Understanding and Negotiating Venture Capital Term Sheets for Startups

I. Introduction

A term sheet is a non-binding agreement that outlines the key terms and conditions of a potential investment by venture capital investors into a startup company. It serves as a blueprint for the final, legally binding investment documents. Understanding term sheets is crucial for startups because it sets the foundation for the relationship between the company and its investors, and can have significant impacts on the startup’s future growth, control, and exit opportunities.

Negotiating a favorable term sheet is one of the most important steps in the fundraising process. Founders need to carefully balance their desire to raise capital with the need to maintain control of their company and not give up too much in terms of economics, governance rights, and future flexibility. A poorly negotiated term sheet can handicap a startup and make it difficult to raise future rounds of financing, attract talent, and achieve a successful exit.

This guide aims to provide a comprehensive overview of the key components of a venture capital term sheet, common negotiation strategies and pitfalls to avoid, case studies of successful and cautionary deals, and additional resources for founders to reference. By the end, founders will have a solid understanding of how to approach term sheet negotiations and secure funding on terms that align with their startup’s long-term goals.

II. Key Components of a Term Sheet

A. Valuation and Funding

One of the most important components of a term sheet is the valuation of the company. This is typically expressed as a “pre-money” valuation, which represents the value of the startup before the investment, and a “post-money” valuation, which includes the new investment. For example, if a startup is raising a $5M Series A round at a $10M pre-money valuation, the post-money valuation would be $15M.

The amount of money being raised and the type of security being sold are also key terms. Venture capital investors typically purchase preferred stock, which comes with additional rights and preferences over common stock, such as liquidation preferences and anti-dilution protection (more on those later). In some cases, investors may use alternative instruments like convertible notes or SAFEs (simple agreements for future equity), which convert into preferred stock at a later date or upon a specific trigger, like a Series A financing.

Sample verbiage: “The Company’s pre-money valuation shall be $[X] million, and the Company shall issue and sell shares of Series [A] Preferred Stock at a price of $[Y] per share for an aggregate purchase price of $[Z] million.”

B. Liquidation Preferences

Liquidation preferences determine how the proceeds from a sale or liquidation of the company will be distributed among investors and other shareholders. These preferences are a key protection for investors, as they help ensure that they will at least get their money back before common shareholders (like founders and employees) in a downside scenario.

There are two main types of liquidation preferences: non-participating and participating. A non-participating preference means that investors must choose between getting their money back or converting their preferred stock to common stock and sharing in the proceeds pro-rata with other shareholders. A participating preference gives investors the ability to “double-dip”- they first get their money back, then they share in the remaining proceeds on an as-converted basis.

Liquidation preferences are often expressed as a multiple of the original investment. A “1X” preference means investors get their money back before common shareholders; a “2X” preference means they get double their money back, and so on. Most venture deals these days have 1X non-participating preferences, but in frothy markets or for hot companies, investors may push for participating preferred or multiple-liquidation preferences.

Liquidation preferences can also have seniority relative to other series of preferred stock. A senior preference gets paid out first; preferences that are pari passu have equal priority. If there are multiple series of preferred stock, it’s important to specify whether the liquidation preferences are stacked (i.e. Series B gets paid before Series A) or blended (Series A and B share pro-rata).

Sample verbiage: “In the event of any liquidation, dissolution, or winding up of the Company, the holders of the Series [A] Preferred Stock shall be entitled to receive, prior and in preference to any distribution of any of the assets of the Company to the holders of the Common Stock, an amount per share equal to [X] times the Original Issue Price, plus any declared but unpaid dividends thereon.”

C. Voting Rights and Board Composition

Voting rights and board composition are critical for determining who controls the company. Preferred stock typically votes together with common stock on an as-converted basis, but may have additional protective provisions that give investors a veto right over major corporate decisions, like issuing new stock, selling the company, or changing the rights of the preferred stock. These provisions usually require a separate vote of each series of preferred stock.

The composition of the board of directors is also heavily negotiated. A typical early-stage board might have 5 seats- 2 for the founders, 2 for the investors, and 1 independent member mutually agreed upon. As the company raises more money, the board may expand but will typically maintain the same balance- investors and founders each get to elect a certain number of seats, with independents as the swing votes.

In some cases, investors may also negotiate for observer rights, which allow them to sit in on board meetings and receive board materials, but not vote. This can be a good compromise if investors want to be kept in the loop but the founders don’t want to give up too much control.

Sample verbiage: “The holders of the Series [A] Preferred Stock shall be entitled to elect [X] members of the Board of Directors. The holders of the Common Stock shall be entitled to elect [Y] members of the Board of Directors.”

D. Anti-dilution Provisions

Anti-dilution provisions protect investors in the event that the company issues stock at a lower price than what they paid, thereby diluting their ownership. There are two common types of anti-dilution protection- full ratchet and weighted average.

Full ratchet is the most draconian- it automatically adjusts the conversion price of the preferred stock to the lowest price paid in a future financing round. So if investors paid $1/share for their Series A preferred, and the company later raises a Series B at $0.50/share, the Series A conversion price would reset to $0.50, effectively doubling the number of shares the Series A investors own.

Weighted average dilution takes into account the amount raised and the price per share in the future financing, and results in a more moderate adjustment. There are narrow-based and broad-based varieties, which weight the adjustment more heavily in favor of the new money or the old money, respectively.

Anti-dilution provisions may have carve-outs for future financing rounds. For example, the term sheet may specify that there’s no adjustment for strategic investors or for equity issued to employees and consultants. It may also have a “pay-to-play” provision that forces investors to participate pro-rata in the next round in order to benefit from the anti-dilution protection.

Sample verbiage: “The conversion price of the Series [A] Preferred Stock shall be subject to a [full ratchet/weighted average] adjustment upon the issuance of any additional shares of Common Stock at a price per share less than the then-effective conversion price, subject to customary exceptions.”

E. Vesting and Option Pools

Vesting refers to the schedule by which founders and employees earn their equity over time. A typical founder vesting schedule is 4 years with a 1-year cliff- i.e. 25% vests after the first year, with the remainder vesting monthly over the next 3 years. Vesting can accelerate upon certain events, like termination without cause or a change of control of the company.

Employee stock options are also an important consideration. Venture investors typically require the company to set aside a certain percentage of its post-money capitalization, usually 10-20%, to be used for future hires. This “option pool” is created by increasing the fully-diluted share count, effectively diluting the existing shareholders. It’s important for founders to model out their hiring needs and not agree to an unnecessarily large pool, as any unused options will effectively result in unnecessary dilution.

Sample verbiage: “All stock and stock equivalents issued after the Closing to employees, directors, consultants, and other service providers shall be subject to vesting over a [four] year period, with [25]% vesting upon the first anniversary of the issuance and the remainder vesting in equal monthly installments over the following [36] months.”

F. Protective Provisions and Drag-Along Rights

As mentioned earlier, preferred stock may have special protective provisions that give investors a veto right over major corporate decisions. These might include issuing new stock, selling the company, changing the rights of the preferred, or amending the charter or bylaws. There’s a lot of negotiation around what triggers these veto rights and what percentage vote is required- usually it’s a majority of each series of preferred stock, voting separately.

Drag-along rights allow majority shareholders (usually the preferred) to force the minority (usually the common) to agree to a sale of the company. This prevents a situation where a few small shareholders could block an exit that’s favored by the majority. Tag-along rights are the inverse- they allow minority shareholders to participate in a sale on the same terms as the majority.

Sample verbiage: “The consent of the holders of at least [X]% of the then outstanding shares of Series [A] Preferred Stock shall be required for any action that: (i) alters or changes the rights, preferences, or privileges of the Series [A] Preferred Stock; (ii) increases or decreases the authorized number of shares of Common Stock or Preferred Stock; (iii) creates any new class or series of shares having rights, preferences, or privileges senior to or on parity with the Series [A] Preferred Stock; (iv) results in the redemption or repurchase of any shares of Common Stock or Preferred Stock (other than pursuant to employee or consultant agreements); (v) results in any merger, other corporate reorganization, sale of control, or any transaction in which all or substantially all of the assets of the Company are sold; or (vi) amends or waives any provision of the Company’s Certificate of Incorporation or Bylaws.”

III. Negotiation Strategies

A. Identifying and prioritizing key terms

The first step in any negotiation is to identify what’s important to each side. For founders, the key issues are usually valuation and dilution (to minimize the amount of the company given up), board control and voting rights (to maintain control over key decisions), and liquidation preferences and other terms that could hinder the company’s ability to raise future rounds or achieve an exit.

Investors, on the other hand, are primarily concerned with downside protection (liquidation preferences and anti-dilution) and governance rights (board seats and protective provisions). They also care about valuation, but are often willing to be more flexible on price if they feel the other terms are favorable.

It’s important to prioritize the key terms and focus the negotiation on those. Trying to “win” every point will likely result in a breakdown of the deal. Instead, identify the must-haves, the nice-to-haves, and the points that can be conceded. A good framework is to ask “what are the terms that could potentially kill the company if we agree to them?”

B. Leveraging competition among investors

One of the most effective ways to get better terms is to have multiple interested investors. A competitive dynamic shifts the leverage to the company and forces investors to sharpen their pencils on valuation and other key points.

To create this dynamic, founders should run a well-structured fundraising process. This means setting a tight timeline, meeting with as many qualified investors as possible, and keeping them all on the same page in terms of diligence and negotiations. Having a “lead” investor set the terms can be helpful, as other investors will often defer to their diligence and just focus on getting their desired allocation.

Building relationships with multiple investors and positioning the round as oversubscribed can also create a sense of urgency and scarcity value. Founders should be careful not to overplay their hand, though- if the round is perceived as being shopped too widely, investors may lose interest.

C. Seeking professional advice

Founders should always engage experienced legal counsel to assist with fundraising negotiations. Most startups use a handful of Silicon Valley-based law firms that specialize in venture deals, like Cooley, Fenwick & West, Gunderson Dettmer, and Wilson Sonsini. These firms have seen thousands of deals and know the market norms, which can be invaluable in getting to a fair deal quickly.

In addition to lawyers, founders should seek advice from experienced entrepreneurs, investors, and advisors who have been through the process before. Many accelerators and incubators, like Y Combinator, Techstars, and 500 Startups, have great networks of alumni and mentors who can provide guidance and make introductions to investors.

D. Balancing short-term and long-term goals

One of the most challenging aspects of negotiating a term sheet is balancing the short-term goal of getting the deal done with the long-term impact on the company’s future financing and exit options. For example, agreeing to a participating preferred liquidation preference with a high multiple and no cap might help get the round closed, but could make it very difficult to raise the next round from new investors, who would have to come in behind the prior investors in the preference stack.

Founders need to think through the implications of each term not just for the current round, but for the next round and beyond. Maintaining flexibility for future pivots and strategic decisions is key. It’s also important to align investor incentives with the company’s mission and values- an investor who is just looking for a quick flip may push for terms that are not in the long-term interests of the company or its employees.

IV. Common Pitfalls to Avoid

A. Overvaluing or undervaluing the company

Getting the valuation right is critical. If the company is overvalued, it will be difficult to raise future rounds at a higher price, potentially leading to a down round, dilution, and loss of credibility with investors and employees. On the other hand, undervaluing the company means giving up too much equity and control, which can be demotivating for the team and leave the company with a lack of runway to achieve its milestones.

Founders should do their homework on comparable deals and use objective metrics like revenue, growth rate, and market size to justify their valuation. They should also consider the stage of the company, the experience of the team, and the competitive landscape. Investors will often try to anchor the negotiation with a low valuation, but founders need to be prepared to walk away if the price is not fair.

B. Agreeing to onerous liquidation preferences

As discussed earlier, liquidation preferences can have a big impact on the distribution of proceeds in an exit scenario. Agreeing to a multiple-liquidation preference (greater than 1X), a participating preferred with no cap, or a redeemable preferred (which gives investors the right to force the company to buy back their shares after a certain period of time) can all be red flags for future investors and acquirers.

These terms are relatively rare in early-stage deals these days, but founders should still be on the lookout for them. If an investor is pushing hard for a 2X or 3X liquidation preference, it may be a sign that they don’t have much faith in the company’s prospects.

C. Giving up too much control

Another common mistake is giving up too much control of the board and key governance rights. Founders should fight to maintain at least equal representation on the board, if not an outright majority. They should also be careful about agreeing to broad protective provisions that give investors a veto over things like hiring/firing key employees, setting the budget, or even pivoting the business model.

It’s also important to negotiate for independent board seats to provide a counterbalance to the investor directors. These are typically industry experts or experienced entrepreneurs who can provide valuable advice and perspective.

D. Failing to properly allocate option pools

Startups need to be thoughtful about how they allocate equity to employees. Failing to reserve enough shares for future hires, allocating too much to early employees before the company has proven itself, or neglecting to put vesting schedules in place can all create problems down the line.

Founders should work with their investors and legal counsel to size the option pool appropriately based on their hiring plans and industry benchmarks. They should also consider implementing longer vesting schedules (4-5 years) for early employees and building in mechanisms like vesting acceleration upon termination without cause or a change of control.

V. Case Studies and Examples

A. Airbnb’s seed round (2009)

In 2009, Airbnb raised a $600,000 seed round from Sequoia Capital and other investors at a $2.5M pre-money valuation. The founders were able to negotiate for some founder-friendly terms, including a board seat for themselves and accelerated vesting of their shares upon termination without cause. They also avoided particularly onerous terms like a participating preferred liquidation preference or a multiple-liquidation preference.

This deal is notable because Airbnb was still a very early-stage company at the time, with little traction and a lot of regulatory risk. However, the founders were able to convince investors of their vision and potential, and structured a deal that gave them the capital and support they needed to grow without giving up too much control.

B. Uber’s Series A (2011)

In 2011, Uber raised an $11M Series A round from Benchmark Capital and other investors at a $60M pre-money valuation. The company agreed to a fairly standard 1X non-participating liquidation preference for the Series A investors. However, the founders were able to negotiate for two board seats for themselves and the ability to appoint an independent director.

This deal is notable because it was one of the first significant rounds raised by a ride-sharing company, and helped establish Uber as a market leader in the space. The founders were able to

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maintain significant control over the board and governance of the company, which would prove important as Uber scaled rapidly and faced various legal and regulatory challenges.

C. Snap’s Series A (2012)

In 2012, Snap (then known as Snapchat) raised a $13.5M Series A round led by Benchmark Capital at a $60M post-money valuation. The founders were able to negotiate some very favorable terms for themselves, including retaining 86% of the company’s voting rights through a dual-class stock structure. The Series A investors received a 1X non-participating liquidation preference and a board observer seat, but no board seat or significant control provisions.

This deal is notable because it was a highly competitive round, with multiple top-tier firms vying to invest. The founders were able to use that leverage to negotiate terms that were highly favorable to them, while still providing enough economic upside and governance rights to attract top investors. Of course, the dual-class stock structure would later become controversial as Snap prepared to go public.

D. Cautionary tale: Zenefits (2015)

In 2015, HR software startup Zenefits raised a massive $500M Series C round led by Fidelity at a $4.5B valuation. The company had been growing extremely rapidly, but was also burning a lot of cash and facing questions about its business model and compliance with insurance regulations.

In the rush to get the deal done, the company agreed to some investor-friendly terms that would later come back to haunt them. Specifically, the Series C investors were given a “full ratchet” anti-dilution provision, which meant that their shares would be repriced at the lower valuation of any subsequent down-round. This is in contrast to the more typical “weighted average” anti-dilution that takes into account the size of the down round.

Sure enough, Zenefits hit a wall in 2016 as regulatory investigations and management turmoil took their toll. The company ended up doing a recapitalization at a significantly lower valuation, which triggered the full-ratchet provision and massively diluted the common stockholders, including the founders and employees. The company eventually stabilized and was acquired by private equity firm Francisco Partners in 2018, but the full ratchet was a key factor in the founders losing control of the company.

The lesson here is to be careful about agreeing to overly investor-friendly terms in the heat of a competitive fundraise. The full-ratchet anti-dilution in particular is a term that most experienced lawyers and advisors would caution against. It’s important to think through the potential downside scenarios and make sure the company is protected.

VI. Additional Resources

For founders looking to learn more about term sheets and venture capital deals, there are a wealth of resources available online and in print. Here are a few of the most useful:

A. Sample term sheets and clause explanations

• The National Venture Capital Association (NVCA) publishes a set of model legal documents, including a term sheet, at https://nvca.org/model-legal-documents/. These are a great starting point for understanding the key terms and how they fit together.
• Y Combinator, one of the top startup accelerators, also publishes a sample Series A term sheet at https://www.ycombinator.com/documents/. This is a more founder-friendly version that can be a useful counter to the NVCA docs.

B. Recommended books and blogs

• “Venture Deals” by Brad Feld and Jason Mendelson is a must-read for any founder looking to raise venture capital. It covers all the key terms and negotiating points in detail, with plenty of real-world examples.
• “The Entrepreneur’s Guide to Business Law” by Constance Bagley and Craig Dauchy is another great resource that covers a wide range of legal issues for startups, including fundraising and deal structuring.
• “The Art of Startup Fundraising” by Alejandro Cremades provides a more tactical guide to the fundraising process, with tips on how to build relationships with investors and pitch effectively.
• For ongoing insights and analysis, the “Venture Hacks” blog at https://venturehacks.com/ and “The Startup Law Blog” at https://thestartuplawblog.com/ are both excellent resources.

VII. Conclusion

Negotiating a venture capital term sheet can be a daunting process for founders, especially those going through it for the first time. There are a lot of complex legal and financial concepts to understand, and the stakes are high in terms of the company’s future success and the founders’ own economic outcomes.

The key things for founders to keep in mind are:

1. Understand the key components of a term sheet and how they impact the economics and control of the company. Don’t get hung up on valuation alone, but consider the broader package of terms and how they fit together.
2. Prioritize the terms that are most important to you and be willing to negotiate hard on those. But also be prepared to make concessions on other points in order to get a deal done. Know your walkaway points and don’t be afraid to stick to them.
3. Seek out experienced advisors, including lawyers and other founders/investors who have been through the process before. Their advice and perspective can be invaluable in avoiding common pitfalls and getting to a fair deal.
4. Think long-term about the impact of the terms on future financings and exit scenarios. Don’t agree to terms that could handicap the company or make it difficult to raise more money down the line.
5. Remember that the goal is not to “win” every point, but to find a middle ground that aligns the interests of the company and the investors. Venture capital is a long-term partnership, and it’s important to build trust and transparency from the beginning.

By taking the time to educate themselves on term sheets, seeking out expert guidance, and approaching negotiations with a spirit of collaboration and long-term thinking, founders can set themselves up for success in raising venture capital and building lasting businesses.