Early stage companies grow by attracting capital. Capital comes from investors, often referred to as venture capitalists (VC). VCs want control over their investment while founders want control of their company. And so the tug of war of an early stage investment negotiation begins.
A term sheet typically sets forth the terms and condition upon which a VC proposes to make an investment in an early stage company. The term sheet both initiates a formal negotiation and sets the tone for the future relationship between the parties. VCs are highly sophisticated investors who have tremendous experience investing in early stage companies and are savvy about the issues that are important to investors. For founders, it is essential to understand and carve out the issues that are most important to their own interests, so that any negotiation focuses on those issues, rather than every single point. Concentrating on the material issues also helps to build the founder’s credibility with the VC and close the investment swiftly.
Don’t Underestimate the Power of the Term Sheet
Even though a term sheet is not legally binding, it sets forth the initial agreement between the founders and the VC. If a founder agrees to a term in the term sheet, it will be very difficult to change that term in the definitive documents, and any material change will likely affect the founder’s credibility, which in turn may affect the relationship between the VC and the founder. Founders should be comfortable with the terms in the term sheet before they move on to final documents.
Understand the Terms before the Negotiation
Understanding the typical provisions addressed in a term sheet before beginning a negotiation helps to focus a founder on the issues that are important. Not every issue is worth arguing about, and certainly not every argument is worth winning. Certain terms, however, are worth negotiating, and those usually center on control, valuation, liquidation preference, anti-dilution and veto rights. Founders should understand the meaning and impact of those terms.
- For instance, control deals with the makeup of the board of directors, which is the governing body of the company. Who is on the board and who has control of the board, will determine how critical decisions concerning the company will be made.
- Valuation of a company before an investment is made, referred to as “pre-money valuation,” is often a highly negotiated issue, primarily because a founder typically aims for a higher valuation and lower dilution, so that when the VC comes in, the ownership of the founder is minimized. However, a higher valuation is not necessarily an advantage, particularly if after the investment is made, a subsequent investment or financing round values the company at the same or lower valuation. A company attracts investment when it is strong, and shows an upward trend. If the value of a company decreases after the initial valuation, it implies that the company is not doing well, or the initial valuation was too high, neither of which will generate great interest or security for a VC.
- Liquidation preference is a significant term for a VC and protects against the possibility of losing the VC’s entire investment. This is the means by which the VC is able to recoup his or her investment prior to other, more junior, shareholders. For example, in a 1x preferred return (which is a typical liquidation preference), the VC would be entitled to receive 100% of the initial investment before the holders of common stock that do not have a preferred return. Sometimes a VC will also negotiate for “participating preferred stock,” which would allow them to essentially double-dip in a sale. In this example, if a VC has a 1x return with a liquidation preference of $1,000,000, and owns 30% of the company, on a sale the VC would get the first $1,000,000, and then participate alongside the common stockholders in the balance (such that the VC would be entitled to 30% of the balance leaving 70% for the common stockholders). From a founder’s perspective, the VC in the above example would be getting a second bite at the apple, rather than leaving 100% of the balance for the common stockholders.
- Anti-dilution provisions are designed to protect VCs from future down rounds (i.e., future investment or financing rounds at a lower valuation), with the “broad-based weighted average” being the most founder friendly. The broad-based weighted average is a formula intended to protect the ownership of the early shareholders as more investors come in and additional stock is issued, thereby diluting the existing shareholders. Anti-dilution provisions can be complicated and are best discussed with a founder’s legal team. Note that anti-dilution provisions are not the same as preemptive rights, which are the rights of a VC to purchase additional stock in a subsequent round at the price offered in such round, so that the VC may protect its ownership percentage of the company.
- Veto rights are rights that protect VCs from certain actions being taken without their consent. For instance, actions that dilute their ownership, or actions to sell the company in the future typically require the consent of the VC. When negotiating veto rights, weigh the actions so that those actions that do require consent of the VCs are not too restrictive. Also bear in mind that the VCs do not generally invest in a company to take control of the company. Rather, the VCs balance their interest in growing their investment with the founders’ ability to use their knowledge and expertise to operate the company.
The above provisions are merely a sampling of terms set forth in a term sheet that are worth negotiating early. There are, of course, other provisions that also end up in a term sheet, but it is best to determine which ones are worth the initial fight. Rather than focusing on terms that are relatively standard, such as rights to information or tag-along rights, a founder would be better off focusing on those terms that have greater significance.
Understand the VC’s Perspective
Once founders are comfortable with the typical terms of a term sheet, it is easier to understand the perspective of the VC, which makes for a much easier negotiation. Once the founders appreciate the concerns of the VCs (anti-dilution, board representation and liquidation preference, to name a few), reaching a middle ground to address them results in a faster closing of the deal. Equally important is keeping in mind that founders and VCs are after the same thing: success. Coming to a compromise on important terms paves the path to a long and fruitful relationship.
Cash Is Not Always King
Naturally when looking for investment, founders look to maximize the amount of money they can get. However, it is important to look past the cash and evaluate the deal as a whole. Assess whether the investors can provide strategic advice, make introductions and offer mentoring and experience in the industry. While at the outset this may not appear to have monetary value, in the long run, such experience could be priceless. Finding the right long-term partner is the ultimate goal.
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Stella Lellos is a partner in Uniondale, NY-based Rivkin Radler LLP’s Corporate Practice Group. Stella has significant experience in all aspects of complex corporate transactions. She focuses her practice on private company mergers and acquisitions, leveraged buyouts, corporate finance transactions and general corporate representation of U.S.-based and international companies.