Any time you’re looking to raise capital, whether equity or venture debt, you’ll inevitably be asked to sign a term sheet, a contract outlining the details of the investment. And, although they’re usually non-binding, the fact is that investors expect you to honor them once signed. That’s why it’s critical to understand and negotiate the provisions of a term sheet before you agree to it, especially if you’re giving up equity.
Make a mistake, and you could find yourself contending with long-lasting and, frankly, undesirable implications for your business. To help you avoid that scenario, below we’ve provided a quick guide to how term sheets work. Keep reading to learn about the mistakes that founders and CEOs often make when negotiating term sheets, and how you can avoid them altogether.
And, for anyone looking for more information on term sheets, we’ve also flagged some additional resources at the end of this post that provide further details.
Term sheets explained
Most term sheets use standard language from templates published by either the National Venture Capital Association (NVCA) or the Canadian Venture Capital Association (CVCA). Investors then modify that language to suit their needs. Nevertheless, term sheets always contain several key components. These include a valuation, securities being issued, board rights, investor protections, dealing with shares, and miscellaneous provisions. You can learn more about these components here.
While successful, mutually beneficial equity term sheets are executed all the time, if you don’t understand and negotiate them effectively, you could end up in a constant battle with an investor who has a very different vision for your business than you do. That includes how your business should be run. You might find yourself hamstrung and unable to bring on new investors or giving away more equity than you intended. You could even be forced out of the business you worked so hard to create.
It’s important to identify and avoid these pitfalls. Let’s take a closer look at five ways that founders and CEOs can get themselves into trouble when negotiating term sheets:
1. They underestimate the impact of share preferences on common shares
It’s a common mistake to think that if you’ve sold 30 percent of your business to an investor, the investor simply gets 30 percent of the profits when the company is sold. What some founders and CEOs don’t realize is that if the investor has preferred shares — as is commonly the case — things get more complicated.
Preferred shares mean the investor gets its capital back ahead of common shareholders. This can be catastrophic for common shareholders if the company struggles and is sold for a lower-than-anticipated price. For example, if an investor bought a 30 percent stake in your company for $5 million via preferred shares, and the company is later sold for $10 million, the priority return of capital means 50 percent of the purchase price will flow to the investor, rather than 30 percent.
And it’s not uncommon for the preference to be amplified via cumulative dividends and double dip provisions can take another massive chunk of total sales proceeds. This might be ok for companies that achieve big exits, but anything less than that will land yours in trouble.
2. Aggressive valuation causes the investor to add protective provisions to control the additional risk
If an investor believes that the valuation of your company is high, but still wants to do a deal, it might incorporate other deal terms to bridge the valuation gap and mitigate its risk. These can take the form of aggressive protective provisions. These might seem reasonable at the time, but they can be used to limit your ability to run your own business.
Protective provisions can include the right to approve a majority of the board, all the company’s future share issuances and borrowing, and the hiring and firing of senior officers. In other cases, you could be agreeing to full price anti-dilution protection for the company, or reverse vesting on founder shares.
Make no mistake, in some circumstances agreeing to some of these protective provisions on a term sheet could see you lose control of your company entirely.
3. Agreeing to standard terms without knowing what they are
Standard terms might sound innocuous, but agreeing to them without knowing what they are is asking for trouble. Just because they’re standard, doesn’t mean they’re the best thing for you and your company, or that they’re fair.
Many of the protective provisions and share rights mentioned above are part of standard National Venture Capital Association (NVCA) approved terms. For example, standard CVCA terms give the investor the right to require the redemption of its shares after a specified investment period, the right to make the company complete an initial public offering of its stock, first right to have its shares listed, and to buy new issuances of shares ahead of founders.
You need to ask questions and understand exactly what those standard terms are before you sign on the dotted line.
4. Accepting an excessively long due diligence process
Term sheets usually include exclusivity provisions, meaning the company cannot enter into negotiations with any other investors while the interested party completes its due diligence before committing to invest. Generally 30 to 45 days is considered reasonable for a due diligence period, but some investors might demand 90 days or more. Long periods do more than simply let the investor complete due diligence. This timeframe allows them to monitor your company’s performance, before they decide to commit. And, when you’re dealing exclusively with one investor for three months, you can’t entertain any other, potentially beneficial, offers. Your alternative fundraising leads might grow cold and you could run low on capital.
Crucially, because term sheets are non-binding, your investor could potentially renegotiate terms that are unfavorable to you before closing, or walk away altogether if your company experiences a downturn during this time.
5. Having an investor that doesn’t provide the value-add they promised
Finally, if you’ve been promised a value-add by your investor, such as resources or contacts, you need to investigate their ability to deliver before you sign the term sheet. All investors know the benefits of making these promises, not all will have the skills and contacts to actually make it happen.
If they have said they will help you to raise additional funds and fail to do so, that’s going to cause conflict down the track. Not everyone will make good on their commitments, so if value-add benefits are important to you in an investor, you need to do your own due diligence before you sign. Take care to look at their track record and see if they’ve delivered for other companies in the past, and will be able to do so for you too.
How to avoid problems before they arise
Seeking investment is a tricky business, but you can’t let the prospect of raising capital blind you to the potential pitfalls of going with a particular investor. You need to understand exactly who you’re partnering with and whether or not they’re a good fit for your business. Just as they will be doing their due diligence on your company, so too should you be your own diligence on theirs. Don’t be afraid to do your homework and to ask questions. For example, you’ll want to know:
- What their goals and priorities are and if they line up with your own
- What their past successes and failures are
- If they’ve had any exits and, if so, what kinds of valuations they got
- If they’ll put restrictions on how you can use their capital
- If they have a track record of delivering the value-add they’ve promised other companies they’ve invested in
- Whether or not they’ll be willing and able to support you the next time you go to raise capital
Different investors invest in different types of securities, depending on what stage the business is at, and what they consider the risk of their investment to be. You need to know the difference between a Simple Agreement for Future Equity (SAFE), common shares, preferred shares, and convertible debentures. These are complex issues that have a profound impact on a business at exit, so you need to understand exactly what kind of security is being asked for.
And don’t enter into equity capital-raising negotiations without a bit of cash in the bank. If you approach investors with nothing in the tank, you’ll be in a weaker position. Either start negotiations well in advance of needing the capital, or consider venture debt to shore up your financial position. A good cash position will give you an advantage because it means you require less money from investors and you can improve returns to shareholders.
Raising capital is a complicated commercial transaction and, as your term sheet is effectively the blueprint for the investment, one of the best things you can do is to involve a lawyer at this stage. An experienced lawyer can help you focus in on the things that matter and identify and advise you on terms that are not commercially reasonable.
Ultimately, negotiating a successful term sheet comes down to education and awareness. If you know what to expect, you can save yourself a lot of trouble further down the road.
Negotiating your next term sheet and getting it right
No matter who you intend to partner with, negotiating a term sheet can be complicated. Term sheets aren’t always balanced or fair, so you need to do your own due diligence to ensure the best outcome for your business. While on the surface, a term sheet might seem reasonable, remember that they can give your investors far-reaching powers that can compromise your vision for your business, and interfere with how you intend to run it.
Knowing how term sheets work and where the potential pitfalls lie is critical. So too is finding an investor who makes the process easy for you, and is motivated to achieve the best outcome for both parties. When you’re armed with knowledge and can avoid problems from the outset, you’ll be much better able to negotiate a fair and balanced term sheet that will meet both your needs and those of your investors.
To find out more about term sheets and how to successfully negotiate them, check out our recent white paper, “How to negotiate a successful term sheet.”