Venture Capital Term Sheet Overview
After your startup has made it through the VC presentation stage, the next step is to negotiate a term sheet. Term sheets are relatively short contracts which list key financial information regarding potential funding arrangements, as well as conditions which must be met by a startup company prior to financing. These agreements are usually non-binding except for clauses related to confidentiality and exclusivity.
While term sheets are generally non-binding, they should not be taken lightly as they determine the playing field for final negotiations and establish investor expectations. Many nascent businesses reach this stage without having consulted an attorney or financial advisor. If this is you, now is the time to bring in an experienced professional.
Term sheets are full of idiosyncratic terms and disadvantageous language included for the VC’s benefit. Spend a little money now to save a lot of heartache down the road.
Negotiating Concerns For Startups and Venture Capitalists
While some term sheet language is fairly standard, or boilerplate, many items are negotiable and require good old-fashioned bargaining skills. As is the case with any negotiation scenario, startups which receive the best terms are those that are aware of and address the concerns held by VC’s, expressed or otherwise.
Here are a few investor concerns to keep in mind:
- Your startup’s current and projected valuation
- Control over business strategy and decision-making
- Projected levels of ROI (Return on Investment)
- Registration rights on the occurrence of a public offering
- How risky of an investment your company may be
Understandably, startup founders have, or should have, a few concerns of their own, including:
- Dilution of company ownership
- Loss of managerial control
- Adequacy of financing
- Future capital requirements
- Alliance with a capable Venture Capital which has helpful industry connections
The key to the term sheet negotiation process is keeping these issues in mind from day one and avoiding losing the forest for the trees.
Term Sheet Items to Focus On
Most term sheets contain information like liquidation preference, voting rights, dividends, and board seat designations, among others. These are certainly items with which startup founders should familiarize themselves and scrutinize, but of particular importance are the valuation and post-funding employment provisions.
There are literally dozens of ways to value a company, and most VC’s have customized valuation formulas which they prefer to use. Though exceptions do exist, most business valuations take into account the following factors:
- Valuations of comparable companies
- The scalability of the startup’s business model
- How profitable the business has been and is projected to be
- The management team’s experience and strength
- How competitive the company’s market is
- Consumer demand for whatever product the startup is selling
Most startups do not have the necessary skills to properly evaluate a proposed valuation. Founder bias and a misunderstanding of projected worth often lead business owners to harbor unrealistic opinions about their company’s value. For these reasons, among others, it is best to involve a financial advisor to help founders not only understand the basis for a VC’s proposed valuation, but also prepare a defensible counter-proposal.
It is not uncommon for founders to hold salaried positions within the company for which they seek financing. Though most Venture Capitalists prefer to have key employees remain in place after funding is provided, some will attempt to modify the terms of those arrangements or cut unwanted employees out altogether by excluding reference to the issue on term sheets and acquiring managerial control through stock ownership.
Having an experienced team guiding you through the VC funding process is one way to ensure key items like the above are not overlooked and avoid many of the trap doors investors like to slip into term sheets.