More frequently than it should, the following situation occurs: a founder reaches out or is introduced, excited about a recent VC term sheet they’ve been provided, and asks for assistance in closing a Series Seed or Series A equity financing. After a few questions, it becomes apparent that the company already executed a “quick form” term sheet and just needs assistance closing the actual deal. You can imagine the reaction when it's explained that a majority of the deal education and negotiation is handled at the term sheet stage.
Term sheets set the tone not only for the immediate deal at issue, but every subsequent financing as well.
Term sheets set the tone not only for the immediate deal at issue, but every subsequent financing as well. Future rounds almost invariably build on the prior round, and unless the company’s leverage is phenomenal, it is rarely possible to walk back rights given to investors in prior rounds – even if those rights have caused issues for the company and headaches for the founder team. And unfavorable terms can often damage both the company and the early-stage investors, because future investors will expand or exclude these rights in subsequent rounds.
When used correctly, term sheets can shorten deal cycles, prepare the company for future rounds, and limit legal spend on both sides of the deal (a concept I’m all too happy to embrace if it preserves capital for early-stage companies and VC’s). Simply put, a well-crafted and mutually-agreeable term sheet can cut out the back and forth that makes deals more time-consuming and expensive. So what makes for a good early-stage term sheet?
Setting the valuation approach out in clear language eliminates the risk of confusion or disappointment three weeks from signature. I will typically include a simplified pro forma capitalization table (we can help with this) as an exhibit to ensure all parties are on the same page.
After valuation and percentage ownership, control rights are another important term to make clear in a term sheet. Board seat(s) and protective provisions (the ability to block certain actions by the company or its leadership) are two key points to understand and discuss before signing.
Liquidation preference is often confused for legalese, but is actually a commercial point that translates to real dollars at exit – simply put, liquidation preference defines the preferential treatment (if any) that a class of stock may receive on a sale of the company. Founders must understand what an investor asks for on this point and when/how to push back. For investors, taking an objective look at the effect of your early-stage liquidation preference on subsequent rounds is equally necessary.
Whether a founder can or must find co-investors to fill out a round or whether the lead investor will slot these co-investors for the company, it’s important for the parties to discuss expectations on this point and set them to writing in a term sheet. It eliminates a major source of miscommunication later in the deal.
Although generally non-binding, any standard early-stage term sheet will likely contain a binding “no-shop” or “exclusivity” provision that limits a founder’s ability to “shop” the term sheet offer for a better deal while the VC is expending resources to diligence the company and draft deal documents. This is a reasonable ask, but overly-aggressive confidentiality provisions should be avoided. Founders should be allowed to discuss term sheets with others in their circle to seek guidance/advice.
If you’re a founder or startup searching out investors for an early-stage round, reach out to Matthew McElwee at Founders Law LLC to discuss these terms in more detail, as well as how to carefully negotiate the terms that actually matter when building your deal.