How to not over-optimize your Series A term sheet

by Matt Bartus

Negotiating term sheets isn’t straightforward and when you combine first-time entrepreneurs with inexperienced counsel, the results can be toxic.

Entrepreneurs have access to a wealth of online information about starting companies and getting funded. This is good, but it sometimes causes a condition like Medical Students’ Disease where many first-time founders get overwhelmed by the various lengthy and “legalese heavy” provisions in a term sheet and don’t know what to negotiate because they don’t have the appropriate context.

Without this context and the experience that goes with it, founders sometimes feel the need to optimize every term in a term sheet according to guidelines they’ve found online. This slows deals down, raises (and wastes) legal fees, and negatively affects the founder’s and investor’s ability to work together after the deal.

Two examples

A founder recently expressed his outrage to me that a VC wanted an 8% non-cumulative dividend preference on the preferred stock, given the historical lows of current interest rates. He didn’t realize that dividends in fast growing companies are almost never paid, thus making this provision essentially irrelevant and a relic of past practice. Even if the dividend preference was “out of market” at 10%, it probably wouldn’t have mattered.

Another example: one of my partners enjoys telling the story of representing a VC that was investing in a company started by a first-time founder using his father — who was not a startup lawyer — as legal counsel. My partner wasted a week convincing the father that liquidation preferences in preferred stock were not only legal but also customary. This should have been at most a five-second conversation. The founder was not well-served in this situation, and he paid the price dearly since the VC’s legal fees are paid by the company.

The “Rule of 3″

I recommend you hire counsel that does these types of deals day-in and day-out. That shouldn’t be a surprise.

Next, follow the “Rule of 3.” Focus your energies on three initial issues to negotiate. Sure, there might be more (or fewer) issues worthy of discussion, but, in my experience, there are ususally about three issues in any given term sheet that are worth arguing about at the start.

Pushing back on vesting acceleration for termination without cause

Of course, if you accept the term sheet “as is” and don’t negotiate the important issues, you will lose credibility with the investor. How a founder acts during this phase can have a significant impact on the relationship going forward. You want to show investors that you’re not a pushover and that you’ll argue important issues.

One of the founders I’m advising recently received a term sheet that was pretty reasonable, except that the terms of his vesting contained no acceleration for termination without cause. In other words, he could be fired at any time and lose his unvested stock. When we pushed back on the VC, the response from the VC was:

“We’re all in this together, and we really need you to help build this company. We would never terminate you without cause, that would destroy our investment thesis.”

This founder thought that was a reasonable response and wasn’t inclined to push back because he needed the money. However, I told him what everyone reading this already knows: Even though what the VC said is probably true, things often change, founders are terminated all the time, and he could end up with nothing.

He won that particular battle because the VC knew it was a reasonable request, and the VC learned that this founder was willing to stand up for himself when it was the right thing to do.

Focus on the issues that really matter

On the flip side, if you argue endlessly about 10 points, seven of which are largely immaterial, all parties will cease to focus on what really matters. You need to show investors that not only will you stand up for the important issues, but that you also know what the important issues are.

This strategy doesn’t apply in all transaction types. In a complicated M&A negotiation, the parties engage in tactics that might include throwing up red herring issues to detract from more important ones. However, an investment transaction is fundamentally different from an M&A deal because the parties must work together — usually intensely — after closing, and aligned interests are critical.

Six terms to scrutinize closely

Work with a trusted advisor or an experienced lawyer to help weed out the most important issues. Resources like Brad Feld’s term sheet series detail the various term sheet provisions. And here I’ve identified below some of the most common terms that are worth fighting over.

1. Valuation/Dilution. This is obviously one of the most important issues, although not a legal one. Make sure you understand the effect of including the option pool in the pre-money valuation. Think about alternatives to simply changing the valuation, such as using warrants.
2. Liquidation Preference. This is usually the next most important business issue, although it is often mistaken for a legal issue and sometimes glossed over — at your peril.The liquidation preference defines the return that an investor receives in a sale of the company, and it can have a very significant impact on the founder’s return. Be sure to model out expected exit values so you understand the actual dollar differences between the liquidation preference formulas. Also keep in mind that terms put in place in the Series A often carry over to the Series B and beyond, so be careful what you agree to here — even if it seems relatively harmless at this stage. The fact that Series A terms carry over into later rounds (and sometimes negatively affect the Series A investors in those later rounds) can often be used as leverage to resist their inclusion. For example, a “participating preferred” for a small seed round might not result in a meaningful extra return for the investor at exit (at least in absolute dollar numbers), but it will be very painful to the founders if all future rounds include participating preferred stock. MATT WE NEED TO INCLUDE COMMON APPROACHES… ISN’T IT OBVIOUS BY NOW THAT WE SHOULD BE DOING 1X NON-PARTICIPATING.
3. Board of Directors/Voting Provisions. The makeup of the board of directors and governance of the company is critical to the success of the company. One common arrangement is one director appointed by common stock, one director appointed by the Series A stock, and one independent director. But there are many variations on this theme and Venture Hacks has argued for more aggressive terms. Have a constructive discussion with your investors about board makeup and ensure that everyone is aligned on the governance of the company.
4. Founder Vesting This is a critical area to review and understand.
   • On what date does vesting commence?
   • Does vesting accelerate upon termination without cause?
   • Does vesting accelerate upon a change of control?
5. Anti-dilution Protection. Nearly all VC deals in the United States have some form of anti-dilution protection to protect the investors from the future sale of preferred stock at a lower valuation. The variations in the types of antidilution protection define the extent to which the VC is protected. If it isbroad-based antidilution protection, move on. If you see the phrase full ratchet, talk to your lawyer.
6. No-shop. It’s common for the only binding part of a term sheet to be a restriction that you don’t engage with other VCs for some period of time after you sign the term sheet. This is a reasonable request, as the VC is going to be paying lawyers to draft documents and perform due diligence on your company. But be sure the time period is not too long — 30 days is plenty of time to finalize a VC investment in almost all cases.

Most of the other provisions in the term sheet are either harmless or have become so customary that it’s not worth spending any time negotiating them. There are always exceptions and special situations, so talk to your own counsel, but here are some of the things that you can mostly ignore in most cases:

1. dividends (except for accruing dividends)
2. information rights
3. conversion rights
4. customary protective provisions (i.e., special voting rights)
5. registration rights
6. standard conditions to the investment
7. rights of first refusal

Certainly these and other boilerplate provisions are relevant, but I would not advise any of my clients to spend any time negotiating them unless they are so “out of market” that it might harm the client to accept them or your company represents a special situation.

But does your typical entrepreneur care how many S-3 registration rights the investor has? He doesn’t — and he shouldn’t. He owes it to himself and his investors to negotiate and resolve important points early, get the deal closed quickly, and get back to the business of growing the company.