Funding & Exits — Chapter 8: Startup Funding: From Term Sheet to Close

Six steps take you from term sheet preparation to a closed financing. They are:

  • Prepare for term sheet negotiations
  • Hold term sheet negotiations
  • Line up other investors
  • Participate in due diligence
  • Discuss mutual expectations regarding management authority, board membership and priorities / budget for the next 12 months
  • Negotiate final definitive financing agreement

Prepare for term sheet negotiations

When you decide it’s time to initiate a fund raise, sit down with your lawyer. Discuss the status of your business — its traction, its opportunity, its current cash position and runway — and determine the leverage you believe you possess as you head in to the next financing event. Then go through each key term reviewed in the past two chapters — especially the “heads up” terms — to develop your negotiating position. For each term, document your position and supporting arguments. From pre-money valuation to liquidation preferences to participation to drag-along rights, develop a strong, factually supported point of view. Do this together with your lawyer. This will prepare you for the term sheet when it arrives.

Hold term sheet negotiations

When the term sheet arrives in your email inbox, respond immediately: “Thank you for your confidence in our company and team. We would be happy to arrange a time as soon as possible to discuss term sheet points. What’s your availability on …” If you know that multiple VCs are interested in leading the investment round, then buy time — give yourself a day or so before your first call is scheduled. Then use that time to immediately reach out to all other VCs at bottom funnel, and alert them you have received a term sheet. This will spark quick action for those VCs that are seriously interested in being the lead investor. You’ll also learn which VCs are interested in following on the round.

If you do receive multiple term sheets, alert all VCs that have sent a term sheet of that fact. Meet with your lawyer, and go through all terms for all submitted term sheets, identifying the pros and cons of each. Develop your negotiating posture. Now is the time to consider the investor’s profile. How do the VC firms who have sent term sheets compare on capacity to follow on in future investments? What domain knowledge and connections might they bring? Who is the lead partner on the deal? Do you like her? Would you enjoy working with her as a member of your board?

Many factors go into choosing your investor. Be sure to consider more than just the economic factors: after the money is in the bank, you’ll be in a long term relationship with a partner and a firm. Make sure the relationship feels comfortable, strong and sustainable.

Before initiating detailed negotiations on terms, a good opening gambit is to ask for references. Ask to be introduced to three or four other portfolio company CEOs, including at least one who led a company that struggled after the VC’s investment. You will learn much from these conversations. These will lead you towards the VC you are most interested in as your lead investor.

As you begin to engage in negotiations, there will be terms you are comfortable with, terms you will want to change, and probably terms not yet in the term sheet that you feel must be added. VCs often want to keep term sheets high level, saving the most difficult conversations for later. But for you, the better strategy is to deal with all the most contentious terms now. A more detailed term sheet will result in a smoother path to the final definitive financing agreement. If you have initiated negotiations with more than one VC, somewhere along the way you will narrow down to your finalist.

There is a natural sequence in term sheet negotiations:

  • Pre-money valuation
  • Key economic terms, such as liquidation preference, participation and anti-dilution provisions (and, for convertible notes, the discount and the cap)
  • The board seat (yes, no or observer only)
  • Key control terms, such as pay-to-play and protective provisions (especially degree of freedom to raise debt financing, pivot the product and make management compensation decisions)
  • Key terms relating to management compensation, such as right of first refusal, co-sale, stock option acceleration terms and management compensation agreements
  • Conditions precedent to a financing

The more prepared you are to engage these conversations, the better the outcome will be. With preparation, the term sheet negotiation process will move along briskly. And your investor will be impressed by you and the team.

Once you have completed these negotiations, you are ready to sign the term sheet.

Line up other investors

With the lead investor term sheet signed, you can now send the term sheet to all investors who have expressed interest in following on. This phase is also a negotiation. You may have received a $4M commitment from your lead investor, but you want to close an $8M round. You may have seven investors each wanting to invest at least $1M; you may want just two additional investors. In this situation, you have the leverage and can be choosy. Or your lead investor may have stipulated they’ll invest $4M only if you can raise a total of $8M, and you have to scramble to find these other investors. In this phase of the process, the terms are already stipulated; in most cases follow-on investors will simply accept them.

Participate in due diligence

Your investor agreed to the term sheet based on claims you made about your company, and the assumption that if there were any material negative facts, you would have disclosed them. In the due diligence process, the investor now has the opportunity to validate these claims and confirm that no adverse facts about the business have been left unexposed. There’s no sugar coating it: the due diligence process is an extended proctology exam.

The key areas of diligence include:

  • Technical
  • Team
  • Pipeline
  • Financial
  • Legal

If you have prepared well for your funding process, all of the supporting materials in these diligence domains exist in your data room.

The technical diligence process is led on your side by your VP Engineering. Often the VC will bring in a technically proficient consultant to evaluate your code base, architectural schema, state of documentation, and your testing and recovery procedures. The investor may also want to confirm what software was developed by you, and what was open source code that can’t be claimed as protected intellectual property.

Diligence on the team is simply to confirm that you are who you say you are, and to learn more about your team’s strengths and weaknesses. Unless you have fraudulently represented your credentials, team diligence almost never derails a deal. The investor’s greater purpose is to understand you and your team better, so as to be a more effective board member or advisor.

The sales pipeline review achieves two investor objectives. First, it confirms that the claims already made about historical pipeline performance are indeed true. And second, the investor can observe whether pipeline conversion continues to follow historical averages during the six to eight weeks from term sheet to final close. At least one monthly reporting cycle will occur during this period; it will be the final financial insight the investor gains into the company before the money goes into the bank.

It is possible that in this “negotiation month”, your company’s performance may fall below your projections and the investor’s expectations. In this situation, an investor may seek to refactor the terms of the investment — possibly lowering the pre-money valuation, or strengthening terms that provide downside protection. Since you are now past the point of a signed term sheet, and you have informed other VCs that you are now in a no-shop phase, this is a bad position to be in.

That is why you should make every effort to deliver your numbers in the “negotiation month”. If you do fall short, be proactive. Immediately sit down with your investor and walk through the numbers. Explain what happened, and what your plan is to improve performance. The more forthright you are, the better your relationship with the investor will be. The deal still may be refactored, but at least you’re more likely to get it done, and to retain a strong board member relationship once it’s done.

In financial due diligence, your investor inspects the books. The investor’s expectations as to the state of your financial systems and controls are likely to be stage appropriate. The level of sophistication that is expected if you are seeking a seed stage investment at the Minimum Viable Product value inflection point is much different than if you are seeking a D round at the Minimum Viable Expansion point. If you have prepared well, all the supporting financial and accounting documentation is ready for review. An investor will be impressed if every data request is responded to promptly, and if the data is in good order.

Legal diligence involves confirmation of patent claims, review of the state of customer agreements and discovery of any outstanding legal actions or past legal issues. As to intellectual property, the investor will seek to understand the degree of protection you have sought (patents, copyrights and trademarks), and the stage each of these are in (in process or awarded). Customer agreements will be inspected for consistency and indemnification, to confirm risks have been mitigated. And of course, any past or pending legal actions will be closely scrutinized to ascertain future risk.

Management authority, responsibilities of board membership, top company priorities, and budget next 12 months

During the period leading up to completion of the definitive agreement, you will have ample time to strengthen your relationship with your investor. During this time, it’s smart to propose a dinner or three where you and your investor can engage in strategic conversations. The boundary between board and management has always been fuzzy. It’s important for you to engage your future board member in a conversation about authority — and to test it with scenarios. What level of information sharing makes sense? What freedom of movement does the CEO have? Some of this will be built into the agreement, but it’s important to find common ground at the level of principles.

It’s equally important that you and your new investor are aligned on the company’s top priorities — especially over the next 12 months. It’s your company, so the investor will expect you to articulate and defend these priorities. By discussing, debating and defending these priorities, you help deepen the investor’s understanding of the company and strengthen his support of you.

One practical output of the priorities discussion will be a budget for the next 12 months. This is often a requirement in the conditions precedent to financing.

Negotiate final definitive financing agreement

The definitive agreement will be very long. It may be over 100 pages when all is said and done. Your lawyer and the VC’s lawyer are the ones that will negotiate every word. Throughout this process, your lawyer will present issue after issue. Challenge your lawyer to be pragmatic, and to choose the battles. On each item, demand a clear statement of risks and tradeoffs. If you negotiated hard at the term sheet stage, and if the term sheet addressed all the major issues, then the negotiations over final detailed terms will involve a long list of small battles.

Hang in there, and take them one by one. On the really important battles, push the lawyers out of the way and hold a direct conversation with the lead VC partner. The two of you are much more likely to approach the issue fairly and pragmatically than two opposing lawyers will. Eventually the small battles will be over. The entire agreement will be complete and the money will be in the bank. When that happens, you have just one thing left to do: celebrate.

Of course, receiving cash from your successful funding round is just the beginning. After the celebration is over, your work begins anew. Take a moment to look outward towards the next funding event, and ask yourself: “what must be true?”.

To have a successful next funding event, you will need to prove you have reached the next value inflection point in your company’s growth. For instance, if your recent funding event came as a result of having proven Minimum Viable Traction, you will next need to prove Minimum Viable Scaling. So stare down what must be true in the domains of people, product, revenue engine and systems. By knowing what must be true, you can plan and execute accordingly. You can then invest your cash to methodically close the gap in all necessary categories of progress so as to reach the next value inflection point and be fundable.


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