As an entrepreneur you might not even think about a term sheet until you are late into the fundraising process. However, understanding term sheets is essential to coming from a position of strength in the negotiations process and ensuring you make the right decisions for your business.
We sat down with Michael Sachaj, Principal at Hyde Park Angels, to dispel some of the common myths about term sheets and break down what really matters.
Incorrect Myth #1: Term Sheets Are Incredibly Complicated
If you know these terms and how they relate to one another, you’ll put yourself in a good position during negotiations.
Board Structure and Composition:
A term sheet specifies what your board structure and composition will be.
Usually you want a three or five-person board. An odd number is essential because you want a tiebreaker on divisive issues. For early stage startups the board usually consists of:
- An Investor
- A Founder
- An Independent
The independent board member is tactically chosen and voted on by the investor and founder. It is important that the founder and investor agree on the third board member because being aligned can help prevent tension down the road.
Similarly, if the board has five members, the makeup would be two investors, two common (founders), and one independent.
Occasionally, an investor might be more aggressive and want two investors on a three-person board. In that case, the entrepreneur has to decide if they’re willing to give that up in exchange for funding.
It’s standard for a term sheet to include a vesting schedule for the founder. This area can perplex some founders, so it’s a good thing to research ahead of negotiations.
Vesting, in general, is in place to protect all parties. For co-founders it protects against one of the founding members walking away two days after funding is raised. It also protects investors, incentivizing the founder to keep working hard at growing the company after a round.
The vesting period can be three or four years, with equity vesting monthly. Sometimes investors will try to not give any equity up front or they might want to extend the vesting period beyond four years.
This is a binary concept – an investor either gets a liquidation preference or they don’t. “The purpose of the provision is to protect investors if a company exits at a value lower than what was initially expected,” Michael notes.
A liquidation preference means that preferred shareholders (the investors) receive their money back before any of the common shareholders (employees and founders).
There are two-types of liquidation preferences: non-participating and participating. Think of participation as double-dipping into the proceeds pool. For more examples, register for The Ultimate Entrepreneur’s Guide to Term Sheets on 11/9.
Incorrect Myth #2: Investors Will Try and Pull a Fast One On the Entrepreneur
The VC ecosystem is smaller than you think. It’s also a space that is built on relationships. Michael states, “For that reason, it makes sense for both investors and founders to build reputations based on fairness and being pleasant to work with.”
Understanding the reputation of a VC from multiple direct sources can give you a better sense of their track record of working with startups.
Incorrect Myth #3: Someone Will Leave the Negotiation Unhappy
Michael stressed the importance of knowing the terms and how they affect one another. “When you come into the negotiation room and you understand your priorities and how they interplay, you’ll start to see the different terms as levers. You can adjust the levers and there could be a different way for you to get the end result you want.”
Incorrect Myth #4: Term Sheet Negotiations Are a Long Process
Typically the term sheet negotiations shouldn’t take more than two weeks. The document is about five pages long and not legally binding. If an entrepreneur is not responsive throughout the process, then it will slow down, regardless of the reason. Maybe the entrepreneur doesn’t have lawyer and could be scrambling or they’re shopping around to other firms.
“During negotiations you also want to limit the number of times you go back and forth. For that reason it’s important to know your priorities and what you’re willing to fight for,” Michael says. An investor relationship typically lasts from eight to ten years at the early-stage, so you want to go into it the right way.
Incorrect Myth #5: There’s No Proven Way to Prepare for Term Sheet Negotiations
Several things have happened in the last few years that have made term sheet negotiations easier to manage.
First, more seed companies are investing in simple agreements for future equity (safe). “To prepare for future funding rounds, it’s in the interest of all parties to have an agreement that’s standard, agreeable and acceptable in the future,” Michael said. Term sheets are also shorter in length and have a predictable syntax. The National Venture Capital Association has some great templates to check out.
Second, Brad Feld wrote a book called How to Be Smarter Than Your Lawyer.
“Every entrepreneur and investor uses this book as a reference – sometimes even in the negotiation room. It has created a balance,” says Michael. The book, by Feld, levels the playing field in negotiations, demystifying a lot of the core elements of the process.
Join Michael on 11/9 for his webinar on navigating term sheets. At Hyde Park Angels, Michael manages the deal flow from end to end. His webinar is part of HPA’s Entrepreneurial Education Series and will delve into what terms mean, what are best practices during negotiations and how to set yourself up for long term wins.