Grasp VC Term-Sheets: how good founders draw an opportunity

“As you’ll learn, there really are only two key things that matter in the actual term sheet negotiation — economics and control.” Brad Feld, Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist

A fundamental element in the life of any startup is the capital raising process, and with this comes the negotiation of the terms and conditions with investors (typically in the form of a Term Sheet), which will differ throughout the life of the startup. In the early stages, the elements to negotiate and the type of contract will be simple; in subsequent stages, they tend to be more complex.

It is important to understand the terms to be negotiated, as well as the impact they will have on the future of the company. The terms and their negotiation can be divided into two main approaches: economic value and control.

Can you imagine an entrepreneur or investor who does not have in mind the economic value of an investment?

The economic value is directly related to the valuation of the company, the ownership percentage, dilution, the option pool, liquidation preference, anti-dilution protections, information rights, and dividends.

Control relates to the ability to impact in the startup’s strategic decision-making process. Some elements are the composition of the board of directors, the right to vote and veto, and investor protection provisions (ie. drag along, tag along).

The above is represented in the following matrix of economic value vs. control.

1. Rough diamond: (High valuation — high control) it is represented by any startup where the entrepreneur obtains a high valuation while maintaining high control. They are usually seed or early-stage startups with a solid team, a disruptive business model, and significant traction. These companies usually end up being very valuable unicorns with the founder keeping a significant control over the company, such as SpaceX.

2. Diamond: (High valuation — low control) An established startup that is on its way to becoming or that already is an unicorn can be considered a diamond. In this case, the capital raising rounds have decreased the entrepreneur’s equity or the control of the company has been transferred partially or completely to other investors and maybe to a more capable management team. This is the case of WeWork where the founder was forced to step down due to the poor strategy and flaw execution.

3. Carbon: (Low valuation — low control) This is the quadrant that every entrepreneur wants to avoid, having a low valuation and little control of the startup. On the contrary, investors have an opportunity to significantly influence the strategy of the startup and seek new channels to generate value. Usually these startups tend to be acquired or wind-up at some point in time.

4. Turquoise: (Low valuation — high control) Usually this quadrant is accompanied by startups in seed or early stages where the founders still have a lot to prove to benefit from a higher valuation. For this reason, entrepreneurs usually still have control in decision making. Many companies in this quadrant tend to be profitable businesses.

Recommendations:

Not all investment rounds have a term-sheet. If you are raising a seed or an early stage round you are probably going to sign a convertible or SAFE note, so there will be no need for a term-sheet.

- Read the term-sheet: Don’t forget to read the term-sheet carefully. A single word can make the concept of the term different.

- Understand the terms: It is important that the entrepreneur understands not only the concept but also the purpose of the terms and the negotiation context.

- Hire a good legal team: Do not go for the lawyer you know, specially if he has not advised on VC transactions, even if he is your most trustworthy lawyer. Network with relevant legal firms in the VC ecosystem so that you have the best advice possible.

- Know your investor: Not all investors are the same or have the same criteria while negotiating an investment. It is essential that you know them as an entrepreneur and have an open dialogue with them, as well as a clear view of the intentions of both parties.

- Term-sheets involve a negotiation: Don’t expect to win in all terms, it is a negotiation process and you also have to give in, always look for win-win scenarios.

- Before negotiating, define your priorities: Identify the term-sheet that suits your needs based on your control priorities of the company or on economic issues.

- Think that today you are building the future: What you agree to now must be fulfilled and may be invoked by the parties in the future. In addition, it may impact future rounds of capital raising.

- Understand your reality: If you have a great business idea but an unexperienced team you may want to give up some control in order to take advantage of the investors experience.

Some entrepreneurs downplay the relevance of raising capital and negotiating terms and conditions. Every entrepreneur who is really concerned about building a company that lasts over time should be concerned with a perfect understanding of the terms and conditions, as well as the negotiations process.

Be a humble learner

- Migue Morkin, Founder and CEO of Sirena

Hector Shibata. Director of Investments & Portfolio at ACV a global Corporate Venture Capital (CVC) fund and Adjunct Professor for Entrepreneurial Finance.

Ricardo Latournerie. Investment analyst at ACV.

ACV is an international Corporate Venture Capital (CVC) fund investing globally in Startups & VC funds.

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