competition from other venture capitalists.  The length of time of exclusivity is negotiable.

Information rights.   This gives the venture capitalist certain rights to obtain specified company information (reports, financials, etc.).   This should be done while still protecting certain aspects of the entrepreneur’s business.

Participation rights.  This gives the venture capitalist a right of first refusal to invest in future rounds.

Co-sale and ROFR.  This gives a venture capitalist the right to sell stock to the same buyer, at the same price and same percentage that a founder or other major holder sells to.

Registration rights.  This requires the entrepreneur’s company to register venture capitalist stock for sale on the public markets.

With all of these economic and non-economic terms included, an entrepreneur must pick his or her “battles” in the negotiations with the venture capitalist.  The entrepreneur must also know what kind of leverage he or she has in negotiating these terms.  For example, if an entrepreneur has four or five different venture capital firms interested in investing in the business, the entrepreneur has greater leverage in the negotiations.  It is likely no secret that venture capitalists are sophisticated negotiators, and know going into the negotiations what is important to them.  They are going to hire savvy, experienced attorneys to represent them in the negotiations over the term sheet.  An entrepreneur needs an attorney on his or her side of the table that is equally capable at negotiating term sheets, can help one avoid major pitfalls, and make sure that the entrepreneur achieves his or her goals with the term sheet, both monetarily and for the long term future of the company.

ABOUT JASON BELICE

Mr. Belice has been a corporate and real estate transactional attorney since 1998. He has significant legal experience in all aspects of representing privately and publicly held companies. Mr. Belice’s corporate practice includes domestic and international mergers and acquisitions, private placements of equity and debt, venture capital financings, film and entertainment financings, corporate governance, reorganizations, employment equity and compensation arrangements, entity formation and counseling senior company executives on complex legal and compliance issues.  For more information, please call (866) 508-8940 or go to http://www.beliceinc.com

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