In my previous article, I went over some legal clauses that are a common point of negotiation in term sheets. But other than the technical aspect, what business considerations should you make when negotiating with prospective investors? Here, I’ve interviewed Morgan Polotan, an experienced venture capitalist, on pitfalls that founders often fall into when navigating term sheets.
Term Sheets Are One-Way Doors
A term sheet sets out the economic and governance foundation of a startups for the life of its business. While it isn’t set in stone, meaning that terms can be re-negotiated in subsequent financing rounds, future investors tend to start with the prior round terms as the expectation of the terms they should receive. At best, they will ask for the same terms as those of the previous round. At worst, they will ask for much more. So, any suboptimal term in the term sheet of your current round can haunt you in each subsequent financing round.
Information Asymmetry
There is massive information asymmetry between founders and investors. Even an experienced founder will have negotiated less than ten term sheets throughout the course of their entrepreneurship careers, whereas an experienced investor will have negotiated dozens, if not more. A first-time founder will have negotiated zero term sheets, whereas even a first-time venture capitalist will have taken part in over a dozen term sheet negotiations.
Venture capitalists know they have the upper hand and often use that advantage to negotiate better deals for themselves. A classic example is a negotiation involving the valuation of a startup. Investors will tell a founder they want to invest on a $20 million valuation, knowing full well that the effective valuation is less once you consider the expansion of the option pool and the conversion of outstanding SAFES, notes, and warrants into the valuation. But they don’t say that, and unless a founder is sophisticated enough to understand startup valuation math, founders will think the valuation is actually $20 million. In reality, dilution might be much higher than what founders think, and they will get much less than they think in the event of any exit. This pattern of asymmetric info leading to worse outcomes for founders repeats itself throughout the term sheet.
Because of this inherent information asymmetry, founders should study term sheets until they know more than the average venture capitalist. How? By getting your hands on any materials or courses that you can, and by connecting with as many investors as you can. Why? Having a goal to know more than a venture capitalist about term sheets is the only hope a founder has of equalizing the negotiating leverage created by the experience gap.
Managing Resources
Do not rely only on your lawyer to teach you basic term sheet concepts. Founders should absolutely partner with a good lawyer experienced in venture deals, but they should be able to fall back on a network of investors, accountants and operators to learn about the business aspects of term sheet negotiations. Lawyers are there to advise on legal strategy and issues specific to your startup’s situation, not to crank out numbers after factoring in option pools, outstanding SAFES, notes, and warrants.
What’s next?
Scaling a startup can be challenging, and it’s not uncommon for founders to focus on securing investment at the expense of considerations. While term sheets are short documents compared to the subscription documents that investors sign, they are one of the most important documents in the course of a startup’s life. Because they set the tone of what investors can expect early on, founders should learn about term sheet clauses as early as possible, maybe even well in advance of their first financing rounds.
