How Do You Negotiate a VC Term Sheet?

Receiving a term sheet from a venture capital firm is a major step towards scaling your startup. Negotiating these terms is all about striking a careful balance between founder and investor interests. The goal is to find terms that set both parties up for success. 

In simple terms, a VC term sheet is an investment proposal for startups. However, it is not a legally binding commitment to investment. The investment is contingent on the startup passing the VC fund’s due diligence checks as well as a successful negotiation. 

Here are some of our top recommendations to help you successfully negotiate a VC term sheet in your fundraising process.

Economics and Control Are Key During Negotiations

When negotiating, there are two overarching factors to keep in mind: economics and control.

When considering the economics, think critically about how much founder dilution will happen as a result of the investment, and whether the investment is worth it. While some investments may come with a large dollar amount, it may make the venture less profitable in the long run for founders when looked at through this perspective. 

The question of control is simple—how much control will your investors have, and how will that affect your operations? Factors such as board seats or spending permissions are two critical control considerations. 

Understanding the ins and outs of VC term sheets will put you in a better position to negotiate for yourself when it’s time to raise funds. Consider this your ultimate guide to jumpstarting that knowledge and your first step towards raising capital as an early-stage startup.

The Most Popular Methods for Raising Early-Stage Capital

Before you start seeking out venture capital investments for your organization, it’s important to understand the most popular methods for raising early-stage capital. 

The three primary approaches are SAFE, convertible note, and priced equity rounds. 

SAFE

A Simple Agreement for Future Equity, or SAFE, was popularized in 2013 by startup accelerator Y Combinator, which wanted a simpler alternative to convertible notes. This is the preferred method of many early-stage startups because of its straightforward approach. It uses simple legal documents to make the process transparent and efficient. 

The SAFE is very similar to a convertible note in terms of structure, but it offers some distinct advantages for startup founders. 

SAFEs do not have a specific maturity date—instead, they convert when a predefined event happens. SAFEs also do not accrue interest, which makes them financially advantageous. However, some investors do not like working with SAFEs for that same reason. 

Convertible Note

A convertible note is a form of debt that converts into stock later on when your organization offers equity funding. The investor provides a loan to the startup, and instead of paying that loan back in cash, the organization pays it back in future equity. 

Investors often use convertible notes when the organization isn’t ready for valuation, which is the case for many early-stage startups. Convertible notes give them a way to raise capital without forcing this decision to happen too early. 

VC funds use convertible notes when they feel that equity in a high-growth startup will eventually be worth far more than their initial investment. 

Convertible notes are usually faster to close than other types of early-stage investing because they require fewer documents to complete. They also tend to have lower transaction costs, with the average amount sitting at less than $1 million.

As with any loan, startups will need to pay interest on convertible notes. However, this interest is paid in equity rather than cash. The structure of a convertible note varies depending on the individual transaction, and they are often very complex. Investor demands like board seats or protective provisions need to be taken into account.

Negotiation points for convertible notes include interest rate, note maturity, conversion rate, and automatic conversion options. 

Priced Equity Rounds

Priced equity rounds are structured very differently than SAFEs or convertible notes, and they happen later in a startup’s development. One of the main differentiators is that you receive a VC term sheet for a priced equity round, whereas SAFEs and convertible notes use different documentation. 

This process is used for Series Seed or Series A fundraising and is a relatively straightforward one. Your organization provides shares to investors in exchange for a predetermined amount of money.

However, compared to SAFEs or convertible notes, these rounds take longer to complete because they involve agreeing on a valuation and undergoing extensive due diligence.

5 Principal Transaction Documents of a VC Term Sheet

There are five principal transaction documents included in a VC term sheet. The structure of these term sheets tends to be similar regardless of which VC fund you’re working with, although the terms of the investment itself will vary. 

Here is some important terminology to keep in mind when reading a VC term sheet. 

• Pre-money valuation: This is an investor’s valuation of your organization before making their initial investment. 
• Post-money valuation: This is the amount of the pre-money valuation and the investment combined. 
• Fully-diluted capital: This is the number of shares outstanding if all possible securities were converted into shares. 

Here’s a quick overview of the five principal transaction documents and what they contain. 

1. Certificate of Incorporation

The Certificate of Incorporation is the public document that is filed with the state when the investment is made. It’s often referred to as the charter. 

Charters contain a variety of economic and control provisions that should be discussed in negotiations. These include liquidation preferences, potential dividends, and participation terms for investors. 

There are also protective provisions that limit the actions founders can take without the approval of a certain percentage of shareholders. This is an important consideration that founders must think critically about, as it has the potential to throw a wrench in everyday operations.

2. Stock Purchase Agreement

The Stock Purchase Agreement (SPA) defines the basic terms of the purchase and sale of securities, such as the price of securities and the number of shares. It also specifies the due diligence measures necessary for the investment to go through. 

For example, the investors will ensure that the organization has the rights to their intellectual property, doesn’t have outstanding litigation, and that the shares they are purchasing have been validly issued. The stock purchase agreement also requires the purchasers to be accredited investors. 

3. Investor Rights Agreement

The Investor Rights Agreement (IRA) is one of the most important documents to review and negotiate in your VC term sheet.

As the name implies, this document defines what rights your investors will have after the deal goes through. The decisions noted here play a big role in the overall control of your organization, which is why it’s so important to review the IRA thoroughly. 

IRAs set out financial information rights for your investors. Some investors will need access to certain pieces of financial information to fulfill fiduciary responsibilities for their portfolio. However, not all investors will need financial information rights. 

Your IRA should also define participation rights, which gives your investors the opportunity to continue to provide money and invest as they see fit. 

4. Right of First Refusal and Co-Sale Agreement

The Right of First Refusal (RoFR) and Co-Sale Agreement is another key document that ensures you and your investors are on the same page about the future control of your organization. 

Investors want to know that your founders are in it for the long haul, so this document defines when and under what circumstances they can sell their stock. Most RoFR documents make it difficult for founders to sell stock to prevent organizational shakeups early on in the startup’s lifespan. 

5. Voting Agreement

The final document in your VC term sheet is the Voting Agreement. This is another document that is crucial to negotiations because it outlines a variety of key control provisions. 

It specifies how both founders and investors will vote going forward. 

If investors will receive a board seat, that is defined in this document. Any provisions for the sale of the organization as a whole are typically defined here as well.

What to Look Out for in a VC Term Sheet

Before moving forward with your investment, evaluate your VC term sheet from all angles. Look beyond the short term and consider the ways that the investment would affect your startup as you grow in the long term. 

The following two considerations are ones that are typically the most common concerns when reviewing the term sheet: 

Liquidation Preferences

One particularly important aspect to consider is the investor’s liquidation preferences, which determine how payouts would be structured when the organization is sold. 

Anything beyond a 1X non-participating preference is likely to put your team at an economic disadvantage if you are bought out. 

Control Terms

The control terms are also incredibly important to review, as they will affect the way your organization operates on a day-to-day basis. 

You want to find a balance between good governance and autonomy. In particular, control provisions on spending could make it very difficult to finalize important contracts as your organization grows. 

Think beyond where your organization is right now and focus on where you want to be in the future. 

The Best Negotiation Advice: Consult an Expert

A VC investment is a huge step forward for any startup, but you need to make sure that investment is in your best interest. 

Working with an expert accounting team will help you avoid any “gotchas” and negotiate an investment that works for all parties involved. 

At Graphite, we specialize in hands-on accounting for startups. We were born from a VC fund, so we know all the ins and outs of managing your investments. 

Get in touch today to learn more about our expert financial services to help you navigate the complex terrain of startup fundraising.