Negotiating Term Sheets

Negotiations, like taxes, are an inevitable part of life. People negotiate every day whether they realize it or not – what to get at a restaurant, where to fill up gas, who to delegate work to. These small negotiations are often not always conspicuous, which is why we don’t pay too much attention to them and make decisions in the heat of the moment. With decisions that require more thought and have larger consequences, negotiating becomes a must. There is no better example than when a founder successfully convinces a VC to invest in their company, and hands him or her a term sheet to look over.

A term sheet outlines the details of what an investor is willing to pay for a piece of your company. In return the investor receives, in addition to the designated equity, other guarantees that allow the greatest returns for that investor. Now even though most parts of the term sheet are non-binding, there are still a few things any founder lucky enough to be in this situation must consider. Once you receive a term sheet, your mind must immediately shift from trying to sell your company’s vision to trying to get a win-win deal out of the term sheet.

Before you meet with the VC again to discuss the term sheet arrangements, it’s important to know several things. First, you (and your lawyer) need to identify the most important parts of the term sheet. Usually this would tailor around the valuation, liquidation preference, and anti-dilution provisions but usually varies per founder. Identifying the top 3 most important issues that you want to stick to your guns to allows you to be flexible with the VC on other things they may care more about. For the most part, a lot of items in the terms are standard across the board and trying to negotiate on those pieces shows that you’re either a) a rookie who’s never done this before, or b) immature and wasting the VC’s time.

For founders to get the most out of their negotiations with VCs on term sheets, the best way to get a deal that favors founders (and not just VCs) is to have leverage. Leverage is everything, and one way to attain is it to have more than one VC interested in giving capital to you. The ability to go up to a VC and let them know that there are other offers on the table puts the pressure back on them. If they are truly interested in backing you. they become more attentive to your requests and the negotiation floodgates begin opening. You are also in the best position possible because with multiple VCs clamoring for your signature, you have the opportunity to set your terms and are more likely to get them.

Another way to show VCs you mean business is actually knowing what is in a term sheet and identifying what each statement means. Term sheets normally aren’t more than three pages, but if you’re not familiar with what most of the terms on the sheet means, you can be in a weak leveraging position. This is also why it helps to have a top-notch lawyer who specializes in venture financing. Understanding the difference between a 1x liquidation preference with no participation and a 3x liquidation preference with full participation is will save you a significant amount of time and headaches once a liquidation event does occur. If you’re serious about raising money, you should be committed to inspecting every single part of the term sheet and finding areas that look suspicious or that should absolutely be negotiated.

Of course this also means that to have a successful negotiation, you have to know everything about the person across the table. Understand what they commonly look for and what they will and will not budge on. Talk to founders who have had their company invested by the same VC and see how their term sheet negotiations went. Knowledge is power here.

Eventually there will come a time when you and the VC simply can’t come to the right terms. Before you even get to this step, it is important to know what your BATNAs are and when you’re willing to walk away. BATNAs, or Best Alternative to a Negotiated Agreement, can help you during the negotiation process by discovering what your opportunity costs will be should negotiations fall through. Having multiple VCs show interest in your company is an example of a BATNA because if your first deal doesn’t happen, you have other VCs you can work with without skipping a beat. This also allows you to draw a line in the sand and mark it as the point at which you as a founder should walk away from the table. If you reasonably believe your terms are justifiably fair to all parties and there is no agreement from the other side, you can comfortably walk away knowing that you tried your best.

Negotiating term sheets should be about trying to achieve a win-win outcome between the founder and VC. According to Brad Feld, the hardest thing to do in negotiations is to look at these term sheets from the opposing side’s point of view. Doing so helps you gain insight on what the opposing party is looking for in a deal. You can use this information to make compromises where you think is best while also trying to secure the non-negotiables you desire. It’s important to remember here that once you and the VC come to an agreement on the term sheet, communication doesn’t cease from there. Rather, this marks the beginning of what should be a close and long partnership, one that will forever be built upon the negotiations of the term sheet.