Term Sheet Negotiations

TL;DR

When a founder pushes back on a term sheet, the strongest leverage is a credible alternative like a convertible debt round already on the table. In this simulation the entrepreneur counters a $3M pre-money, $2M investment offer (40% ownership) with a $6M pre-money, $2.5M ask (roughly 29% ownership), arguing the debt option buys 12 months of runway and a higher future valuation.

Transcript

hi I'm Greg hi Valon a partner at aura Carrington and Sutcliff in the emerging companies here in Silicon Valley charm sheets is my life and if you ask my wife that's it that's all I do but I have the pleasure today to have two fantastic co-panelists who I sat in the middle I should have let them sit next to each other because the best kind of Mokta... Read More

Key Insights

• A term sheet is only 2-3 pages long but summarizes the critical aspects of a financing, making each term worth negotiating carefully before signing.
• Convertible debt is a founder's leverage: a note that converts into equity at a later Series A financing, usually at a discount or with warrants tied to the future valuation round.
• Pre-money versus post-money math drives ownership: a $3M pre-money plus $2M investment equals $5M post, giving investors 40% (two million over five million).
• The founder's counter of $6M pre-money and $2.5M investment produces an $8.5M post-money valuation, dropping investor ownership to about 29% (2.5 over 8.5).
• Investor value beyond cash matters: Ken argues Opus opens doors at customers and partners and helps recruit VP-level team members, justifying the valuation.
• Capital as competitive advantage: with $2M in the bank a startup can 'press on the gas' while rivals operate on only 500k of seed or angel money.
• Firms run term sheets differently: at Opus a term sheet means all diligence is done and they are ready to sign, whereas other firms treat it as the start of their process.
• Deal flow sets what is 'market': Opus sees about 3,000 deals a year and invests in about 8 companies, using that volume to benchmark a fair valuation.
• Founders should learn the process in advance through resources like venturehacks.com and good advisors, so they need fewer 'lifeline' calls to their lawyer mid-negotiation.

Questions & Answers

Q: What is a term sheet in venture financing?

A term sheet is a document, described as only two to three pages long, that contains summaries of the critical aspects of a financing. Despite its short length it covers the most important terms of the deal, which is why negotiating it is one of the most important parts of the venture financing process. In the simulation the VC presents a standard term sheet used at his firm as the starting point for the deal.

Q: How is pre-money versus post-money valuation calculated?

In the example the term sheet has a three million dollar pre-money valuation. When two million dollars is invested into the company, the post-money valuation becomes five million. Investor ownership is the investment divided by post-money, so two million over five million equals 40 percent. The founder's counter of six million pre-money plus a 2.5 million investment produces an eight and a half million post-money valuation and about 29 percent ownership.

Q: How can convertible debt give a founder leverage in a term sheet negotiation?

The founder holds a convertible debt option already on the table with angels, which functions as a competitive alternative deal. Convertible debt is a note that converts into equity at a future Series A financing, usually at a discount to that later valuation or with warrants. Because the founder can raise about 850k in debt to fund roughly 12 months of runway, he can walk away from an uncompetitive Series A price and set a higher valuation later.

Q: Why did the founder ask for a higher valuation than the VC offered?

The founder said the pre-issue valuation, not the investment amount, was the problem. He argued that his convertible debt would give him 12 months of runway into product launch, after which he could drive a Series A valuation he felt confident would be two, three, or four times the current offer. Because he acts on behalf of all shareholders, taking the lower priced round when a debt document was available did not make sense to him.

Q: What value does a VC claim to add beyond the money invested?

Ken argues that Opus Capital works hard opening up doors at customers and partners and helps founders recruit the VP-level team they are looking for. He also frames the amount of money going into the company as a competitive advantage, saying that with two million dollars in the bank the startup can press on the gas and take the market by storm while competitors operate on only around 500k of seed or angel money.

Q: How do venture firms differ in how they issue term sheets?

Ken explains that different firms work in different ways. At Opus, when they put out a term sheet they are done with all of their work and are ready to sign the deal. Other firms put out term sheets that are the start, or the beginning to middle, of their process. This distinction affects whether a founder can realistically push a partnership to go back and approve a higher valuation after the sheet is issued.

Q: Who were the participants in this term sheet negotiation simulation?

The session was moderated by Greg, a partner at Orrick, Herrington and Sutcliffe working with emerging companies in Silicon Valley. Ken Elovic is a general partner at Opus Capital, a firm investing in IT startups for about 35 years, formerly named Weiss, Peck and Greer Venture Partners. Farb Nivi is CEO and co-founder of Grockit, an online collaborative learning game whose first beta product is a GMAT preparation platform.

Q: What resources did the founder recommend for learning term sheet negotiation?

Farb recommended venturehacks.com, a blog he calls a shameless plug for his brother but which also has contributors like the Babak Nivi and others. He described it as a great place to find a primer on what to expect and what the process looks like from a real-world entrepreneurial standpoint. He stressed it is not a replacement for a really good lawyer and that excellent lawyers and great advisors were critical to negotiating his Series A and Series B.

Summary

In this video, three panelists discuss the terms of a term sheet for a potential investment in a company. They discuss various topics such as valuation, vesting schedule, board composition, and liquidation preference. The panelists present differing perspectives and negotiate their preferences.

Questions & Answers

Q: Can you introduce yourselves and explain your experience with term sheets?

Greg and Valon are partners at adventure capital firms, while Barb is the CEO and co-founder of a startup. Greg and Barb share their experiences negotiating term sheets, highlighting the importance of understanding the process and having good advisors.

Q: What is the sticking point for Barb regarding the valuation?

Barb is looking for a higher valuation for his company, as he believes he already has a convertible debt offer on the table that values his company higher. He suggests that if the valuation cannot be met, he would consider doing a debt round instead.

Q: How does Ken respond to Barb's valuation concern?

Ken acknowledges Barb's perspective but explains that the valuation in the term sheet is based on market standards and the amount of investment being provided. He suggests that having more capital available would give Barb's company a competitive advantage.

Q: How do they negotiate on the valuation?

Ken proposes a range of $2-2.5 million for the investment, with a minimum post-money valuation of $7-7.5 million. Barb is open to the idea but expresses his preference for a higher valuation. Ultimately, they agree to continue discussing the valuation within the proposed range.

Q: What is the issue with the vesting schedule for Barb's shares?

Barb wants the vesting of his founder shares to start from the time he began working on the company, rather than from the date of the term sheet. He explains that he has been working full-time for a year without any income and wants that time to count towards his vesting.

Q: How does Ken respond to Barb's vesting schedule concern?

Ken understands Barb's perspective and appreciates his commitment to the company. He suggests that the vesting schedule in the term sheet aligns with Barb's work on the company and addresses the concerns of potential future team members.

Q: What compromise is reached regarding the vesting schedule?

They agree to give Barb credit for one year of vesting upfront, with the remaining 80% of shares vesting over the next four years. This allows Barb to have some of his shares vested immediately while still providing long-term incentives.

Q: What issue does Barb have with the board composition?

Barb is concerned that the term sheet states that only the CEO, who is a common shareholder, can have a seat on the board. He wants to ensure that the common shareholders have the ability to vote for board members.

Q: How does Ken propose a solution for the board composition?

Ken suggests leaving the language as it is for now, with the CEO having a board seat. However, if Barb were to cease being the CEO, they would then negotiate to expand the board to include Barb as a board member and an additional board member appointed by the preferred shareholders.

Q: Does Barb agree with Ken's solution for the board composition?

Barb is concerned that this solution still limits the voting rights of common shareholders. He suggests removing the independent board seat and creating a board with two common and two preferred shareholders. Ken agrees to consider this alternative.

Q: What is the issue with the liquidation preference in the term sheet?

The term sheet states that the Series A investors will receive three times the initial purchase price in any liquidation event. Barb argues that this is too high and suggests a 2x preference instead.

Q: How does Ken justify the liquidation preference in the term sheet?

Ken explains that the participation and liquidation preference in the term sheet are meant to incentivize both parties to work towards building a large and successful company. He argues that a high liquidation preference aligns with their goals as venture capitalists.

Q: Is a compromise reached regarding the liquidation preference?

They agree to set the liquidation preference at a 2x multiple without participation, meaning that the Series A investors would receive 2 times their initial purchase price in a liquidation event, but would not participate in any remaining proceeds.

Takeaways

Negotiating a term sheet involves addressing various concerns and finding compromises that satisfy both the investors and the founders. It is important for founders to have a strong alternative option, such as convertible debt, to have leverage in negotiations. Valuation, vesting schedule, board composition, and liquidation preference are key areas of negotiation. It is important for both parties to understand market standards and consider the long-term goals and incentives for building a successful company.

Summary & Key Takeaways

• The panel pairs Ken Elovic, a general partner at Opus Capital (formerly Weiss, Peck & Greer) focused on early-stage IT investments like DoubleClick and Riverbed, with Farb Nivi, CEO and co-founder of Grockit, an online collaborative learning game whose first beta is a GMAT product.

• In the simulated negotiation the founder identifies valuation as the sticking point, revealing he already has $750k-$850k of convertible debt committed on a note open up to $1.5M, which gives him a walk-away alternative if the Series A price is not competitive.

• The founder counters the $3M pre-money offer with a $6M pre-money, $2.5M investment ask, arguing 12 months of runway to product launch would let him drive a Series A valuation two to four times higher, while the VC notes his partnership already approved the original terms.