Raising Your First Round: Understanding the Term Sheet
Earlier this week, we hosted a Term Sheet Showdown in Singapore. We’re mid-way through our FinTech accelerator program in Singapore, and the 11 teams in our cohort have turned their attention to fundraising, positioning with investors, and getting to grips with the ins and outs of term sheets.
For founders that have never fundraised before and have little experience with legal jargon, the term sheet can be daunting.
So to help break down the seed-stage fundraising process, and to lift the veil on the way VCs think about and negotiate term sheets, we brought together founders, a lawyer, and a pair of VCs, to battle out a term sheet live on stage.
- Nikhil Kapur, Senior Investment Manager @ GREE Ventures
- Jasmine Liew, Investment Manager @ 500 Startups
Michelle and Rosalind played the roles of co-founders of Grow Mi Muni, an agritech company that allows users to grow a physical plant by managing it virtually. Grow Mi Muni was seeking its seed round of funding.
They were supported by Chris, playing the role of corporate lawyer at Tulip LLP. On the other side of the table were Nikhil and Jasmine, partners at VC Fern Funda Ventures.
The key talking points based on the substantive terms of the term sheet have been covered excellently by Nikhil, in his blogpost here. From a more strategic standpoint, here are the key takeaways from the showdown:
1. How much room do founders have to negotiate on the term sheet?
The question arose as to how founders can elicit information from VCs as to which terms are categorically non-negotiable — ie. they are required to be included by the fund’s Investment Committee. The two VCs on the panel took differing views on this point.
For Nikhil, whatever is in the term sheet is what the VC wants to achieve. If it’s in there, it should be considered desirable by the IC and he wouldn’t expect to see much deviation in a final form. The scope for negotiation, he said, comes from the strength of the founders’ position vis-a-vis the level of competition for this deal and the potential of the business.
The lesson for founders here is that you make your own room when you build a high-potential company. You’re not just creating a higher valuation for yourself, you’re creating a position where everything is negotiable.
Jasmine made the point that she would typically kick off with a more onerous term sheet than she would expect to ultimately agree to, and would expect push back from founders to take them closer to a final form. So in this scenario, the VC would expect to end (rather than start) at a position that they would have been happy to sign off on at the beginning of negotiations.
The difference of opinion between VCs demonstrates the risk of accepting particular terms or negotiating stances as ‘market standard’ — quite clearly, in this case there is no market standard and founders stand to lose or gain depending on how well they understand the investors sitting across the table from them, their agendas and how they operate.
2. Think about this raise in the context of those that will follow
The panelists discussed the inclusion of an onerous 2x liquidation preference at length during the showdown. One key point that arose from the debate around this term is that the terms that are agreed at this stage, will likely form the basis for negotiations in later fundraising rounds — ie. incoming investors at a later stage will seek the same entitlement that has already been given to seed stage investors.
With that in mind, founders would always do well to consider what a particular term would mean when carried over to investors in the future. With the 2x liquidation preference in our own term sheet, should this be sought by and agreed with incoming investors in the future, and then triggered on a sale, very quickly the founders’ own entitlement to proceeds from that sale would be all but eviscerated.
Onerous terms agreed at seed stage will likely drive founders into a position with smaller upside in the future. And in fact, the same is true for the seed-stage investors that stand to benefit in the short term. The risk here is that everyone loses their appetite to continue to grow the company in the future. Without a significant incentive, those driving the growth of the company are unlikely to maximise returns, and so everyone (founders, seed stage investors, later stage investors) loses out in the long run.
3. Why won’t my VC sign the term sheet? Is it legally binding?
Nikhil raised the point that he would never expect to actually sign the term sheet. Some VCs do, and some don’t — but ultimately, it’s not legally binding and a signed term sheet doesn’t mean that the deal must go ahead.
In the majority of cases, an agreed term sheet does lead to completion of the investment, but it isn’t a certainty. The term sheet negotiation process in itself is a great indicator for founders and investors as to what it’s like working with the other party, and whether they can trust them now and in the future.
Use this process to assess whether or not you think the investor has your back and will support you in the future, and make sure that your interests and plans for the company’s future are aligned.
4. Is it fair to expect the VC to pay my legal costs?
If you can swing this, you’re doing incredibly well. Both VCs on our showdown panel were adamant that they wouldn’t pay, and made the good point that most VCs wouldn’t have the necessary management budget to pay these costs in any case.
For founders, you should expect to pay legal fees out of the capital that you’re raising. As Nikhil pointed out: “if we’re giving you a few hundred thousand dollars, we take it as read that you’re in a position to cough up the $10k needed to pay your lawyers.”
5. Do I even need a lawyer for a seed round?
At seed stage, some say yes and some say no. The risk for founders in hiring lawyers, is that if the deal doesn’t go through, they still have to foot the bill for legal work done up to that point.
However, even if you have some fundraising or legal experience yourself, you’re risking a potentially huge impact on your control/management/equity in the future if you miss (or mis-understand) something hidden in the term sheet. So at least getting a lawyer to give your term sheet a once-over before agreeing to sign makes a lot of sense. Michelle recalled that using an expensive, reputable law firm for her fundraising in real life was a great decision, and that paying the money for security in the long-term was well worth it.
If you missed the Term Sheet Showdown and would like to attend in Singapore in the future, please send me a PM. We’ll add you to the invite list for the next one.
More articles by Samuel Hall
One of the most important skills for early stage founders to master is their pitch. You’ll spend a lot of your time…medium.com
Honesty is not just something your parents should have taught you. For startup founders, it’s a necessity. Being honest…medium.com