In this Endeavor masterclass, we invited John Kim, Co-Founder at Datavest Partners & Endeavor Mentor, to discuss the critical role of term sheets in negotiating and creating a foundation for startups beyond investing rounds.
For any startup, the investing round is where the first breath of fresh air comes. Finally, it all seems to be falling into place. But anyone who has taken a business from the ground up will assure you this is only the beginning. Initial talks will set the stage for smooth sailing or a rocky road.
“Having a healthy discussion upfront can clear up misinterpretations down the road and that you are aligned for the long haul,” says Kim at the top of the masterclass. “It’s much easier to negotiate the high-level terms rather than trading legal documents that are 20 pages back and forth and red lining [each other]”.
Term sheets can make or break these discussions, and are the key to setting good precedents for any startup.
Why Term Sheets are Important
The goal of term sheets is to facilitate healthy discourse for years to come. Being up-front and laying things out from the start is pivotal. Other than non-confidentiality agreements, or “no-shop” clauses, term sheets are non-binding so the air around this discussion needn’t be heavy. Although non-binding, term sheets are still necessary. Kim asks the audience to consider the potential alternative of legal redlining between what should be collaborative partners.
Investors can have influence beyond when the check is cashed, term sheets can clarify the extent of this influence. “What you need approval for, what can be blocked, how the economics will work, all of this is up for discussion”, says Kim.
Negotiating Term Sheets
Before anything, you’ll want to confirm your VC’s interests. It’s vital to discuss ownership percentages and how stock is to be vested before term sheets. Kim recommends foresight. “You might know where you are now but think about where you might end up later…. influence levels might shift down the line, so consider that”. You’ll be working with them for years to come, so take the time for due diligence. This way you can put yourself, and everyone else, in the best possible position.
You might consider speaking to other founders that have raised capital from your investors. “Ask [investors] for references, and they expect that so don’t be shy”, urges Kim. Get advice, not only from your VC lawyer, but also from mentors and peers. “Don’t limit it to one or two investors. Keep it as broad as possible”.
Managing Valuation Expectations
“Bigger isn’t always better,” says Kim. “If things get too high too quickly and you aren’t able to keep up with the valuation you set risk for a down round.” He suggests that the best way to get a reasonable valuation is to work backwards from how much cash you will need and how much investors will ask for.
The option pool, or the right to buy common stock in the future, is a serious consideration. Are there sufficient shares reserved for future leverage, either for employees or investors? The option pool can not only affect your valuation, but it can also be used in the term sheet discussions to reduce investor greed. As Kim puts it, “Later on, when you show investors good progress, they will be more willing to take the dilution with respect to increasing the option pool.” Keeping option pools open is in everyone’s best interest, so don’t be afraid to remind them of that.
Any healthy discourse must include the possibility of negative outcomes. For term sheets, that’s liquidation preferences. “While it’s ugly to think about, liquidation events can get much uglier if preferences are not discussed ahead of time”, warns Kim. You may feel that discussing liquidation could sour the conversation and make things harder but including them is a sign of maturity and vision.
Having liquidation contingencies is standard practice, but that doesn’t mean everyone needs to be included. Kim advises keeping participation to a minimum to avoid accruing dividends. “Satisfy founders and VC’s in order to avoid a greedy first round that could set a precedent”. You could use liquidation preferences to bridge valuation gaps, but, again, the precedent can hurt you later so be cautious.
“Smaller is better. More conversations, less coordination issues. Find the right balance [for everyone]”, Kim urges. Avoid doling out influence as bargaining chips for shares. Instead, consider layering voting rights differently. A CEO might have different rights than a Founder, for example. Board “observer” slots can be offered in place of board seats for smaller players.
With more than 15 years of venture capital experience, Kim considers term sheets to be one of the most important elements to long-term success. In his Endeavor Masterclass Kim also covers securities, types of liquidation preferences, dividends, key terms, and much more at length.
“It’s a little give and a little take. Listen closely to what the other side is saying is important to them”.
If you’d like to see the Masterclass in full, you can check it out here.