Receiving a venture capital term sheet is one of the biggest milestones in a young company's lifecycle.

It's also one of the riskiest periods for your organization's future. 

Get it right, and you can potentially set your company up for years of growth and success. Get it wrong, and you risk dilution and loss of control to investors.

Whether you're a first-timer or an experienced entrepreneur, founders need help navigating the VC funding process. Having an experienced venture capital lawyer on your side helps you understand how term sheet negotiations work and avoid the costly mistakes that can set your company back.

Understanding a Venture Capital Term Sheet

In simple terms, a venture capital term sheet is the roadmap for an investment in your company. It is a non-binding document that outlines the key terms of the deal, including funding, ownership, and investor rights, along with other provisions such as exclusivity. 

Term sheets are only presented when the investor is serious about moving forward. It's an indicator that the initial talks have gone well, and the investor is satisfied after doing their due diligence.

While many include standard VC term sheet clauses, both sides can still fully negotiate the precise terms at this stage. Once both sides agree to the terms, attorneys begin to draft the definitive legal documents that make the agreement official. 

The Core Components of a Venture Capital Term Sheet

When you receive a VC term sheet, you might be surprised to learn that it's only one to two pages, at maximum. Don't worry, the dense legal terms will come later. 

At this stage, venture capital deal terms can be broken down into two categories: economic terms and control terms. 

Economic Terms

The economic terms you'll find in a term sheet govern how the investment money flows into your organization, as well as how investors get paid at exit. 

The heart of the term sheet is the venture capital valuation of the company. It breaks down into two key areas: how much your company is worth before the VC funding process, and how much it is worth after funding. This is known as pre-money and post-money valuation. 

The venture capital investment terms outline the exact amount of money the investors intend to put into the company. This is often invested as a lump sum, but can also be released in stages as certain milestones or conditions are met. 

Liquidation preferences are a form of VC downside protection that outlines who gets paid first if the company is sold or liquidated. In most cases, the standard structure is the one time non-participating preference. This means investors are paid before common shareholders. 

Sometimes liquidation preferences can be structured more aggressively, such as participating preferences, which can significantly reduce what founders actually receive on exit.

Option pools reserve shares for future employees. Whether these options are structured as part of the pre-money or post-money valuation is important. When calculated as part of the pre-money valuation, they can effectively shift dilution of shares onto the founders.

Control Terms

Control terms outline how decision-making power in the company is structured. While most of the attention goes to economic terms, control terms have a major impact on how your company will operate in the years to come.  

The term you'll want to pay the most attention to is board composition. Investors typically want a say in major company decisions, usually via a spot on the board. 

A standard early-stage board composition will include one founder, one investor, and one independent member. If investors want more board spots than founder spots, that can be a potential red flag. 

Investors may also seek protective provisions, such as veto rights over actions like issuing new shares, taking on debt, or selling the company. These are often standard provisions, but their scope can vary widely. 

Anti-dilution protections are another control term you'll find. Weighted average anti-dilution terms are commonly used to protect investors during future fundraising efforts made at a lower valuation, while remaining fair to founders. Full ratchet provisions are a more aggressive form, which may dilute founder shares more heavily.

Vesting terms may also appear in a term sheet, and are used to ensure that founders and key team members remain involved in the company over time. 

Why Term Sheet Negotiations Matter

When negotiating a term sheet, small details can have major consequences. While not legally binding, they form the basis for the entire deal. Once the term sheet is signed, both parties should expect the deal to move forward as outlined in the terms. 

That means the time to negotiate these terms is before signing the term sheet.

First-time founders may not notice or understand small differences in language. However, an investor-friendly liquidation preference or a large option pool based on pre-money valuation can negatively impact ownership, control, and even future payout for founders. 

For that reason, many founders choose to work with a venture capital lawyer during term sheet negotiations. 

While many terms are standard, having a legal professional review the venture capital deal terms alongside you helps identify any terms that may be aggressively structured. 

How a Venture Capital Lawyer Supports Term Sheet Negotiations

A venture capital lawyer does more than just review the term sheet. They help you interpret it, and understand the implications of each provision, so you can negotiate from a place of understanding. 

Identifying Non-Standard Terms

Venture capital lawyers have seen enough term sheets to quickly recognize non-standard terms.

Some areas where VCs may try to include non-standard terms may be in unusually high liquidation preferences, overly broad veto rights, and aggressive anti-dilution clauses. Venture capital lawyers can review the terms and advise you when to push back and when terms are reasonable. 

Structuring Favorable Economic Terms

VC lawyers often model various exit scenarios. This gives founders a more practical understanding of how liquidation preferences or valuation adjustments can impact the deal. 

Sometimes a higher valuation isn't always the best for your company. Venture-backed companies are expected to grow past their initial valuation. Failing to reach those expectations can result in a lower valuation at your next investment round, producing what is known as a down round that can potentially damage the perception of your company and dilute equity. 

A lawyer can help you ensure you receive a fair valuation that doesn't overly inflate your pre-money valuation. 

Protecting Founder Control

This is one of the biggest areas where a venture capital lawyer can make a difference. If not structured fairly, control provisions can quickly reduce the decision-making power of founders. 

A lawyer will help structure board composition in a way that is fair to both founders and investors, as well as narrow the scope of protective provisions. It's a balance between giving investors a voice and allowing founders to run the business effectively.

Reducing Long-Term Risk

How your initial round of VC funding is structured can impact future rounds. For example, anti-dilution protections may not matter much when the company continues to grow and achieve higher valuations, but a down round can have a major negative impact on founder ownership stakes.

Giving too many broad rights and preferences to your initial investors can also make investment unattractive for future investors. VC lawyers can identify long-term risks and help negotiate terms that support future growth. 

Common Mistakes in Venture Capital Term Sheets

Even experienced founders can overlook or underestimate the impact of certain VC term sheet clauses. 

Participating liquidation preferences are a major area where we see founders giving up too much to investors. These provisions essentially allow investors to “double dip” during an exit, meaning they get paid for their investment as well as share in the proceeds. 

A non-participating preference is more favorable to founders. This structure lets investors choose to either get their investment back, or convert to common stock, but not both. 

Full ratchet anti-dilution provisions are among the most aggressive protections investors may try to include in a term sheet. These provisions can come into play when the company experiences a down round, re-pricing previous investment rounds as if they happened at the lower valuation. This effectively pushes the burden of dilution onto the founders. 

It's also not uncommon for investors to push for overly broad veto rights or to try and claim more spots on the board than founders or neutral members. Either of these can be forms of excessive investor control, and ultimately weaken the power of founders to run their company.

SVTech: Your Ally in the VC Funding Process

Receiving a venture capital term sheet is a major opportunity, but failing to negotiate terms before signing can haunt a company for years. 

If your organization is currently involved in the VC funding process, the best time to seek help from a venture capital lawyer is when you receive your first term sheet, or even earlier. A lawyer will help you review the venture capital investment terms to make sure there are no overly aggressive provisions, and help you retain control. 

Waiting until after the term sheet has been signed to bring in a lawyer significantly limits your negotiation power and ability to make changes. First-time founders in particular can benefit from the experience a lawyer brings, and ensure that the deal is in the best long-term interest of the company before signing. 

SVTech can provide the guidance needed to negotiate a venture capital term sheet from a place of understanding. Contact us today to schedule an initial consultation, and approach your next round of fundraising with confidence.