Term Sheet Preparation and Negotiation

Term Sheet Preparation and Negotiation: A Guide for Startups

As a founder, few documents will have a greater impact on your startup’s future than your first term sheet. This preliminary agreement, typically spanning just 500 words, outlines the terms and conditions of a proposed investment, covering everything from your company’s valuation to control over key decisions and the allocation of proceeds should you sell or go public.

Whether you’re negotiating with a venture capital fund or angel investor, it’s essential to get your term sheet right, as it will likely serve as a blueprint for your current and future funding rounds. Securing favorable terms will give you more leverage in current and future negotiations, while any misstep could diminish your control over the company or reduce your payouts in the event of an acquisition.

As seasoned lawyers, NEXT has guided countless clients through the complexities of preparing and negotiating term sheets for a multitude of transactions, ensuring deal clarity and safeguarding our clients’ interests every step of the way.

Term Sheet Preparation: Understanding Key Provisions

A term sheet is a non-binding preliminary agreement that outlines the conditions you and your investor agree on before drafting your final, legally-binding documents. Think of it as a letter of intent that will open the door to serious negotiations with venture capitalists or angel investors.

The key provisions of your term sheet will shape both your relationship with investors and your company’s future. Once you have a clear grasp of these elements, you’ll be better equipped to enter negotiations with potential backers.

Financial Terms and Valuation

  • Pre-money valuation: The pre-money valuation represents your company’s value before a new investment is added and is critical in determining how much equity your company will give up when raising its target amount. For example, if your pre-money valuation is $4 million and you’re raising $1 million, you’ll give up 20% of your company in the round (calculated as investment amount divided by post-money valuation of $5 million).
  • Option Pool Size: This provision sets aside shares for employee stock options. The size of your option must be carefully negotiated, as it will dilute your ownership and impact the share price in the round.

Economic Rights and Protection

  • Liquidation preferences: This will determine the order and amount of payments when your company is sold or liquidates. The most founder-friendly option is a 1x non-participating liquidation preference, meaning investors get back an amount that is either their investment amount or based on an “as converted” ownership percentage of the sale price—whichever is higher—but not both.
  • Anti-dilution provisions: These provisions protect investors if your company issues new stock at lower prices in future rounds. Because they significantly impact a founder’s ownership during down rounds, it’s important to understand the various anti-dilution provisions:
    • A weighted-average anti-dilution provision adjusts the conversion price based on both the number of new shares and their lower issuance price. A broad-based weighted average provision is considered more founder-friendly, as it considers a larger pool of outstanding shares, resulting in less dilution for founders.
    • Full-ratchet anti-dilution clauses are rare and significantly less favorable to founders.

Control and Governance

  • Board composition: The makeup of your Board of Directors will determine authority to make key company decisions. Venture capital investors typically want board seats proportional to their investment. However, founders should be cautious about giving up board control too early.
  • Protective provisions: These provisions give investors veto power over major decisions like an amendment to the certificate of incorporation or bylaws, hiring executives, or operational pivots.
  • Founder vesting: This provision requires a founder to “earn” equity over time, rather than own it outright. Standard vesting schedules span four years with a one-year cliff, meaning you must stay with the company for at least one year to vest any shares.

Process Terms

  • No-shop clause: A no-shop provision prevents founders from seeking other investment offers after signing the term sheet, usually for 30-90 days.
  • Confidentiality Clause: A term sheet should always include a confidentiality clause to protect any company information shared during negotiations.

Negotiating a Term Sheet: Key Considerations

Successful term sheet negotiations require careful preparation and a clear understanding of your company’s position in the market. By defining your priorities, identifying potential trade-offs, and doing your homework ahead of negotiations, you’ll be better positioned to secure favorable terms.

Understand Your Negotiating Position

Your leverage in negotiations depends largely on investor demand for your deal. Multiple interested investors will strengthen your position, while having only a single interested party limits your negotiating power.

Understand Your Investor

The typical angel investor is an individual investing their own money. They tend to focus more on relationships and founder potential. Venture capital funds invest other people’s money, so their processes are more structured and formal.

Focus on Key Terms

While every provision matters, a founder’s energy is best spent on those with the greatest impact: valuation, liquidation preferences, board composition, and protective provisions.

Seek Professional Guidance

Term sheet negotiations are not the time for on-the-job training. An attorney who regularly handles term sheet negotiations will identify any problematic provisions before you sign.

Maintain Perspective on Partnership

Who you’re partnering with is as important as a term sheet’s provisions. Conduct reference checks of potential investors before entering negotiations.

Term Sheet FAQs

How Do Angel Investor and VC Term Sheets Differ?

Because venture capitalists typically manage larger institutional funds, VC term sheets tend to be very detailed and lean toward investor protection.

What Term Sheet Red Flags Should Founders Be Aware Of?

Founders should be wary of any provisions granting an investor excessive control and veto rights.

What Happens Once a Term Sheet is Signed?

Once a term sheet is signed, the due diligence and legal documentation phases can begin.

Position Your Startup for Long-Term Success

Term sheet negotiations represent a critical juncture in your startup’s development. The decisions made at this stage will influence your company’s trajectory for years to come.