Congratulations! Your business has charmed an investor. Now you’ll need to wade through the term sheet, an outline that lays out the finer points of your funding. The valuation of your company is right there, as is the amount of the investment. But there’s a lot of other legalese, too. Add time pressure to the mix, and a lot can go wrong. Before you sign that term sheet, read these few pointers from the pros.
Do: Woo multiple investors simultaneously
Investors often come to the negotiating table with more power than founders have–but there’s a way you can increase your leverage. Pitch your company to several firms and try to simultaneously line up more than one offer, says Noam Wasserman, an entrepreneurship professor at the University of Southern California’s Marshall School of Business (and a member of Inc.‘s advisory board).
The timing is particularly important: Term sheets often include clauses that may prevent you from pursuing other investors for the next 30 days. “If you can interest a couple of people at the same time, you’ll be golden,” Wasserman says.
Don’t: Get overwhelmed by lingo
If you’re baffled by all the legalese, consider using one of Y Combinator’s SAFE contracts, says Amol Sarva, a technology entrepreneur who co-founded Knotel, Halo Neuroscience, Knotable, Peek, and Virgin Mobile USA. “These easy-to-read financing documents are not only friendly to founders, but also fair to investors,” with “vanilla” terms, he says.
Under a SAFE (simple agreement for future equity) contract, an investor makes a cash investment in a company that may convert to stock in the event of an equity financing round or merger. SAFE contracts include some common protections for investors, such as pro rata rights (the ability to participate in future funding rounds), but leave out some more controversial terms, like provisions related to board-seat privileges and veto rights.
Do: Know your priorities
To simplify the negotiation, Wasserman advises founders to broadly categorize a contract’s terms into two buckets: those that relate to finances versus those that relate to control. Then ask yourself: Which do you value more? Do you want to see your company grow even if you’re no longer running it–or do you want to remain in control at all costs?
Terms that dictate board seats, veto rights, or drag-along rights (which may allow an investor to force the sale of a company) all relate to a company’s control. Terms concerning your startup’s valuation, options pool, and liquidation preference fall under the financial category. In the negotiation, push for better terms in the category most important to you, and stay flexible on the ones that are not.
Don’t: Be a pushover
Know when to walk away. “I turned down at least one term sheet because of terms that might not benefit the company in later stages,” says Amir Trabelsi, CEO of Genoox, a tech company that runs a genetic data analysis platform.
In one situation, an investor wanted the right to single-handedly force the company to refuse to take on new money, veto rights that Trabelsi felt were too extreme. He was also worried about the message his concessions could send future investors: “You need to think ahead about how the company is structured and how it’s going to be built.” He eventually found other investors and raised $6 million for the company in July.
Do: Pay attention to small details
It’s easy to be blinded by a term sheet’s headline numbers, like the valuation or investment size. But remember to sweat the small stuff, says Stephanie Zeppa, a corporate and securities partner for San Francisco-based law firm Sheppard, Mullin, Richter & Hampton. For example, a missing “non-” can cost you a lot of money.
Most of the time, Zeppa says, VCs’ term sheets entitle investors to “nonparticipating preferred stock” if a company is liquidated, meaning they will recoup their initial investment at a specified multiple, plus dividends. But if the term sheet instead asks for “participating preferred” stock, your investors may be entitled to an even larger share when the company is sold. “It’s only a one-word difference, and it could be a huge economic change,” Zeppa says.