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The Latest Changes in VC Deal Terms — Understanding the Term Sheet

by kirkcoburn
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Entrepreneurs are brilliant innovators, but they may find themselves little more than upscale panhandlers when they’re ready to get their product or concept to market. Enter the fairy godmother — the venture capitalist — bursting with cash to invest in your company. Don’t assume that the first VC firm to offer you a meeting is the best for you. They’re conducting due diligence on you, so you should return the favor and research them. Find out what other deals they’ve done in your industry and how those succeeded (or didn’t).

So, you put together a business plan and a concept model, create a slide deck for your presentation, get a haircut and clean up your best hoodie, and set forth to pitch your idea to a room full of VC partners. Lo and behold, they like your idea and agree to proceed with investing.

Now comes the fun part: negotiating the terms of the deal with the VC.

What a Term Sheet Means to an Entrepreneur

Soon after you’ve shaken hands on the deal, you’ll get the term sheet.

A term sheet by any other name is still the same — it could be called a Letter of Intent, Agreement in Principle, Memorandum of Understanding, or Entrepreneur’s Bingo. But it’s essentially a non-binding agreement between you (the entrepreneur) and the venture capitalist, outlining the broad outlines of your deal. It covers topics like investment and collateral: basically, what you’re getting with the money and what you’re giving up in return.

One other thing — the term sheet is binding on a couple of points:

  • You cannot disclose the terms of the deal, or even its existence, under the terms of the Confidentiality Agreement.
  • It should come as no surprise that the VC has exclusivity for a period of 60-90 days. This effectively shuts you down from shopping around elsewhere while you are negotiating.
  • Attorneys are crucial to both sides: the term sheet allocates a budget for investor counsel.
  • In some jurisdictions, the term sheet does create an enforceable duty to negotiate in good faith. Ask your attorney if this codicil applies to you.

If you can’t come to an agreement with your first VC, keep your thoughts and opinions to a closed circle. VC is a small community. If you speak poorly of one, it will get back to the others, and you may find it difficult to get a meeting with other firms.

Components of the Term Sheet

Without further ado, let’s get to the nitty-gritty of  a term sheet. What does it look like, and more importantly, what are the “standard Venture Capital terms” that may apply?

Entrepreneurs usually come into the VC game with a working knowledge of some of the lingo, but now’s the time to do a deep dive into the vernacular. This way, you’ll know what you’re reading when you get that magical term sheet.

But first things first: hire a VC attorney to advise you through the process. Even the initial seed round of funding means highly detailed legal documents with an inordinate number of subordinate clauses and whatnots. You will need an attorney well-versed in finance to really understand what you’re signing. As you go through subsequent rounds of raising money, the term sheet and the ensuing final documents get a lot more complicated.

That’s why you should start your learning curve before you start pitching VCs.

In its simplest form, the term sheet lays out the money the VC is investing, how it plans to manage and protect that investment, and an exit strategy. In reality, term sheets are not simple — nor should they be. You’re negotiating a complex investment deal with layers of interlocking financial instruments and risk. As you go into future rounds of fundraising, the players and the terms get more sophisticated.

Look for a Lot of Pages in the “Sheet”

Back in the day, all term sheets looked pretty much the same — same font, same white paper, same document layout that vaguely resembled a subpoena. They were pages and pages full of double-spaced mumbo jumbo, and then you signed on the dotted line after agreeing to how many cups of coffee you’d drink in the VC conference room.

It’s probably due to the millennials showing off their mad PowerPoint skills, but somewhere in the 2000s, term sheets started to look less like serious banking documents and more like just a sheet of paper. Or an ad in the Student Union: colorful, a variety of fonts, some charts, and only a couple of pages. Conventional wisdom says to beware the limited term sheet that relies on few specifics and a lot on “Standard Venture Capital terms apply.” You’re not the VC expert, and “standard” can have a multitude of interpretations. While your lawyer may smile at a short term sheet, rest assured it’s because she just calculated all those billable hours that come from negotiating all those “standard” terms.

The moral of the story is that you want every detail of the deal spelled out in the original document. All the minutiae and fine points must be hashed out before the deal is finalized, so all those points should be covered in full in the term sheet.

Term Sheet Terminology

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Know the basics of how a term sheet works so it doesn’t capsize your company.

Now that we have established that the term sheet is not a bit of light reading, these are the actual terms you’ll see in the document. They can be broken down into three categories: economic, control, and exit terms.

Economic Terms

  • Pre-Money Valuation (what your company is worth today)
  • Investment Amount
  • Post-Money Valuation (what your company is worth after the VC capital infusion)
  • Preferred vs. Common Stock (investors want liquidation priority…as later stage investors come in, they want their money back first. Make sense?)
  • Option Pool: Like any other stock options, the right buy shares at a pre-determined price. The pool is the number of shares reserved for future purchases

Entrepreneurs and investors really do have the same goals for a company (honest), but they may not see the same path forward. One early point of contention may be in the number of common stock shares issued, or the issuing of them at all. Issuing common stock to the public is a somewhat common condition of a term sheet, and it’s really not worth the argument with the VC if you don’t like the idea.

Throw them a bone with this one.

Control Terms

This may be referred to as “Corporate Governance” on the term sheet. This section defines the balance of power within the organization. Early on, it may give more power to the investor in the areas of voting rights, board composition, and decision-making. You may be reluctant or downright opposed to giving away the control of your baby. However, keep in mind that the VC sees this as a partnership with a common goal but that they have the expertise you lack. Keep these terms in your back pocket so you can navigate the conversation:

  • Stake in the Company: The VC will want some ownership in return for capital.
  • Seat on the Board: The VC usually places an industry expert on the board. This individual serves in an advisory role and may or may not have voting rights.
  • Anti-Dilution Provision: This is a control that effectively protects the early investors by not allowing for the sale of shares for less than the original share price.
  • Drag Along: This provision is for investors wanting to gain some control (mechanism) over their ability to pressure other investors to support a transaction. Based on the price of the transaction, some investors may be losing money on a transaction when you are not…thus this provision becomes really important.
  • Pay to Play: This forces investors to continue investing in further fundraising rounds if they want to keep their preferred stock.

Liquidation or Exit Terms

Obviously, the magic word here is IPO. Or an acquisition (which is more common with CVC deals, where the startup has a synergistic business that streams into the existing lines of business of theirs or someone else’s business). Also, VCs have to plan for the worst in the term sheet, and that means how to liquidate the company and its assets if it doesn’t succeed. Some of the plan elements may include:

  • Preferred shareholders get paid before common shareholders, usually at 1X their investment. VCs are going to be in the category.
  • Participating, Non-Participating Liquidation: These exit options for investors may have some tax strategies involved but are mainly based upon an investors belief in how to best maximize their return upon a liquidation (study carefully).
  • IPO (Initial Public Offering): Congratulations, you did it! Your company is going public. Your investors are happy, you’re happy, and your product is a success.

Subsequent Term Sheets and Fundraising Rounds

The first term sheet is the simplest — you’re dealing with one investor, a small company, and a relatively small amount of capital. As you grow, you’ll need more money and further rounds of raising money. These rounds — Start-up (seed), A, B, and then C — get more complicated with the term sheets as you’re dealing with equally complicated share structure. The gist of the deal remains the same — money for you, a stake for them — but the terms expand to include these possibilities:

  • ESOP: That option pool you set aside early on has grown so that you can offer your original employees stock options. The world does have billionaires who were on the ground answering the phone at Google.
  • Voting rights: different rounds may contain different voting rights.
  • Pay to Play: this is a tool to encourage existing investors to keep investing (makes new investors feel better).
  • Veto rights ensure the company isn’t sold too early for a quick exit.
  • Founders may be asked to sign Non-Compete Agreements to ensure your commitment to the company.
  • Intellectual property rights may be on the table as an extra layer of security for investors.

Sure, there is a lot to digest here. Your legal team — at some point you’ll go from one attorney to a team, as you’ll need specialists in your industry along with your VC expert — can translate the legal lingo for you. But as the Founder of the company, you’re still ultimately responsible for the company, your employees, and your investor’s capital. Take the time to educate yourself before you’re facing the VC lions so that you are prepared for whatever the term sheet lays out.

If there’s something else that you think needs to be said (or explained) about term sheets, let me know and we can continue the conversation. If you want to catch up on the rest of the changes happening in current VC deals, read the other installments of my series:

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