Negotiating a Series A Term Sheet

The prospect of navigating your first preferred stock term sheet negotiation with an institutional investor can be daunting. You will likely be confronted with a number of provisions that you have not encountered before or have limited experience with. Understanding and assessing the materiality of these terms and having a well-thought-out negotiating strategy are critical to finalizing the term sheet quickly and effectively. Doing so will allow you to move to definitive documents and closing and, ultimately, get you back to running your business.

Here are a few simple steps and lessons that can streamline the process:

  • Understand which terms are most important and why
  • Determine market ranges for these terms
  • Concentrate your efforts on improving these terms
  • Do not assume a non-binding term does not matter

This article is not intended to provide a comprehensive overview of the terms in a Series A term sheet (even the key ones). Instead, it provides a framework that can help you minimize the time, stress and cost spent negotiating the term sheet, and maximize the effects of your negotiating efforts.

Understand what terms are most important and why

Not every term is created equal. Although each term has a purpose and effect that you — with the help of your advisors — need to understand, there are typically a limited number that will have the most impact. While the most critical terms may vary from deal to deal depending on the context, generally these will be:

  1. Valuation (how much the company is worth pre-financing, which affects dilution)
  2. Liquidation preferences (how proceeds will be distributed on a sale of the company)
  3. Composition of the board of directions (the number of directors and who gets to designate them)
  4. Protective provisions (veto rights on key company actions)
  5. Drag-along rights (the right to force other stockholders to support a sale of the company)

These five terms set the main economics and control rights. Your counsel can walk you through the importance and effects of each of these terms.

These terms will be significant in nearly every deal, but have particular importance at the Series A stage. Terms for later round investors typically build upon the terms set in earlier rounds. For example, do not give an expansive set of protective provisions to Series A investors under the theory that you will negotiate these down in your Series B round. You will be fighting an uphill, and likely fruitless, battle.

Determine market ranges for those terms

Now that you know what to focus on, you need a sense of what is reasonable for you or your investors to expect for those terms. Understanding market practice will significantly streamline your negotiations. Your negotiation of the term sheet is also one of your first business interactions with prospective investors. If you are way off market, this will likely reflect poorly on you in the eyes of your investors. Likewise, if prospective investors do the same, this may signal that these are not the best business partners for you.

Fortunately, you do not have to independently research and become an expert on every term. There are a number of useful resources you can use to assist in this exercise. First and foremost, talk to your lawyer. Locate a lawyer experienced in start-up financings. He or she will have a good sense of prevailing market practices and variations with specific types of investors (e.g., strategic or certain foreign investors), and can steer you to trusted third-party surveys for additional information for certain terms, such as valuations for similarly situated companies.

Concentrate your efforts on improving these key terms

You do not have infinite bargaining time or leverage. Spend the bulk of your negotiating time and efforts getting these key terms to where you want them to be. Be reasonable but firm in your positions on these issues.

You should not completely ignore the other terms. Terms such as antidilution protection, conversion rights, founder vesting, option pool increases, information rights, registration rights, right of first refusal and co-sale rights, redemption rights and exclusivity are important.  Make sure that they are within market. Thankfully, while there are always different flavors/variations, the market range of many of these other terms is fairly settled in the venture community. If you are dealing with a respected venture fund with experienced counsel on both sides, you will likely find that these other terms, though requiring some back-and-forth, will land within market.

Do not assume a non-binding term does not matter

Most preferred stock term sheets are either fully or largely non-binding. This does not mean they do not matter. It also does not mean that you can agree to terms now to get an investor hooked and expect to make material changes later in the definitive documents. If you are dealing with a sophisticated, reputable investor, you should expect the material terms of the definitive documents to largely align with the term sheet.

Bottom line

Your goal in negotiating a Series A term sheet should be to obtain the best result in the shortest amount of time. Focus on what matters and listen to your counsel so that you can get the money in the door and get back to building the next great company.