How To Negotiate a Term Sheet

What is a Term Sheet?

Once a venture capitalist (VC) expresses interest in investing at a particular valuation, the next step toward closing the deal is negotiating a term sheet. A term sheet is a non-binding agreement that lays out the conditions of your agreement with the investor. Once both parties find the term sheet acceptable, it will serve as a template for the final, legally binding contract.

Why is Negotiating Term Sheets Important?

Understanding how to negotiate a term sheet with a potential investor is crucial because you will be working with the investor for a long time. Crafting an agreement both sides feel equally comfortable with will prevent friction down the line. But perhaps more importantly, you need to understand how to negotiate terms that will adequately protect your company.

Here are seven tips that can help you negotiate a more favorable term sheet:

1. Understand the Terms (and Which Matter Most)

Obviously, you should familiarize yourself with the terms you'll be evaluating in the negotiation. There are a daunting number of terms in total, but some are much more important than others. Here are a few essential terms to know:

Valuation

A pre-money valuation is the amount you and the investors agree your company is worth before their investment. Usually, you decide this amount before you draft a term sheet. A post-money valuation is the amount your company is worth after the investment. For example, a $3 million pre-money valuation plus a $1 million investment equals a $4 million post-money valuation. This number usually determines the percentage of the company the investor will own. A $1 million investment into a company with a post-money valuation of $4 million would give the investor 25% ownership.

Protective Provisions 

Protective provisions protect investors by giving them certain "veto rights" regarding company decisions. For example, an anti-dilution provision prohibits the company selling stock at a lower price (thus diminishing the value of the investor's stock) for a certain period of time after the VC invests.

Liquidation Preference

Liquidation preference guarantees preferred shareholders (investors) get their money before common shareholders (founders and employees). It's a key term to consider because it can significantly impact the returns you'll see from a successful exit. Potential investors will also care about it considerably because it's a form of protection for them from losing money — they want to ensure they get a worthwhile return even if the company fails.

Board Composition 

Investors expect board representation, which means you and the VC will need to decide who will sit on the company's board of directors. The lead investor in the round will often expect a board seat with which they'll represent the investors as a group.

Exclusivity 

The investor may request that you don't enter negotiations with any other VCs for a certain period of time after you've closed your deal. It's normal for the investor to expect an exclusivity period, but don't agree to one longer than about 45 days.

Voting Rights

There are two kinds of stock that signify ownership of your company. Founders and employees hold common stock. Investors hold preferred stock. Preferred stock comes with certain privileges (like getting paid first if the company liquidates). One of these privileges you'll need to negotiate is the voting rights that come with each share of preferred stock.

2. Know Your Priorities

Pick the three (or so) terms that are most important to you. These three issues are the ones you'll spend most of your time and energy fighting for. Try to find out which issues the investor cares about most. You don't want to appear obstinate by arguing over every little detail, but you also want to show the investor you're the kind of leader who can identify which battles are worth fighting.

In a term sheet negotiation, you often have to think on your feet. Being sure of your priorities and knowing your limits before you begin the negotiation can help you make quick decisions when investors push back.

3. Learn About Investors in Advance

Before you begin negotiating, learn as much about the investor as possible. You can start by researching past deals the particular investor involved has made and talking to the founders they've worked with. 

You should also ask questions during the negotiation process. Doing so will help you understand the investor's motivations, expectations, and rationale, which can help you reach a mutually beneficial agreement more quickly. 

4. Consult an Expert 

The best way to get better at negotiating term sheets is to speak directly with someone who's already done it. You can use Mentorcam to get personalized advice from founders who have raised hundreds of millions of dollars from other venture capitalists.

5. Remember: You have more leverage than you think

Although investors can have a bigger share of the capital to bring the funds in, startups do actually get a lot of leverage even without putting up any term papers or even an ad. When a person invests in your business, they win. Most institutions have only one investment per year and a successful one or two is what matters most. The investment also has no intention of starting your relationship badly and so there may be room for negotiation. I suggest checking the references of the company that you speak with. Give yourself enough time for the decision making.

By the time you're discussing the term sheet, the investor already wants in. They probably hope they don't have to walk away just as much as you do. Keep this in mind as you negotiate, and don't be afraid to get assertive about the key issues.

One way to increase your advantage is to talk to other founders or VCs (who aren't involved in your deal) to find out what the market standards are in your industry for a company like yours. Their perspective will help you gauge when an investor’s offer is reasonable and when it's justifiable to ask for a better deal. At the same time, doing your own due diligence here ensures you won't lose credibility by asking for too much.

6. Talk With Multiple Investors

When you're negotiating with multiple investors at once, it gives you a considerable advantage. The higher the demand for your startup, the more other investors will want in. Plus, the knowledge that there's competition creates a sense of urgency that can work in your favor.

7. Be Flexible

You shouldn't think of the negotiation process in terms of winning or losing. You're beginning a relationship with the investor, and starting it out on the right foot is essential. Stand your ground on the issues that are most important to you, but be flexible enough to reach an agreement that ultimately works for everyone.

You should also show flexibility regarding the amount of money you ask for. Communicating to the investor that you're willing to budge a little on the size of the investment can prevent them from walking away if they're uncomfortable with your first ask.

Conclusion

It's normal to feel uncertain about term sheet negotiations if you don't have much experience --- but with preparation and practice, you'll learn how to spot the most common red flags, negotiate confidently, and reach a positive outcome for everyone. If you want to improve your chances of success further, spend some time with a mentor in advance. A veteran founder with years of experience navigating VC term sheet negotiations is the best source of information. 

Some founders hire professional legal consultants to help them make sense of terms sheets. However, you can reach out to one of Mentorcam's fundraising experts today and receive tailored advice for a fraction of the cost.