Once upon a time, some founders needed money. They pitched a group of investors, and the investors agreed to give them many gold coins at a set valuation. The founders were happy, and the investors were happy. The company prospered, and everyone lived happily ever after.
Well, not quite. In fact, not even close. The parties did eventually reach a deal, but not without mistrust, hostility and bad feelings on both sides. Because they didn’t use a term sheet, negotiations over material terms turned hostile and nearly derailed the deal. Hardly a fairytale ending.
Things didn’t have to take this sinister turn, though. Everyone in this scenario—which is based on a true story, by the way—could have easily spared themselves rancor, hours of wasted time and extra legal fees. All they had to do was share their key points and discuss them before asking their lawyers to draft financing documents.
Which brings me to term sheets and some practical advice: Don’t attempt any transaction without one. And don’t commit to doing a financing using something masquerading as a term sheet. Lately, I’ve been seeing an increasing number of “term sheets” that have shrunk to under two pages and are peppered with words like “customary” and “typical.” And recently, a startup I counsel that was seeking a second preferred stock financing received a skimpy four-page term sheet. That’s one-third of the length of the National Venture Capital Association’s standard term sheet. These documents don’t reflect all key terms for a deal; rather, they’re Cliffs Notes for a deal.
While it’s commendable to want to keep things simple, a solid working term sheet spells out the nuts and bolts of a deal: We give this. You get that. We get this, you give that. It avoids “customary” and “typical”—because founders and investors may have very different definitions of those words. Why bother to write this down? As the above example shows, even when both parties have the best of intentions and a desire to collaborate, so much can go wildly wrong between a handshake and the final financing documents.
Shorter Isn’t Always Better
Investors will argue that a short term sheet is more efficient—but that brevity isn’t necessarily in the best interest of a company. While the founders are negotiating terms, they’re committing to a 45-day exclusivity period when they cannot entertain other financing offers. If the deal falls through, a critical month and a half is gone.
Creating a comprehensive term sheet means listing all key terms of the deal and flagging economic, control and deal-related issues you could one day face. If you’re doing an equity financing, what are the key terms of liquidation preferences and protective provisions? Does a preferred stockholder get a board seat and observer rights? If a licensee creates new intellectual property under a license agreement with your company’s IP, who owns that property?
Ask Questions
Whoa. Too many questions, right? Yet you need to ask all of these—and more. Remember that investors typically write up term sheets, so they’re going to include terms favorable to them and their interests. And a little secret: They not only expect you to negotiate these terms, but they want you to push back. Prospective investors will be disappointed if you and your fellow founders happily ink a term sheet without questions or negotiations. They’ll fear that you’re a similar pushover with customers, vendors, your board and your employees.
Raising concerns in a non-confrontational manner shows sophistication and a commitment to protecting your startup’s interests while trying to be collaborative. Someone who can successfully negotiate the key points in a term sheet can also likely handle other key transactions. So roll up your sleeves and get busy. If you and your team want to make a significant change to the business terms, don’t ask your lawyer to call their lawyer. Pick up the phone yourself and talk it through with your prospective investors.
Work Through Differences
There’s no denying that these discussions can be uncomfortable. Your job is to disagree without being disagreeable. The skill with which you handle that negotiation will not go unnoticed by the people who decide whether to fund your venture. Investors don’t say this, but they view term sheet negotiations as a test run to see how founders resolve differences of opinion.
Working through terms also helps you determine whether your potential investors’ values and style are aligned with yours. Are they collaborative? Ruthless? Condescending? Sometimes those differences are so significant that they can’t be bridged, even with candid talks and good-faith negotiations. If that’s the case, you each can walk away feeling relieved that you’ve dodged a bullet. As disappointing as that outcome may be, the term sheet has served its purpose.
Ideally, your differences can be hammered out and the term sheet will become a roadmap for a financing round that moves your company forward. Forthright term sheet negotiations set the stage for an honest, collaborative business relationship. Reaching agreement on your key terms up front—before your term sheet’s bullet points become binding legal documents—goes a long way towards ensuring a happy ending.
Gary Schall helps entrepreneurs and emerging companies navigate legal issues, from formation to equity and note financings through exit events. He is the co-chair of Wilmer Hale’s emerging companies and venture practice group. Contact him at [email protected].
