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Chapter 8: The Fundraising process: Negotiation phase - term sheets
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After an investor expresses interest in investing in your startup, a negotiation phase begins. This process is initiated by the investor presenting a term sheet. The final outcome of the negotiation process is a term sheet agreed upon by both parties.
In this blog post, we will cover the various aspects of a term sheet.
What is a term sheet?
In venture capital, a term sheet is a (mainly) non-binding document that outlines the key terms between an investor and a startup; it does contain some limited binding elements such as confidentiality, costs and the applicable law. Think of the term sheet as a blueprint for your relationship with your investor. Generally, the term sheet has two major components: economic terms and control terms. The economic terms covers investments, equity and related financial matters, while the control terms often shape decisions on how the company operates. Below, we have set out a few of the terms that are usually included in a term sheet:
Economic terms
Valuation : This refers to the value of the company. It is important, because it indicates the level of ownership that can be granted to investors based on their investment. Valuations are typically expressed in pre-money or post-money terms.
Liquidation preference: This refers to the rights on the order and amount of payments to investors when a liquidation event, such as the company's acquisition, occurs.
Dividends: These are the rights to a portion of the company's profits via a distribution to shareholders. On occasions, in order to invest proceeds in the company, a hiatus on dividend payments is agreed.
Pro rata rights: These enable investors to invest in future rounds at a level that prevents dilution, thus allowing them to maintain their percentage ownership.
Anti-dilution rights: These protect investors from equity dilution resulting from a ‘down round’, which occurs when newly issued stocks are priced lower than the initial investment.
Option pools: These are blocks of equity set aside for incentivising and compensate employees.
Control terms
Board of directors: This refers to the number of board seats granted to investors following their investment. The number of board seats will determine the level of control an investor has over the company. For certain key decisions, enhanced majority requirements may be provided within the articles of association of the company. Similar mechanisms can also apply at the shareholders’ level.
Information rights: These provide investors with access to certain key confidential company information. They may also include access to company facilities and personnel.
Protective provisions: These are investor rights that allow them to approve of, or reject, certain actions that could impact their investments, such as decisions to sell or take on debt.
Drag-along rights: These permit investors to mandate a sale where specific conditions have been met.
Co-sale (‘tag along’) rights: These enable investors to sell their shares along with those of the founders/management.
Right of first refusal (ROFR): These grant investors the opportunity to be first in line to purchase shares that the founders/management (and sometimes other investors) have put up for sale.
Pay-to-play rights: These allow investors to compel other investors to invest in future rounds.
Which of these should you focus on the most?
Knowing what to focus on within a term sheet can help you avoid future undesirable commitments. The most common areas of contention between investors and founders are as follows:
Valuation: The company's valuation directly influences your dilution as a founder. A higher pre-money valuation reduces dilution and consequently preserves your ownership. However, it is crucial to strike an appropriate balance, as an overvalued startup may struggle in subsequent funding rounds or exit scenarios.
Liquidation preference: The liquidation preference defines the order of payout in the event of a company's exit. It’s vital to understand whether the investor is asking for a multiple liquidation preference, as it may mean they get more than their share of the exit proceeds.
Board of directors: This control term can greatly impact the future of your company. A balanced board often works best. It ensures that the founders retain a voice in significant decisions while allowing investors to monitor their investment. In order for the board to remain an efficient platform for debate, it’s important not to overkill on the number of director roles sought.
- Protective provisions: These determine the veto powers of investors. Overly restrictive protective provisions can restrict a company’s agility and impede its growth. It’s therefore important to negotiate these clauses correctly, in order to maintain the right degree of operational freedom.
How can you negotiate better terms?
Securing favourable terms in your term sheet involves a blend of tactical preparation and astute negotiation. Here are some ways you can enhance your negotiating position:
- Have an In-Depth Understanding of your Business: Thoroughly understanding your business model, market potential, and unique selling propositions can provide you with useful leverage in valuation negotiations. A compelling narrative, backed by robust data, can enhance investor confidence and justify a higher valuation.
- Foster Competition: If you can generate interest from multiple investors, you may find yourself in a stronger negotiating position. Investors may offer better terms in order to outbid their competitors.
- Engage Legal Expertise: Term sheets are legally complex documents. Engaging a legal expert experienced in startup funding can help you navigate potential pitfalls and strengthen your negotiation position. Having your legal expert connect with your financial expert is a must.
- Be Resilient and Patient: Negotiating a term sheet can be a prolonged process. Showing resilience and maintaining a long-term view can prevent premature or even unfavourable compromises.
- Be Ready to Walk Away: Not every deal is a good deal. If the terms offered may harm the future growth or control of your startup, you must be ready to walk away from the deal. Adopting this mindset help empower you to negotiate from a position of strength.
- Open Communication: Transparent and open communication can foster trust and facilitate negotiation. Express your expectations and reservations clearly on any proposed terms.
PwC Pro Tip
- When negotiating your term sheet, make sure you know what you want: identify which terms are standard, which are important for you and which you are prepared to cede during the negotiations.
- It is vital to review the term sheets with a legal team experienced in startups and venture capital.
Looking for expert advice on your Term sheets? We work alongside a multidisciplinary team at the law firm PwC Legal to provide you with a full range of legal business solutions. Follow the link to learn more. |
In the next blog post, we will discuss another aspect of the negotiation phase: the due diligence process.
For more information on how PwC can support you in your fundraising, and how we support startups and scaleups visit our website.
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