Understanding Term Sheets

15 minutes, 12 links

From the Holloway guide toRaising Venture Capital

Understanding Term Sheets15 minutes, 12 links

So, you got the call. Or an email. Or you were chased down the street. A firm wants to invest in your company, and they’ve drawn up some stuff they need you to look at. “Talk to your lawyer and get back to us ASAP.” What you have is called a term sheet, one of the most exhilarating components of raising venture capital, and one of the most intimidating.

Definition A term sheet is a written summary of the proposed key terms of an investment. The terms must be negotiated and agreed upon by both the investing party and the company seeking investment. After agreement on the terms has been reached and formalized in a signed term sheet, legal documents (commonly called “long-form docs” or “final docs”) are prepared, reviewed, and executed to finalize the investment. In itself, a term sheet is not a legally binding document, but its conditions of exclusivity and confidentiality are legally binding.

Many of the important terms you’ll see in your term sheet have already been discussed in detail in this Guide. We link to the relevant sections so you can easily access all the information you need.

To see what your term sheet might look like, the toolTerm Sheet Generator by Wilson Sonsini Goodrich & Rosati (WSGR) will build one for you based on a set of questions you can answer.

Founders should consider two things with regard to corporate counsel when negotiating a term sheet: (1) leveraging their experience doing deals with many different investors to put yourself in the strongest negotiating position and (2) managing the process with diligence, as the legal bill for the paperwork related to a priced round—from term sheets to final docs—can often approach or even exceed $100K if you don’t.

Even if this is your third time raising money, the investors you’re negotiating a term sheet with have probably done this 20+ times. This puts you on the ugly end of a drastic information asymmetry. Great attorneys who know venture capital terms will have many years of experience across hundreds of deals done with many investors. Choosing the right lawyer can be as important as choosing the right investor. You want someone who understands how to support startups and work with venture capital investors. Even if someone is from a nationally ranked firm and an expert in real estate, public finance, or bankruptcy, that does not mean they will be a great startup lawyer. Great startup lawyers aren’t just good with deal terms, they also can help read the dynamics between negotiators, have a strong sense of what’s market for a deal, and give solid practical advice appropriate for the stage your company is at. Aside from being helpful when creating a target list of investors, your lawyer can help to even the playing field when you’re negotiating with seasoned investors.

When you receive a term sheet, you should share it with your counsel. Then walk through each term line by line with them. Many founders see this as a costly exercise, but to skip this step is penny-wise and pound-foolish. If you are the founder responsible for negotiating the investment, it is your responsibility to understand what you’re negotiating. Even if you have terrific counsel whom you trust (hopefully you do!), you’ll only be able to determine what’s worth fighting for in a negotiation if you understand the substance of each term.

Finally, founders should be sure to recognize that corporate counsel is legally obligated to represent the interests of the company. While the interests of the company and its founders can often overlap, that is not always the case. When making decisions that have a personal impact, founders should consider hiring their own lawyers to represent their personal interests. When we refer to lawyers or counsel in this Guide, you can assume we are referring to corporate counsel that represents the interests of the company, unless we explicitly state otherwise.

caution In addition to paying your own fees for counsel, founders are typically expected to pay legal fees for the investment firm. This is usually negotiated as part of the term sheet, so we’ll discuss it later on.

Term sheet negotiations

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.

Economics vs. control

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.

As you read through each term and eventually begin negotiating, consider which terms primarily impact economics, and which impact control.

Side letters

Definition A side letter is a separate contract used in a negotiation to give investors separate terms for an arrangement than those outlined in the primary contract documentation. For example, in the case of a minor investor that wouldn’t normally get information rights, the company can draft a side letter granting that investor those rights.

Side letters are often a fancy way of saying, “Hey, give me rights that no one else gets,” and founders should be wary of giving one investor special rights. On the other hand, some investors, like the venture arms of large corporations, have special reporting requirements that other investors may not require—side letters can be a great tool in a situation like this.