There are two things that investors and startups need to understand about term sheets. The first is what the key terms are, what they mean, and how they are used in negotiating the overall deal. The second is knowing the norms for each term. It is one thing to understand what a term means and something altogether different to know how it is typically used, what is expected, and when a term might be used creatively to offset something else in the negotiation.
One of the biggest mistakes I have seen startups make is relying too heavily on their attorney to put the term sheet together and drive the negotiation. Not knowing how term sheets work is not a good reason to hand the entire process over to your attorney. I have seen too many attorneys who understand how the individual terms work but do not understand the market norms—and the result is often a failed deal.
Some lessons are best learned in advance rather than through experience. For example, a new investor might think it is a great idea to negotiate a two- or three-times liquidation preference, meaning investors receive two or three times their money back before common shareholders receive anything. That may seem great until you realize that investors in the next round will probably demand the same terms—and they might not have done so if the first-round investors had not established the precedent.
Now, instead of receiving $2 million or $3 million from the liquidation preference, the first-round investors find themselves behind the later-stage preference. If the next investors put in $5 million with a three-times preference, they receive the first $15 million from an exit before the first-round investors receive anything. What goes around comes around, which is why understanding market norms is so important.
Some people think that because they are using a convertible note or SAFE agreement, they can avoid doing a term sheet. While that may technically be true, many decisions still need to be made when negotiating a convertible note or SAFE. Those decisions can become quite complex, especially when you consider the various conversion, exit, and tax implications.
I would also like to dispel the myth that term sheets are overly complicated and difficult to negotiate. The RVC template shows you which terms are actively negotiated—such as board composition, liquidation preference, and valuation—and which terms are usually not heavily negotiated, such as conversion provisions and drag-along rights. You soon realize that only a handful of terms typically require significant discussion, and a four- or five-page term sheet can often be negotiated in less than an hour.
The best way to truly demystify term sheets is to learn about the terms in a workshop such as RVC’s Term Sheets and Cap Tables Workshop, coming up this Friday. It is designed for both investors and startups because the best negotiations happen when both sides understand what they are doing.
The workshop will be held online Friday from 10:00 a.m. to noon. I will be the instructor for this week’s session, and I encourage you to come with lots of questions. We will also provide participants with template term sheets designed to make understanding and negotiating a deal much easier.
.jpg)
.jpg)
