HIDDEN TRICKS: Know the terms of your VC deal

"Did you know you sign up for slavery when you accept money from an investor?"

Well, that is what first-time founders think when they read all the fine legal print in the first offer from their first potential investor. Summarized in a "term sheet", the deal has conditions that come along with the money.

Not all of the conditions are what you want as leader of a new enterprise. When you understand what you are agreeing to, you'll be able to negotiate the best terms for your deal.

• Learn the terms and consequences of a term sheet. You can study the terms in books like Term Term Sheets & Valuations. Or try this helpful blog series by Brad Feld: Term sheet terms. And ask your lawyer. And other CEOs.
• Know your local VC market for the terms of a VC deal. Economic conditions alter what investors demand (they do not ask politely). Each VC fund has good times and bad that influence what terms they insist on and will give on. Ask other CEOs, your lawyer, accountant, and coaches. It is up to you to know what you realistically can get with the terms you negotiate.
• Simulate bad times and what you will be constrained by. You may be hemmed in on when you can raise salaries to keep people motivated, what freedom will you have to hire people and a lot more. How about buying equipment needed by the engineers. And PR and travel and pricing big deals, and so on. When you read and apply the fine print, you'll be surprised at how constrained you will be if you accept the first terms offered by an aggressive VC.
• Your goal should be to get the money you want with as few constraints as possible. Serial entrepreneurs expect the board of directors to spend time discussing major moves by the company, but not spend hours discussing rent, salaries of entry level employees, price of PCs and software, and other minutia. Be especially sensitive to veto authorities in the terms.
• Expect different concerns from investors in China and other developing countries. American VCs set the standard of best practices in how to influence a startup. But first-time VCs in developing countries have been burned by first-time entrepreneurs using cash to run out and purchase BMWs and boats (yes, that has happened more than once). So line up your list of potential investors before you contact them, and think about what terms you are likely to get from each VC source. They will be different.
• Angels also know this game of terms and control. Expect the wise angel investor to know what the VCs have been offering. You may be able to get a softer deal from some angels, but be aware that they are street smart and know what terms are being passed around the VC market at this moment. Some can help you negotiate a better deal with an aggressive VC.

BOTTOM LINE: Success will keep you from ever needing to know how terms of a venture financing deal will work. But most startups hit bad times. It happens to all startups. Rough times will come, that is for certain. Then you'll discover what happens to you and your company. So it is wise to study and master the terms of the term sheet. When you do that, you'll add an important element to your unfair advantage.

Comments

[John Bushelle]

The term sheet is the first step in the process leading to definitive agreements that will reflect the terms of the venture capital or other private equity transaction. A term sheet is the “agreement to agree” on the main points of a deal. There is always a tension in the preparation of the term sheet between whether to have a tightly negotiated, detailed term sheet, with most of the terms explicitly spelled out, or to have a more generalized term sheet, with the understanding that significant terms will continue to be negotiated during the due diligence process. The former approach can make drafting the definitive documents easier because the parties have spelled out the specific terms of the transaction, although it may be more difficult to re-negotiate key terms as the parties go through the process of conducting due diligence and documenting the transaction, even though not all provisions in a term sheet are binding. On the other hand, a simpler term sheet requires that more effort be expended during the final documentation phase of the transaction, but gives the parties more room to maneuver (and possibly re-trade) before the definitive documents are completed.