If there is a lot of content explaining the strategy and the necessary steps to raise a VC round, we noticed that once they have obtained their dreamed Term Sheet, founders are often less comfortable with the process. This lack of knowledge often slows down the process and can even create some frustrations at a step where the honeymoon is supposed to start. Let’s talk about the taboo topic of VC-Founders negotiations.
This article provides content we consider relevant on each issue. We also share our viewpoints as well as our founders’ and we try to answer the questions that are the most frequently asked at the negotiation stage. And to get such answers, I relied on some of our outstanding team of entrepreneurs:
- Charles Thomas CEO of Comet which connects top tech freelancers with companies,
- Camille Morvan and Djamil Kemal co-founders of Goshaba, which makes recruitment more ethic through mobile gaming.
- Beena Paradin CEO of Beendi that creates amazing plant-based meals
- Nicolas Reboud CEO of Shine the ultimate bank designed for Freelancers
Term Sheet and Shareholder Agreement
A term sheet is a great news, but all termsheets (even with similar valuations) are not equal.
The first document of the investment process is the Term Sheet (TS). The purpose of the TS is not to agree on all the details of the deal (typically a few pages), but to have an agreement on the most important terms. Our TSs are mainly based on the amazing work achieved by Le Galion. It helps to standardise legal documents and to save a lot of money on lawyer fees.
The shareholder agreement is the natural translation of the term sheet in a more accurate document written in a lawyer language (from 50 to 150 pages according to our experience). There are more details than in the TS but the most important points have been discussed in the TS negotiation. At this stage, the company’s lawyers and investors’ lawyers are the ones organizing the discussion to protect the interest of their clients.
In a nutshell, the term sheet is the equivalent of the back cover while the shareholder agreement is the book.
Having a TS is great, but all TS are not equal. Obviously, valuation is the point that founders look the most carefully but the truth is that between 2 TS, the one with the best valuation can also sometimes be less favorable at the end. This is important to understand the different terms, but also to understand that the more terms you have in the TS, the more favorable it is for the founders. As time flies in negotiations, most startups are getting closer to running out of cash. In these conditions, all the points that were unclear at the beginning are harder to negotiate for the founders and the best is to have the discussion early.
What is the difference between a term sheet (TS) and a letter of interest (LOI)?
The difference is on the presentation, the LOI is written as a letter while the TS is a list of clauses.
Who do I negotiate the terms with?
Most of the time you only negotiate with the lead investor who is the investor who put the most money into the round. As the investors have the same interests, the main investor often negotiates for all of them in order to make the process more efficient. The other investors (including the main investors of the previous rounds) also provide their feedback on the Shareholder Agreement along the process. This is why it is very important to keep all the investors on the same page all along to avoid very stressful last-minute negotiations.
pro tip: each VC (and in some cases each investor) has its own habits and focus. Some of them are super focused on the ratchet clause while other ones don’t care about it. This is good to know a bit their philosophy when the time comes to make a choice.
What can slow down the deal?
Some clauses need to be negotiated between the investors and the founders and the timeline really depends on which extend the protagonists share the same vision. The process is often easier when this vision is also shared by the previous investors (when they exist) meaning that you will not change too much the previous shareholder agreement. However, some clauses also depend on the founders only. For instance, if the founders have a clear idea of the leaver clause (what happens to the shares if a founder leaves the company) they are comfortable with, it helps to get the job done quicker. Other insights are given later.
pro tip: If you have a good relationship with your investors, you should ask them their requirements and conditions in advance. It will help you to lower the number of iterations in the process.
Will I keep the same shareholder agreement clauses for the next rounds? Yes and no… Actually, it depends on the investors you will choose for the next round. Some of them take the current documents and update them with their conditions and others start a new one from scratch. If you want to have a US lead for your next round, they are likely to choose the second option. In both cases, there will be negotiations and room to update some clauses but the current clauses will be taken as reference. Charles Thomas insists on this by saying that “as a founder, each clause needs to be fully understood and you cannot just rely on your lawyers. The first thing you need to keep in mind is the implication of your choice on the next round (Liquidation preference, Leaver clause, English documentation…)”.
Do you want all your investors to sign the same shareholder agreement?
In order to simplify the process, you can decide that the small investors (owning less than 2% of the capital for instance) will not have all the same rights as the bigger ones. In this case, they sign a simplified shareholder agreement that protects their main interests but that simplify the process. This is the role of the CEO to explain to the small shareholders that the interest of the company is that they sign this shareholder agreement. Beena Paradin had an efficient process for that: “I made a call with all the small shareholders to explain to them that it was in the best interest of the company. During this call, I answered the questions and the most experienced investors helped me explain to the other that it was a standard process.”
How to split the work between the company lawyer and the investor lawyer?
Most of the time the lawyers on the founder side knows the history of the company and he will be in charge of all the corporate documents (BSPCE, Cap Table, Waterfall), on the other hand, the investors’ lawyer often manages the redaction of the shareholder agreement and new legal documents.
pro tip: if you have a good relationship with your VC, you can even have only one lawyer for both sides (which substantially lowers the legal fees).
How to be well prepared?
According to Charles, “You need to prepare the process very early, you need to discuss some key clauses between the founders before: what we wanted to do, liquidation pref, leaver clause, how they think the value of the company would grow? You also need to fully understand the vocabulary of the investment and the consequences of the clauses”. Nicolas Reboud on his side considers that “definitely one of the co-founders needs to be involved in the fundraising process, preferably the CEO, but definitely not all the them”. You need to keep your momentum and not to defocus on your business part, especially since the process could be longer than expected.
Representations and Warranties
The Representation and Warranties is a specific clause of the Shareholder Agreement but it is often a bit stressful for the founders and written in a separated document during the process so I decided to be a bit more specific on it. As an investor, you decide to invest in a company based on the information provided to you. You accept that for instance a business plan is something that you cannot guarantee (Venture Capital without risk is not Venture Capital…) but you cannot accept to pay for mistakes that have been hidden to you. This list provided by Investopedia is a good summary of the content that should be provided by the company. Before the investments, the founders based on what they know and the first results of the due diligence provide a list of the main risks for the company (grant for Intellectual Property not well protected, legal dispute with a former employee…). By signing the documents, the investors accept the conditions for the investment and the incertitude related to the points that have been declared.
But what happens if I hide something?
In case the investors find new issues/mistakes that were out of their knowledge (above a predefined amount) the founders and sometimes the previous investors will have to compensate the investors both in cash or equity as the company does not respect what has been described to them.
pro tip: don’t hide important things 😉
How long are the Representation and Warranties typically enforced?
Typically between 18 months and 36 months after the closing but this period is to negotiate and depends mainly on the situation of the company.
pro tip: in case there is an important issue, the clause will probably not be enforced literally but will be a good basis for the negotiation.
Can I lose my shares and also have to pay in cash?
Yes. The idea is that if you have hidden something very important, it means that the company has a very important issue and that you will have to compensate by paying a very important amount (in equity since the amount paid in cash is often limited by contract, this is something). In this case, the survival of the company is in question and losing your share is probably not your main issue…
This clause could look very aggressive but the purpose is to prevent scam and dishonest people. For Beena, talking to the lawyers helped her to better take into account the investor’s viewpoint and to understand the reason why it exists.
Who do I negotiate with?
Each investor. The idea is that as the main part of the document, you negotiate with the lead investor. However, all the investors including the investors of the previous rounds have to sign the terms and sometimes other investors will have specific requirements.
pro tip: Share the result of the negotiation on a regular basis with all your investors even if you only negotiate with the lead on a day to day basis.
Due diligence process
The due diligence process is an audit which could cover different things such as the legal risks, the financial records or a product/technology review. There are different things to check to establish a good summary of the situation of the company at the time of the investment. Obviously, the due diligence is not the same for a 5 years-old deep tech company or for a 1-year-old Saas. Most of the time, due diligence (especially financial and legal) is performed by a specialised company. The most common aspects of the due diligence are well summarised here.
Is the due diligence a pure administrative step?
Not at all! According to Djamil, “the process was really useful to have a clear picture of what’s working really well and what needs to be improved fast. We now have a clear to do about things we need to improve and we are even considering doing it again for ourselves in the next few months”. Nicolas from Shine confirms that “the researches made to answer the questions asked during the due diligence were super useful”.
When do I need to start the preparation?
According to Charles, “You need to prepare it before you sign the Term Sheet. Just consider that the due diligence will start as soon as you have signed the Term Sheet. It will help to both not to slow down the process and to feel more peaceful during this stressful period.”. According to Beena, the accounting part is the easiest as you have an accountant who asks you to do it on a regular basis but for the legal part, you need more self-discipline.
Who pays for the due diligence?
The company will pay for the due diligence and the lawyers with a cap, after that limit the cost is shared between the investors and the company. The investors provide the result to the company, and it is a tool to help the company to have a very complete vision of its strengths and weaknesses at the time of the investment.
Pro tip: You can negotiate a floor, once this trigger is reached, the investors and the company share the costs altogether.
Our best advice for you to make it smooth
- First and foremost, take lawyers very experienced in that kind of deals. You will rely on them for a lot of things and they are the main differential factor between a smooth process and a total nightmare. If there was only one line in this article it would be this one. Charles “has done some reference call” previously with both founders and investors that have worked with them to be sure that they know how it works. “Another important point is to agree on a clear price and on what is included in the package”.
- Let the lawyers talk together as much as possible, good lawyers have the best proposals to each issue for both sides.
- Be reactive and prepared, a few days lost to negotiate a clause or provide some documents can stifle the momentum.
- Prepare a very organised data room that you can share with the investors and the people responsible for the due diligence.
- As a founding team, you need to be clear about what you want.
- Have a good knowledge about what is market practice and what is reasonable to negotiate. The investors also have their requirements from their own investors.
- Set a closing date soon in the process. Even if it is not respected in the end, it will accelerate the process as nobody wants to be the one responsible for delaying the deal.
Our founders also accepted to share with you THE thing they could have done better:
- Camille: We wasted some time by lack of experience. Also sometimes by trying to gain time and go fast you regret it later. Better to take the time early, not rush and do it well right away rather than return to it later.
- Djamil: Work more on the different possibilities of the Liquid Pref and the Leaver clauses before the negotiation. We could have saved a lot of time if we had a much more precise understanding of these clauses beforehand (eg. xls simulations)
- Beena: As we are a company with a history, the shareholder agreement was a bit more complex. We wasted time on discussing the same points several times. It would have been great to have a table with the clauses still to discuss and the output of the discussion on top of the traditional documents.
- Charles: As a founder, you also need to understand very well what you are negotiating. I regret that we didn’t plan a 2h kick-off with the lawyers at the beginning of the process to define all the terms and the process. For instance, you need to understand what is a pre-emption right, and you cannot just decide that the lawyers will negotiate for you. They can also inform you in advance about some practical elements such as insurance and bank accounts. If you don’t have them, it could also slow down your access to the money which is very frustrating!
Our last advice would be not to freak out too much about all this legal stuff. This part would be very intimidating but just keep in mind that as an early stage company, as a founder you are its main asset.
A special thanks to Shabir Vasram for his meme skills and to Mathieu Daix for proofreading.