Posted by Early Growth
December 4, 2014 | 5-minute read (961 words)
You came, you pitched, you conquered. Congratulations! But do you know what to do once you’re asked to sign a term sheet? Let me say that first, you should have already retained a good startup lawyer. Most investors will expect this. And a good lawyer can be a real advocate for you: by keeping negotiations on track, explaining terms, and making sure any deal you sign doesn’t have problematic (and costly) clauses that could leave you at risk.
That said, you should already have a sense of what to expect going into discussions. There’s less chance of you being blindsided. You’ll also have the opportunity to decide ahead of time (and figure out your negotiating strategy on) which points you care about most. It could be the size of the option pool, or maybe the provisions around reverse vesting.
I discussed Change of Control, Reverse Vesting, and Liquidation Preferences in my earlier post on term sheets, so I’ll skip them this time, but here are explanations of some key standard term sheet provisions and what they’re designed to achieve.
Anti-Dilution — This protects investors from “down rounds,” or future sales of preferred stock at a lower valuation than the round they participated in. This provision can provide that re-pricing of the shares be done on a: 1) weighted average basis, “broad-based” (including outstanding and potential outstanding stock) or “narrow-based” (only outstanding shares); or by 2) a “full-ratchet,” where previously issued shares are automatically repriced to reflect the lowest value of newly issued shares.
Board of Directors — This one’s pretty straightforward. It specifies the size of the Board, how seats will be allocated/assigned, and who controls them. VCs will usually want to hold one or two Board seats.
Conversion — This clause states the triggers, whether at the investors’ option or mandatory (at an IPO), and formula for the conversion of preferred shares to common stock. It will also set terms such as a minimum stock price, and/or minimum proceeds, as well as the percentage of shareholders required to agree to any deal.
Drag Along Rights — As the words imply, this compels founders to vote their shares in favor of a merger or sale of the company if the deal has Board approval and the backing of a certain percentage of preferred stockholders. Make sure you understand and negotiate the conditions under which you could be forced to agree to a sale.
Employee Stock Options — This provision lays out the size of the option pool and the vesting structure. Keep in mind that while you’ll hear 20% referred to as the “standard,” this is something you should negotiate. The shares in the option pool are allocated from your founders’ equity, so you need to balance dilution against your ability to offer enough equity to attract the right future talent.
Expiration — The date by which the agreement expires. This varies widely, you’ll sometimes see exploding offers (not a good sign), and it’s in both sides interest to try to keep it short to avoid letting a potential deal languish. You’ll lose momentum, your investors might get cold feet or lose interest, and it encourages deal-shopping.
Information Rights — Stipulates which investors will receive disclosures of financial information such as financial statements, in which forms, audited or unaudited, and at which intervals. This clause should also include confidentiality requirements.
Key Person Insurance — Required insurance coverage on founders and key members of your management team. This is really a no-brainer, whether or not an investor requires it, you need to limit the downside risk to you and the business in case something happens to you or any of the founders.
Lock-up — The mandatory holding period for shares (investors, directors, and officers) post an IPO or liquidity event. 180 days is standard.
No Shop — You agree to not solicit or negotiate a potential deal with another investor for a specified period of time, typically anywhere from 30-60 days. The investor agrees to move towards timely completion of the proposed deal.
Preemptive Rights — Gives investors the right to participate on a pro-rata basis in any future funding rounds. This is to ensure the first investor’s stake is not diluted in later funding rounds involving other investors.
Pre-money Valuation — This is what investors think your company is worth, prior to their investment. It can get really contentious, and there is no “right” answer. The best way to prepare for negotiating is to have a reasonable figure or range in mind, supported with facts, and based on rational criteria. You can get to this by using one or a combination of approaches. Angela Lee of 37 Angels gave a good overview of these in our Fundraising Tips for Women Entrepreneurs webinar.
Right of First Refusal/Co-Sale — The right of first refusal gives investors first dibs, on a pro-rata basis, to any shares founders sell in future funding rounds. The co-sale term requires founders to offer investors the right to participate in any sale of their shares on a pro-rata basis on the same terms as the founders.
More questions on term sheets? Share your insights or questions in the comments section below or contact Early Growth Financial Services for startup advice.
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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.