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Attention Startup Founders: Don’t Neglect Negotiating a Term Sheet With Investors

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Here at Punch, we’ve worked with startups who were so grateful to be receiving VC capital that they did not consult with a legal expert on the terms of the term sheet. They very much regretted it later.

We recently worked with a startup that neglected to set a limit on the level of financial disclosure required by the VC. This resulted in a relationship where the VC was riding the startup constantly with questions related to their numbers and statements, to the point of being dysfunctional and distracting from running the business. The startup would have been much better off if they had narrowed the scope of disclosure required by the VC during negotiations.

VC Terms you should be looking to negotiate include:

  • Valuation
  • Capital Structure
  • Anti-Dilution Provisions
  • Performance/Forfeiture Provisions
  • Employment Contracts
  • Board Representation and VC Share of Control
  • Shareholder Agreements
  • Cashing Out Provisions

No matter what your level of expertise in the startup sector, all early-stage companies should be negotiating the terms of their contract with a VC. Not to mention you may not want to take the offer of the first VC you run across if the terms aren’t favorable - due diligence works both ways, and it’s incumbent on you to seek multiple investment streams.

We’ve laid out some basic guidance below for the primary terms you should be negotiating, but it’s key that all startups consult with their financial and legal advisors to ensure everything is in line.

Is a Venture Capital Term Sheet a Binding Contract?

The term sheet will cover all of the important facets of the financing, but it is not a contract. The term sheet will typically state that it is non-binding except in matters of confidentiality and no shop/exclusivity. However, the term sheet phase is where almost all of the terms of the deal are hammered out before a final contract, and should be treated as your primary opportunity to make sure the deal is in line with your interests. 

Venture Capital Deal Terms to Negotiate

1. Investment Amount and Company Valuation

The valuation of your company is defined in terms of pre and post-money valuation. The pre-money valuation is what your business is estimated to be worth before investment, and the post-money valuation is post-investment. This is one of the most hotly negotiated aspects of the term sheet as it will result in potentially higher levels of investment from the VC.

As an entrepreneur, you’ll want your company valuation to be high to avoid dilution, while the VC will want to lower valuation so there are less risk and more potential for profit. The better of a case you can make for your pre-money valuation, the more likely you are to attract a higher round.

Key pre-money valuation factors include:

  • Experience of the founders
  • Size of the potential market
  • How novel the proprietary technology is and how close you are towards your minimally viable product
  • Initial existing traction (partnerships, publicity, etc.)
  • Recurring revenue and cash flow potential
  • Capital efficiency of business plan
  • Valuations of similar companies
  • How much competition there is to invest in your business

Early-stage investments are typically in the $1 million - $5 million range, while a Series A round can attract anywhere between $5 million and $15 million

2. Capital Structure

A venture capitalist will always look to invest in redeemable preferred shares or debentures in a portfolio company so they lower their risk and have the option to convert to common stock options when things are going well. They may also ask for a debenture along with warrants as kickers, so they can purchase common stock at a nominal price and don’t need to convert their debt to equity.

In your ideal scenario, you’d get them to accept a structure composed entirely of common stock - but this is only realistic when you have a strong bargaining position.

3. Liquidation Preference

Liquidation is typically not an issue in the early-stage phase of investment, but something to keep in mind as you attract A round investment and beyond. It is a protection for investors if the  company ends its business at a lower value than expected due to a merger or acquisition, or bankruptcy.

The two common arrangements are:

  • Non-Participating Liquidation Preference: Investors choose if they want to get all of their money back before the common shareholders or convert their shares into common shares and receive funds based on their percentage of ownership of the company.
  • Participating Liquidation Preference: Investors receive additional “participation” funds on top of their initial liquidation preference based on the investor’s ownership percentage.

It is in the company’s best interest to aim for a non-participating clause to get the best terms in a liquidity event.

4. Anti-Dilution Provisions

Anti-dilution provisions are put in place by the VC to protect the value of their investment. Dilution is a term for when a later investment round increases the number of total shares and the value of existing investor shares goes down. Anti-Dilution protection helps protect the interest of early investors do the value of their investment does not decrease down the road. 

The most common is “weighted average” anti-dilution protection, which reduces the conversion price and increases the conversion rate of the preferred stock held by earlier investors.

You should aim to avoid a“full ratchet” anti-dilution clause that applies the lowest sale price as the adjusted option price or conversion ratio for existing shareholders or any shares of common stock sold by a company after the issuing of an option.

5. VC Representation And Disclosure

Important decisions like whether to merge, liquidate assets, or sell stock will require VC consent, even if they have only a minority position. Generally, they will want one or more of their representatives on your board. However, the amount of bureaucracy and overreaching this creates can bog down your internal processes.

If you and other founders agree to a deal that leaves you with a minority interest, ask for no less than the VCs would probably demand: that they guarantee you board representation and obtain your consent before making any major business decisions.

You should seek, whenever possible, to narrow the scope of these representations and qualify them as being to the best of your knowledge at the time. It is a good idea to negotiate for a provision so that if there are omissions in your statements that later cost the company a small sum such as $50k, the omissions will not be considered a breach of the representation. Also, be sure to ask for a limit on your reports about the company.

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