Negotiating Your VC Term Sheet: A Practical Guide
Once you believe you have found the right VC, negotiating your term sheet distills all of the hope and uncertainty you have held since you started seeking out investment partners into one process. While an exciting time, the long-term ramifications and emotional investment given to your business come to the fore when finalizing the legal side of your funding.
To help simplify an overwhelming yet critical step in your business’ development, what are some practical considerations to keep in mind when negotiating VC term sheets?
Prioritize Long-Term Planning
VC investment is not analogous to a business loan. When you partner with a VC, their expertise and connections will matter as much as the funding they provide. Term sheet negotiations offer an opportunity to clarify your VC partner’s involvement in your business and the set expectations for all parties.
The term sheet will serve as the final agreement’s primary influence.
As VCs provide investment in exchange for equity and a say in business strategy, you’ll want to keep in mind their goals as well. How much autonomy are you willing to part with to secure funding? What is the VC’s exit plan to recover their investment (plus profit), and what timeline do they expect leading up to such? A VC may also choose to alter your business’ direction in a way that does not align with your initial vision.
An Offer Sheet is a Contract—Consider Assistance
When undertaking term sheet negotiations with a VC, remember that you are working on a contract. Suppose you have spent your time focused on product or service development and business strategy. In that case, you may not have had time to familiarize yourself with all of the legal and financial terms and conditions included in the fine print.
When finding yourself evaluating a term sheet, consider enlisting the help of legal and financial experts to help guide you through the process and ensure you are fully informed.
While a VC pursuing an investment opportunity in your business will be championing your success, they will not prioritize it over their own organizational stability or agree to terms that diminish their return too significantly. You should have the help of someone in your corner to ensure the same for your business.
Look at Your Leverage During Negotiations
In any negotiation, you need to consider your leverage. When it comes to negotiating term sheets, alternative VC’s interest provides the most leverage. Acquiring interest from multiple VCs will help you secure the best term sheet from your preferred investor and leave you with options if one is not willing to agree to your preferred partnership distribution.
However, remember that the leverage you hold from alternative VC options disappears once you sign any contracts, and you will need to find other positions of strength moving forward.
Keep a Financially Conservative Perspective
Business owners and entrepreneurs encounter three main hurdles when assessing their own value and during negotiations:
- Too much confidence in their business model
Too little ability to forecast their current and expect burn rates for funding
- Too significant of an attachment to their own equity
When caught on these hurdles, even term sheets that initially look great may prove detrimental in the long run. If you remain overconfident in your eventual success, cannot predict how long funding will last, and are unwilling to compromise on the exchanged equity, you may not be able to secure the funding you actually need.
VCs will offer less funding if you provide less equity in exchange. Burning through that funding too quickly will require you to seek additional investment from your initial or other VCs. However, sourcing additional funding in a time of need significantly diminishes any leverage you have, and you may end up parting with far more equity to secure such than you would have when initially negotiating your term sheet.
Leverage When Needing to Source Additional Investment
If you do need to secure further funding, one avenue you can pursue is to counter too great of an equity loss with the potential effects on your team.
If your VC pushes for too much, you may lose valuable members critical to success when they see their stake diminishing. Stress that you are willing to find a middle ground but sacrificing too much equity to extend your runway will ultimately crash the entire business.
Be Picky with Preferred Shareholder Provisions
Generally speaking, preferred shareholders hold more prioritized rights when it comes to future equity decisions. These prioritized rights include:
“Right of first refusal” – If you intend to sell some of your stake, preferred shareholders must have a chance to purchase it first.
“Tag-along rights” – Also known as “co-sell rights,” these allow preferred shareholders who own a minority stake in your company to sell alongside a majority owner, which can result in significant equity suddenly purchased by a third party.
Liquidation preferences – You want to keep liquidation preferences as low as possible, as a VC (or other preferred shareholders) will receive their money first if you decide to sell your business.
If you manage to retain all of your board seats during VC term sheet negotiations but compromise on too many preferred shareholder provisions, you may find that you only succeeded in the short term.
Build Trust with Your VC Partner
Circling back to the long-term perspective on your VC partnership—negotiating a term sheet is not the time to use all your leverage and squeeze out as much financing as possible. Once again, partnering with a VC provides human capital through networking, expertise, and other guidance as much as it does investment.
If you try to maximize your VC’s investment while minimizing the equity you offer in return, you may erode any trust before you have the chance to develop it. A VC left with a bad taste in its mouth following term sheet negotiations will be less likely to follow up with the advice and guidance you need to succeed.
Consult with CFO Hub
As mentioned above, negotiating term sheets often requires enlisting expert advice. Sometimes it may be necessary as you’ve spent more time on development and strategy than familiarizing yourself with legalese and financial terms.
On the other hand, sometimes you might just be too close to the situation, which is understandable given the personal and emotional investment you’ve made in your entrepreneurial endeavors.
Consulting with CFO Hub puts an expert in your corner who can provide the financial advice needed when negotiating for the best possible VC term sheet. We can help you determine the right term sheet for your business—for short- and long-term perspectives that help you achieve success regardless of what may arise along the way.
We’ll be your advocates, your vanguards, and your navigators.