editione1.1.3Updated September 13, 2022
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Term sheets, and the final legal documents that follow them, are the result of a decades- long tug-of-war between investors and founders. Each clause can be used either defensively or offensively by either party. This is why term sheets are so complicated. In the business of company-building, the incentives for one party to find a loophole to keep or take more ownership are high. The contracts that term sheets set the stage for are the mechanisms both sides use to keep the other party from taking unfair advantage of them.
Term sheets can contain more than 20 specific conditions, each of which is highly nuanced and evolving. Founders don’t need to memorize every term, but they are responsible for negotiating term sheets and getting their company a good deal. Some founders only care about the pre-money valuation and amount raised and then rely on their counsel to tell them what to do with the rest of the term sheet. Every founder with a term sheet in front of them wants it signed yesterday, so they can finish this fundraising round and get back to their company! This temptation is understandable, but you should be cautious about giving even a great lawyer complete decision-making power.
caution Unfortunately, the temptation to just get the thing signed is exacerbated by the fact that term sheets often have an expiration date or an exploding deadline. While there are many firms that do not put an expiration date on term sheets, those that do, use it as a pressure tactic to discourage founders from shopping a term sheet around for better terms. Many founders panic when they see the exploding deadline and then fail to take the necessary time to understand the terms they’re negotiating.
importantIf you need a few extra days to better prepare for a negotiation and speak with your lawyer, don’t be afraid to ask for it. It’s better to take the time to be thoughtful, and if an investor truly wants to work with you, they’ll move the deadline back. But you also want to find the right balance—don’t drag this period out unnecessarily. If it’s taking too long for you to sign the term sheet, investors may start to think there’s something wrong with your process or that there’s some risk with your company. If you’re not sure how much time is right, ask your counsel or close advisors.
dangerDon’t count your eggs before they hatch! Investors sometimes pull out late in negotiations, even after you’ve agreed to terms. Nothing is guaranteed until the money is in your bank account. When you’ve finished negotiating your term sheet and all parties have signed, it’s OK to celebrate with your team. While this is a big step you can be proud of, remember that even though you have the term sheet signed, you still need to complete the negotiation over long-form documents and get the money wired—a signed term sheet is not a closed financing!
It is possible that an investor may rescind a term sheet after signing, or that a founder will walk away. In early-stage deals this is extremely rare, and there are high reputational costs associated with reneging on a term-sheet agreement. As deals move into later-stage territory, however, rescinded term sheets become much more common and the reputational costs of walking away from a deal are much lower.
Even when you do have the money in the bank, don’t take a photo of yourself holding stacks of money—don’t do that, ever.
Here are a few more things to keep in mind as you negotiate your term sheet:
Try to meet in person. If you are in the same city as your investors, meet in person. When you get to negotiating a deal, in-person meetings can make that process move faster. It’s easier to get people to collaborate when they are all in one room.
Helping phrasing. When an investor is trying to get you to agree to a term you think is unfair, you need to protect your interests without sounding accusatory toward the investor: “Sorry, I’m just inexperienced; I read/was told that it’s not wise to [term they want you to agree to].”
Entering a negotiation confident in your position can make a huge difference. Revisit this section on confidence for tips, and for those interested in going deeper, Alex Jarvis has a great podcast filled with practical advice related to how to portray confidence when negotiating.
If an offer is acceptable. Accept it. Don’t hold out for perfect offers that may never materialize.
Respond promptly. Don’t sit on good faith offers of investment that give your company a valuation you can live with. What constitutes a prompt response to an investor is up for debate, but think in terms of one day or two to three days.
Due diligence. After you negotiate the term sheet, the VC firm will ask you for a lot of documents, like your cap table, articles of incorporation, and any contracts you’ve signed with external vendors. They call it a due diligence checklist or a “disclosure schedule.” You can and should ask them for this checklist in advance, so you can keep your files organized in a data room, like Dropbox or Box, which you’ll eventually share with the firm. Every lawyer will have a due diligence checklist, as well, to help you prepare.
At this point, investors will also call around to industry experts, customers, your old bosses, and even friends to learn more about you. They likely made some calls after the second or third meeting they had with you; this time will be more serious.
Remember, even a signed term sheet is non-binding. This is the final audit investors will conduct to determine whether there are any big risks with your company.
Closing. Once you and your investors agree on the final docs, have your lawyer review them to make sure no one pulled anything shady. Confirm everyone signed, check your bank account, and get to work creating a 3–5X return on that money.
Brad Feld and Jason Mendelson of Foundry Group first encouraged people to view the terms of a term sheet on two axes, economics and control, in a running series of blog posts that eventually led them to create one of the most widely respected books on venture capital, Venture Deals. Economic terms are related to who gets paid how much and when. Those related to control dictate who can or can’t do what with or without permission from the other party. This distinction is a deeply helpful frame of reference for understanding and negotiating term sheets.
Founders often forget that they’re negotiating for good economics—for themselves and their team—and appropriate control dynamics. We encourage founders not to think of control in absolute terms, as once you take money from someone else, you are giving up some control.
For example, founders often obsess over maintaining 50.1% ownership of their company after the Series A. Mistakenly, they think this is a control term when it is actually an economic term. More ownership directly translates to more money for the founders in the event of an acquisition or IPO. Founders may think that the class of stock they sell to investors is an economic term, when it’s actually a control term—preferred stock protective provisions can force founders to bring major decisions to a vote that can only pass with majority support from the preferred stockholders, even if the founders own more than 50% of the company.