Posted by Early Growth
October 19, 2012 | 6-minute read (1105 words)
Hooking your first VC is exciting! But, in some ways, once a potential VC offers you a term sheet, that’s when the real sport begins. It’s called “term sheet wrangling.” And it can be serious business.
When you first get the term sheet, keep in mind that that is just a starting point. Before executing the term sheet, you want to negotiate to ensure your best deal terms. Here’s how:
1. Get more than one VC interested. The key to negotiating VCs is to have more than one show interest. This puts you in the best possible negotiation position because, with more than one interested party, you can really push for terms that are favorable to you and ensure that you get the best possible valuation. So, try not to sit down at the negotiation table before you have lined up multiple interested VCs.
2. Understand typical market terms. It’s essential that you have a good understanding of typical market terms. These terms include such things as valuation, preference, anti-dilution, and board members. For a primer, check out my previous post 7 Things You Need to Understand—and Care About—in a Term Sheet. Also, look to your lawyer and other partners in your eco-system, to help you gain a solid understanding of these terms.
3. Valuation is key. You will need to work with the VC to negotiate a “pre-money” valuation, calculated on a “fully-diluted” basis. In other words, the value includes all issued stock and anything that may be converted into common stock, such as a stock option pool. VCs have a vested interest in specifying an option pool. They often require you to set aside a given amount of shares for an option pool and provide that the pre-money company valuation includes this option pool. This decreases the share price. Your goal is to meet in the middle: find a realistic number for the option pool, then negotiate price.
4. Confirm the VC’s interest. In most cases, if a VC offers you a term sheet, he means business. But, there is the rare case when you come across a VC who isn’t truly committed to the deal. This is why it's advantageous to have more than one VC on the hook. Many term sheets contain a “no shop” clause. If possible—and if there’s a lot of VC interest in your business—try to avoid this “no-shop” clause. If you must give in to it you want to make sure the VC has the commitment, the money, and everything else you are looking for. You want to be sure that your VC is sincere before getting too far with negotiations (and certainly before signing off). Don't ever waste your time—and impede your chances of finding a more committed investor—due to one flaky VC.
5. Retain a lawyer with VC financing expertise. Many entrepreneurs want to negotiate terms by themselves. However, unless you’ve been down this road many times before you will need some professional support. To work through the key terms in your term sheet, you need a lawyer who is well-versed in VC terms. If you already have a lawyer, but without this particular expertise, get recommendations for a new lawyer who specializes in VC financing.
6. Take the reins. Yes you will have your lawyer as back-up, but it is not the lawyer’s responsibility to negotiate the terms—that is your job. You are the one who is entering into a relationship with the VC. From the get-go, you need to establish the ability to have open conversations, even when you are discussing difficult topics. Don’t make the mistake of leaving the term sheet in the hands of your lawyer as this can sometimes escalate into a editing war with the VC’s attorney. Don’t check out and let your lawyer lead the show. Get his input on the first draft and let him serve as your support, but be present for all negotiations yourself.
7. Prioritize your non-negotiables. You and the VC aren’t going to agree on everything. That’s just the way it is. So, in advance of your negotiations, decide what you really need—and are willing to fight for—and where you’re prepared to be more flexible. Also, in the interest of creating open lines of communication and expediting the process, be ready to clearly articulate your needs. Remember, you’ve chosen to work with this VC for a reason, so bend whenever and wherever it makes sense to do so.
8. Understand dilution. You need to understand how VC ownership will affect your current equity position. How do the terms impact your dilution? More challenging—and equally important—is calculating, and understanding, how much you will get diluted in future rounds. The goal, of course, is that your company performs well and hits its milestones. In that case, any dilution would be offset by your valuation increases. But, if your valuation doesn't increase apace, the impact of dilution becomes more significant—and painful. That's why it's so important to negotiate the best dilution terms with VCs.
9. Limit stock exit contingencies. Often VCs will want founders to sign a statement agreeing to forfeit part of their stock if they leave the company early. Try to avoid any contingencies on founder stock, or at least keep the contingency period as short as possible, put a limit on shares that would be forfeited, and make the buyout price as high as possible.
As an entrepreneur, term sheet negotiations are only one of many negotiations you will be involved with. The manner in which you engage in term sheet negotiations reflects on you and your business, and lays the groundwork for your relationship with your VC. Many VCs are of the mind that true character is revealed during term sheet negotiations. Show that you are worthy of their trust and full of integrity to raise the bar on these discussions—and prove the VC has made a good choice in choosing to back you.
What are your strategies for term sheet negotiation? Let us know in comments below.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, a financial services firm providing a complete suite of financial and accounting services to companies at every stage of the development process. He's a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.