Venture Deals - Spring 2023 Course - 3. Term Sheets and Negotiations
Notes from Lesson Three of the Venture Deals Spring 2023 course, focusing on term sheets and negotiation.
This post features my notes from Lesson Three of the Venture Deals Spring 2023 course. This is part of a post series. Go to Part 2.
Term Sheets and Negotiations
Term sheets include three main types of terms which relate to:
- Economics
- Control
- Other
Economic Terms
Founders tend to focus on the headline price/valuation, but several other terms adjust the valuation. Let's consider each:
Employee option pools
Many investors will insist that you have an unissued employee option pool in the deal. Consider two scenarios:
£10m pre-money valuation - 20% option pool = £8m pre-money
Compare this to asking for the 20% option pool post-money; your valuation would now be £12m.
£10m pre-money valuation + 20% option pool = £12m post-money.
Always determine if a valuation is pre or post-money. Similarly, if you have already issued some options, ask the VC if the 20% option pool will include the already issued options.
Warrants
If your company has issued an investor a warrant, ensure this is accurately recorded on your cap table. Warrant issues often arise when lawyers go through the fundraising details. If you didn't disclose the warrant to the investor, you, not the investor, will likely suffer the additional dilution.
Liquidation Preferences
When you issue a liquidation preference, you give an investor preferred stock with particular characteristics. This will alter the eventual payouts received during an exit. It's vital to understand the implications of liquidation preferences. To learn more about the different types of liquidation preferences, see: What is a Liquidation Preference? and Beware of the Trappings of Liquidation Preference.
Vesting
Getting founder-to-founder vesting right from the start is critical. Don't avoid difficult cofounder conversations at the beginning of your company because those conversations will only become more complex with time. A vesting agreement gives each founder some level of protection if another founder does something unexpected. A standard vesting schedule is 4 years, either annually, quarterly, or monthly.
Brad Feld gives an example of 3 founders he invested in who said they were committed to working together forever. He tried to argue why they should sign a vesting agreement, and they were suspicious that he wanted it to ease one of them out. Brad liked them and said don't worry about the vesting. Within one year, one founder fired another; within two years, another founder was no longer active in the business. All three founders had the same stock, and the one founder working on the company was frustrated by the value increases that other founders were receiving.
Key lesson: Founders should protect each other from themselves by having vesting.
Redemption Rights
An investor with redemption rights can insist that the company pays them a certain amount for their shares after a particular time. This is to protect the investor when a company isn't moving towards an exit.
Anti-dilution protection
Whenever a company issues new shares, the existing shareholders are diluted. This is fine when the company's valuation is increasing, but if the company has to raise funding at a lower valuation, then existing investors will want protection. This is where anti-dilution comes into effect.
This impacts your valuation because you'll need to give existing shareholders with anti-dilution protection more shares, which changes the economics of the valuation you received from the new investors.
Ask your lawyer about anti-dilution protection clauses in your term sheet and look out for and avoid at all costs full-ratchet anti-dilution, which is hugely dilutive because it in effect reprices your new round at your old round's price.
Remember that you never know when the market conditions will change. Even if your company is growing well, a future fundraise could be at a lower valuation for reasons beyond your control. Protect your interests!
Control Terms
Founders often mistakenly believe that they control the company if they own 50% or more. In reality, the control terms can dramatically change who has the power within the company.
Here are some key ways that control within a company can be altered:
Board of Directors
The board is ultimately responsible for the company's management. Aim to have other non-financial directors on your board, even at an early stage.
Broadly speaking, there are three main types of directors:
- Common stock directors (including founders and the CEO)
- Investor seats (one or many)
- Independent directors
Investors will tend to add a financially-minded director per investment round. Brad Feld coauthored another book entitled Startup Boards: A Field Guide to Building and Leading an Effective Board of Directors to address board composition. One noteworthy point is to add an independent director for every investor director who joins your board in a new round.
Configuring your board of directors to be diverse and have the right people on it will be good for business, especially if your board represents the same diversity as your customer base.
Protective Provisions
If these provisions exist, you have to get consent from your investors to do certain things. This changes the control dynamic within the business, so pay careful attention to protective provisions. You want to avoid overly burdensome ones. For example, some standard protective provisions include:
- Preventing the company from changing the stock without the investors' consent
- Preventing the company from selling without the investors' consent
- Prevent the company from taking on debt that would have seniority over equity investments
Some bad protective provisions which could slow down your company and lead to strange power dynamics might be:
- An investor needing to approve all commercial transactions.
- An investor being able to veto the decisions of the majority.
Drag Along Rights
A term to describe a situation where you would vote your stock in alignment with the majority. It allows a class of investors to 'drag along' other investors.
Like founder-to-founder vesting, drag along rights seem undesirable to founders initially but actually make a lot of sense. For example, imagine a founder leaving a business on bad terms and having considerable company equity, and they could hold up decisions due to the size of their shareholding. Drag along rights would prevent such a situation.
Conversion Rights
This grants the ability for investors to convert preferred stock into common stock. You can have optional and mandatory conversion rights. A mandatory conversion right would be a situation like an IPO when all preferred stock converts into common stock. An optional conversion right might arise when it's more advantageous for an investor to own common stock than preferred stock, for example, when there is a low liquidation preference multiple, and the company sells for a high valuation.
Other Terms
Focus mainly on the economic and control terms. There are some other terms on a term sheet which are noteworthy:
Dividends - Aim for non-cumulative rather than cumulative. Cumulative is more common in PE deals, whereas non-cumulative is in VC deals.
Information Rights - Often, there's a threshold to determine access to company information. If you have a lot of smaller investors, you might want to grant them a different level of information access than your leading investors.
Rights of First Refusal - Grants existing investors the right to invest in the next round. A simple pro-rata right is perfectly reasonable.
Voting Rights - Check with your lawyer that these are boilerplate to avoid situations where an investor can have a disproportionately large voting voice.
No-shop Agreement - This exists to prevent the founders from taking that term sheet elsewhere to try and get a better deal. It gives the investor confidence that you're acting in good faith and willing to do all you can to make this deal happen with them.
Remember, working with VC-experienced legal counsel will save you time and hassle. They will help you to identify and push back against abnormal terms. It will also show your investors that you take negotiations seriously.
Negotiations
There's an asymmetry for founders going into a venture capital financing negotiation. The VC has likely done this many more times than the founder!
Three key things to remember:
- Make sure the VC feels heard and understood. Use basic mirroring or rephrasing to achieve this.
- Listen more than you talk.
- Always have a next step.
Be Prepared with your Best Alternative To a Negotiated Agreement (BATNA)
Establish with your cofounders what your BATNA is, and be clear about the terms that matter to you. Your BATNA represents the most advantageous alternative you can take if negotiations fail. If you negotiate without knowing your BATNA, you'll likely get pushed in a direction that makes you unhappy later.
Understand who you are negotiating with
This conversation is ultimately about people. People have different motivations and self-interests. What motivates and excites the people you're negotiating with? What personality type do they have, and how does this impact their negotiation style? Try and figure this out during the fundraising journey with them.