Negotiating a Term Sheet: Is it Worth It?

Negotiating a Term Sheet: Is it Worth It?

A term sheet is a non-binding agreement between the founders of a company and an investor or group of investors. It includes an outline of the terms and conditions (how much equity and control an investor will have in return for their cash) under which the investor will invest in the company. It may also include binding agreements for nondisclosure, exclusivity, and timing.

Getting to the term sheet in a funding stage, whether it’s Seed or Series A, B, or C, is a considerable achievement. That’s because investors—especially VCs—will see hundreds of pitches a year. However, only a few companies will ever end up receiving an angel investor or VC term sheet, let alone multiple term sheets. After a company does receive one, they might be wondering, “Can I negotiate any of the terms and conditions outlined?”

The short answer? Yes, you can negotiate a term sheet. Term sheet negotiations happen often. However, negotiating can be a challenge for founders. Many lack experience with term sheets. This makes negotiations all the more intimidating, considering that investors deal with these kinds of documents for a living.

In contrast, some founders just want to get the term sheet signed and will skip negotiations to do so. Skipping negotiations is perfectly understandable. Fundraising takes a lot of time and energy, and founders usually just want to get back to building their company and product or products.

Whether or not you negotiate, it is important for a founder to be cautious. There may be terms, and high-level outcomes, that can hurt you later. Term sheets can have a big impact on the amount of company control you retain (“governing” rights, such as board representation and protection provisions), as well as how much money you eventually see (“economic” rights, such as liquidation preferences and dividends). Term sheets can also limit your options for courting other investors, at least for a period of time, so watch out for a non-shop section as well.

This article is not a starting place for learning the basics of negotiation, nor a comprehensive guide to navigating the complexities of the term sheet. It does cover how and why to negotiate many of the most impactful terms and high-level outcomes.

While quickly signing a term sheet and getting back to work sounds easy, taking the time to go through the term sheet and fully understand its implications can benefit you in the months and years to come.

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How to Negotiate

Term sheets don’t tend to include aggressive terms that hurt the founders. In fact, most investors offer founder-friendly terms, knowing full well the real value in a startup is its long-term success. It’s where significant return on investment/capital can be realized.

By providing a term sheet with founder-friendly terms, the investor stands to benefit just as much as the founder. However, there is always the possibility that an investor will offer terms that don’t leave the founders with much protection or many rights.

Parties may choose to avoid addressing key economic and control issues for the sake of closing the deal quickly. This favors investors by deferring negotiations on those issues until after the contract has been signed, leaving common stockholders (read: owners, employees) with less leverage.

When this occurs, knowing how and what to negotiate is vital; it can protect you and your company.

Understand What’s Said & What’s Missing

Before anything, you should review every term and condition included in the term sheet and speak with a lawyer or your advisors about the more complicated matters involved. A lawyer who is well-versed in startup and venture capital deals will be a great help during your negotiations. While their services can be costly, their experience is invaluable. If you can find a good startup lawyer, try to keep them around!

Additionally, take the time to understand what the “market” terms are and get comfortable with how each can affect your position as an owner and founder. Use these standards as a baseline to drive a “normal” deal.

If you can, consider contacting the other companies in the investor’s portfolio as well and find out what terms were negotiable. Respect any nondisclosure barrier you encounter along the way. Asking other founders what terms were the most consequential in the months or years after the deal may help you get a better idea of what aspects of the term sheet are most impactful. Taking these steps can help you decide whether or not a term sheet is fair.

Some Basics to Consider

Term sheets often have an expiration date, or what’s referred to as an exploding deadline (i.e. exploding term sheets). It’s used as a way to pressure the founder from shopping the term sheet around to other investors, however, it’s also a way to keep the momentum of the deal going.

If you need more time to get comfortable with the terms of a deal—and to prepare for a negotiation—it’s important to ask. Remember that prompt responses are appreciated, but that you can ask for more time. Responding to an investor in the next day or two is typically a good window of time.

If you do ask for more time, an investor who is serious about working with you will most likely provide you with an extension. But, you still need to find a balance. You don’t want to drag out this period unnecessarily. Taking too long might cause the investor to worry that investing in you isn’t the best idea. If they don’t provide an extension, there is a chance the investor isn’t the right person. That said, this isn’t the only metric of a good investor or fit. Consider all the other things they bring to the table as well.

Signed term sheets do not mean money in the bank. Just because you’ve signed one does not mean that the investment deal will go through. Remember, these are non-binding agreements and the legally binding documents forming the investment itself have yet to be signed. While it is rare for investors to pull out at this stage—they’re reputation is on the line, and the world of investors is small—it’s important to not get ahead of yourself.

Additionally, when negotiating, it’s important to remember phrasing. In the Holloway Guide to Raising Venture Capital, it’s stated that you need to protect your interests without sounding accusatory, specifically when an investor is asking you to agree to terms you see as unfair. A simple way to do this is to cite your inexperience and explain that you’ve been told it’s unwise to agree to the term, or that it is not founder-friendly. Doing so will hopefully lead to a productive conversation.

If you plan to negotiate, you don’t have to do it alone. Consider having your attorney or your mentor join you for the term sheet negotiation. Many attorneys and mentors are skilled at letting you drive the conversation but supporting you when you meet resistance. Coordinate with your attorney or mentor before the negotiation begins.  

Know What’s Important

Decide what is most important to you and your team. This will help you during negotiations. Rather than haggle over every single term—especially ones that prove somewhat immaterial in the long run—focus on the issues that matter most to you.

Consider reviewing what terms and conditions are included in a term sheet. Having a basic understanding of the terms included will help you determine which are the most important to you. Negotiating these terms, above others, will help you create a favorable term sheet without wasting too much time. And getting the term sheet right in the beginning is critical, as these terms will often set the precedent for any future rounds you might raise.

The following list of items is not exhaustive, however, it does cover many of the important terms worth reviewing and negotiating.

Liquidation Preference

Liquidation preferences give an investor the right to recoup their investment (or a set multiple of it) in the event of liquidation (e.g. M&A, sale, bankruptcy, etc.) before the founders and other shareholders take the remaining proceeds. The order in which parties are paid in a sale or bankruptcy can be complex and might not but fully evident from the term sheet alone.

The liquidation preference provision is commonplace, but it’s an important one to pay attention to and negotiate, as the recovery multiple an investor requests can affect later funding rounds. The terms you set for this funding round often carry over as the precedent for future rounds.

Liquidation preferences are often set at one to two times (1-2x) the size of the investment. These multiples, a primary feature of the liquidation preference, specify how much an investor is to be paid back upon liquidation of the company. For example, if an investor put in $1M as the lead investor, their liquidation preference would be fulfilled at $1M, guaranteeing they get their investment back in full. A 2x multiple would mean they receive $2M in return, even though they only invested $1M.

Some investors want a portion of the profits the company should have made if all goes according to plan, but other investors are happy just to be first in line to recover their investment. It is just another method of allocating risk among the parties.

This number can seem relatively harmless in the early rounds of financing, however, even if the multiple is 2x or above, it becomes something worth negotiating. For instance, if this provision is carried out in a later round that closes at $25M, it means that the late-round investor is guaranteed $50M back before the founders or other shareholders receive anything.

Participation Rights

Participation rights are another primary feature of the liquidation preference. These rights refer to whether an investor is entitled to a share of the value that remains once the liquidation preference has been paid out. Think of participation rights as the right to stand in the place of a shareholder after the liquidation rights are satisfied.

Let’s use a generic example to illustrate the consequences. An early-round investor invests $1M in a startup for a 20% ownership stake. This creates a pre-money valuation of $4M, and $5M post-money. They negotiate a 2x liquidation preference multiple, as well as full participation rights.

This would mean, if the company is sold for $10M, the investor receives twice their investment, which is $2M. After receiving their liquidation preference, they also receive 20% of the remaining $8M (their ownership stake), meaning they receive an additional $1.6M. Therefore, in total, they receive $3.6M (out of $10M). The investor’s total sale price percentage is 36%, even though their equity stake is only 20%.

Including full participation rights in your first funding round can carry over to future rounds. This carry over effect can even be used as leverage to resist the inclusion of participating liquidation preferences. For example, a “participating preferred” for a small seed round might not result in a meaningful extra return for the investor at exit (at least in absolute dollar numbers), but it will be painful to the founders if all future rounds include participating preferred stock.

Cumulative Dividends

Dividends are shares of a company’s profits that are distributed to shareholders. Dividends can be “preferred” or “common”. Both preferred shareholders (investors) and common shareholders (founders, employees) are eligible for dividends. However, preferred shareholders have priority over common shareholders when it comes to receiving dividends. There are two common types of dividends: cumulative and non-cumulative.

In most instances, investors are not investing in early stage companies with any expectation of dividends. The investor plans to benefit from the increased value of the shares at a future exit from shareholdership. Thus, dividends are often not worth negotiating, as the terms surrounding them will be standard. The most common dividend provision provides that dividends will be paid “when, as, and if declared by the Board of Directors.”

However, one exception to this is the inclusion of mandatory cumulative dividends. Cumulative dividends are dividends payable to certain shareholders regardless of the company’s financial state or the Board’s decisions. As the name suggests, the dividends will accumulate in favor of the specific shareholders even if the company does not, or cannot, pay the dividend at the expected time.

You should resist cumulative dividends provisions since these dividends will accumulate at a certain rate (between 6-13%, however, 8% is considered the average) until paid. Upon the event of liquidation, some investors will be owed a lot more money. This future additional payout obligation to the investor/preferred stockholder will ultimately reduce funds available for common stockholders. Though some investors will insist on such terms, you should try to negotiate.

Despite cumulative dividends allowing a startup to delay the dividends payments, the value of those dividends is added on top of the investor’s total payout amount upon liquidation, meaning more money goes to the investor and less goes to the founders and employees.

If the investor is pushing for cumulative dividends, try to negotiate for something more founder-friendly, such as dividends that are paid to the common shareholder as well as the preferred shareholder at the discretion of the Board. Or try to negotiate for non-cumulative dividends instead, where dividends must be paid to the preferred before the common stock is paid any dividends of their own, but if no dividends are paid in a given year then they are not otherwise owed.

Option Pool

During term sheet negotiations, the “pool” is often a critical negotiating point. The investor will usually specify an option pool, or a block of stock options (company equity/shares) for current and future employees. That employee stock option pool is created by setting aside common stock shares as authorized but not issued.

Investors will typically include the new shares needed for the option pool in the pre-money valuation. In this way, investors do not dilute their ownership percentage when those options are brought to life.

On the other hand, if the option pool is included in the post-money valuation, then every shareholder ownership percentage is diluted. The investor (and you) loses value if the option pool is created after financing. Investors don’t like this loss. They want to receive a predictable percent of ownership based on the total amount they invest.

Creating an option pool pre-money is seen as investor-friendly, while creating one post-money is seen as founder-friendly. That’s because pre-money option pools lower the total ownership percentage of founders, while post-money option pools dilute both the founder and the investor’s percentages together.. Here’s an excellent, and simplified, example of the math behind option pool creation.

If your term sheet includes a provision stating the option pool be included in your pre-money valuation, there is often room for negotiation.

The first step is to decide how large the option pool is. You must account for all the key hires you will make over the next 12 to 18 months and add the total amount of equity each employee will receive. Provide yourself with some cushion by adding some shares to the pool, that way you don’t run out too early. Sync up with the investor and come to an agreement on option pool size. Having done that, you can negotiate over who pays for it.

While investors will most likely not agree to creating the option pool after financing closes at the current pre-money valuation, they may be willing to lower the valuation of your company. Doing so will mean the option pool can be created post-closing without affecting the founder’s or the investor’s ownership percentage.

Anti-Dilution Clauses

Anti-dilution clauses, also referred to as anti-dilution provisions, are included to protect the investor from future sales of preferred stock at a lower valuation. When a company has to raise additional capital, the Board of Directors might decide to issue new shares to do so. If the new shares are priced at a lower value than the previous round’s shares, the existing shareholders see their stake in the company diluted, leaving them with a smaller percentage of ownership.

To protect against this ownership dilution, anti-dilution provisions are included in term sheets/deals. They are most often used by VCs, and the variations in the types of anti-dilution clauses define the extent to which the investor is protected.

There are two common types of provisions, weighted average and full ratchet. If the clause included is a broad-based weighted average provision, then you can continue forward with confidence. This type of anti-dilution protection is pretty common, and arguably fairer in balancing the interests of founders, early investors, and later investors. However, if the full ratchet provision is included, try to negotiate. Full ratchet anti-dilution provisions tend to benefit the investor at the expense of the founder and other shareholders. Hopefully, the investor is willing to change the full ratchet term. If not, it may be a sign the investor is not a good fit.

To understand more about weighted average provisions, consider reading What is Weighted Average Anti-Dilution Protection. To understand more about full ratchet provisions, consider reading Full Ratchet Anti-Dilution Protection.  

Pay to Play

Pay-to-play provisions are quite common in life science and biotechnology deals. They are the only provision in this article we promote.

As you well know, biotech and life science startups usually require a huge amount of capital to get a product to market. This means biotech startups are raising multiple rounds. Pay-to-play provisions are designed to encourage the participation of the investor(s) you’re closing a round with to participate in future rounds. An investor that doesn’t participate ends up losing certain preferential rights, such a liquidation preference and anti-dilution provisions.

For example, if a company includes a pay-to-play provision in the terms, an investor that skips a funding round will forfeit their anti-dilution protection. Including a pay-to-play provision prevents the investor from simply sitting out a funding round while passively receiving the benefits of the anti-dilution provisions of a previous round.

You can ask for a pay-to-play provision when negotiating a term sheet, however, you will most likely experience push back from the investor. You’ll need significant leverage to negotiate this provision. Consider asking your lawyer or mentor for advice on how to encourage the investor to agree to pay-to-play, and consider what other terms you might concede to capture this important part of your funding strategy.

Board Representation

The Board of Directors governs a corporation’s direction at the highest level. A typical startup Board arrangement is often made up of three people: two founder representatives and one investor representative. However, there are many variations on the balance of seats and, in some cases, startups can have one or more independent directors who act as neutral third-party members. A neutral party can help resolve issues or disagreements.

A common suggestion for startups is to structure the Board representation to reflect the relative control of the cap table. This balance ensures that everyone’s interests are aligned and fully represented.

An investor focused on board seats, or other terms that define control, may be signaling a lack of confidence in the founders and managers. Investors that want disproportionate Board influence may be attempting to mitigate risk. It is important for founders to consider the implications of working with an investor who isn’t confident in the company leadership.

Founder Vesting

Founder vesting agreements are worth careful review and negotiation. A founder vesting schedule, typically referred to as a stock vesting clause  is included by investors in the term sheet. The schedule gauges the founders and key employees’ commitment to the company and protects the company’s equity if a founder or key employee quits.

A common vesting schedule for startups lasts several years and includes a one-year cliff. The founders will fully own all their shares after the specified years have passed. The one-year cliff is a feature of the vesting agreement meant to prevent an early exit from the founder. While the overall vesting takes place at a certain pace, the founder has no vested equity until the first year passes.

For example, in a four-year vesting with a one-year cliff, the founder will have no vested position until the first year passes. At the one-year mark, the founder will be 25% vested and will continue to gain vested shares in a linear fashion.

If a founder leaves the company before the four years has passed, then they will only be eligible to receive a percentage of their shares. However, if they walk away before the cliff-year passes, they won’t be entitled to any of their shares. The number of months of the cliff period is often up for negotiation.

While some founders see this as a way for investors to control the founders’ involvement, it serves a larger role protecting everyone’s shares. Ryan Floyd, of Storm Ventures, offers a great example. If a three-person founding team closes a funding round where no vesting schedule is enforced, then all three receive their full amount of shares on day one.

If one of those founding members decides to leave the company, they do so with their full amount of shares. This leaves the other two founders to build the company on their own, working long hours and weekends without the promise of succeeding. The founder who departed early not only has access to their shares the day they quit, but gains access to the value the other founders build over time.

The point is, if someone leaves the company, there needs to be a plan in place to handle that equity fairly. Vesting schedules are designed to handle this risk.

Ryan’s advice for startups is “to build and start a vesting schedule for your options before you even start looking for funding. By the time you come to the table, potential investors can see your vesting schedule at work.”

If you want to read more about vesting, consider starting with Brad Feld’s Feld Thoughts article on vesting and Jiah Kim’s What Vesting Is and Why It Is Important for Startup Founders.

Drag-Along Rights

Drag-along rights are a tool for shareholders to sell the entire company to a new owner even if some shareholders do not wish to sell. The drag-along rights allow the majority investor to “oblige” other classes of stock to agree with their voting requests for a liquidation event.

The majority shareholder will use these rights to force a full and complete sale of the company by exercising their majority over the minority shareholders, so that the minority must follow their choice of action. (Important note: if the stockholders are of the same class and terms, the demands of the majority investor will most likely be economically aligned with the minority shareholders.)

When different classes of shares and their separate terms are introduced, such as preferred stock, it increases the importance of drag-along rights provisions. For example, the majority vote required to trigger the drag-along provision can come from the preferred stock class. If the decision does not need approval by the Board, common stockholders may then be forced to sell their shares.

However, some investors and founders argue these rights exist simply to encourage negotiations between the different classes of shareholders rather than as a measure to actually effect a sale. Despite this theory, others may feel the rights are worth negotiating in the investor’s terms.

A majority investor might want to sell the company, but the founders might not. An unexpected buyout offer during a tough time can be an appealing option to an investor who holds attractive liquidation preferences and participation rights. By exercising their drag-along rights, these investors can force founders (and common shareholders) to sell.

The amount of leverage of each party at that subsequent negotiating table can depend on the relative strength of each party’s rights under the drag-along provisions. For this reason, negotiating drag-along rights should be considered.

In Conclusion

While term sheets are complex, and negotiating one seems daunting (it is), remember that it doesn’t hurt to ask questions. This is not an area you are expected to be an expert in. Work closely with your attorney or mentor to gain confidence in negotiating these points.

Ultimately, after considering our advice, and the advice of many internet folks, you should work through the consequences of each and every term in the term sheet (consider doing so with a lawyer) and ask yourself, your advisor, and the investor “How will these terms affect my company’s performance, it’s management, the incentives for myself and my employees, and my ability to raise additional funds in the future?”

These answers will help you pinpoint the terms worthy of negotiation and give you a clearer understanding of whether or not the term sheet is a fair deal.

This article is informative. It is not meant to represent legal advice. Before negotiating or signing a term sheet, it is best practice to speak with a lawyer who has a track record in startup and venture capital deals.