An entrepreneur with a term sheet for investment has a range of decisions to make. Among the most important is which points to negotiate and which points to leave alone. You cannot negotiate every point or you will (a) drive away the investor and (b) fail to concentrate your firepower on terms that do matter.
Recognizing which terms do not matter -- because they are pretty standard or inconsequential from a practical perspective -- is almost as valuable as knowing which terms are not important. Obviously, every deal is different, but LawPivot co-founders Jay Mandal and Nitin Gupta, and Yusuf Safdari, an attorney providing advice to companies on LawPivot, outline a set of points that should rank lower on the priority list for negotiations with investors.
1. Binding nature of the term sheet. You will not get anywhere by trying to argue that the term sheet should be binding. In venture deals, you will not have a binding deal until the definitive financing documents are signed and the “money is in the bank.” However, watch out for “no shop” provisions which often will be binding in a non-binding term sheet. These provisions prevent you from using the existence of the term sheet to get interest from other investors on a different term sheet. You may not be able to avoid a “no shop,” but it may be worth trying if you can build competition for your deal and as a result potentially better terms.
2. Registration rights. Registration rights take up a lot of real estate on your average term sheet. For all that space, there is typically little worth negotiating. In essence, registration rights are a right in favor of investors to have the company register the shares sold in the public offering under the U.S. securities laws. This registration of preferred shares paves the way for liquidity for investors after the IPO.It is rare for registration rights to be exercised in practice because everyone usually wants a company to go public if it can meet market thresholds. Although you should confirm that the registration rights are “market” with your attorney, you probably only otherwise need to confirm that the investors rights to “demand” a registration is limited to one or two instances and that investors can only demand such rights well into the future, e.g., five years out or so.
3. Market standoff rights. Many term sheet will include a provision that investors will be bound by a 180 day or so “market standoff” only if all officers, directors and other 1 percent stockholders are also similarly bound -- which include you as a founder! A market standoff provision prohibits a stockholder from disposing of his or her shares for 180 days after an IPO. Although this does not sound like fun for anyone, investment bankers will require this condition of everyone as the company prepares for an IPO, so you better live with it!
4. Information rights. Term sheet will typically provide that investors have a right to certain financial information and other basic company information. It is pretty difficult to resist this point without seeming like you are hiding the ball or not trustworthy. You should make sure that the information rights do not pose an undue administrative burden, e.g., requiring audited financials when you do not have those customarily available or requiring monthly reporting. Many times the cost of audited financials is not justified for a startup. In addition, you may want to pay attention here if you have a strategic investor that may be your competitor in the future -- do you want them to have full access to your financial information? Otherwise, it is not worth putting up a fight on information rights.
5. Right to maintain proportionate ownership. Many times a term sheet will include a right by an investor to maintain their proportionate ownership if a future financing occurs. This is called various things such as a pro rata right to participate, or a right of first refusal. The point is that you have to offer your existing investors all or a part of the next financing round on the same terms as you are offering to an outside investor.As a practical matter, this provision usually does not cause a problem because your existing investors will often want you to diversify your funding sources and will gladly waive this right. However, if your company is “hot,” they may seek to exercise this right in full or part whereas you may want to make room for a high profile investor that is interested in your company and wants to end up with a certain percentage.A good compromise may be to allow your investors to have a right to maintain pro rata ownership, but make the denominator in the formula based on the fully-diluted capitalization of your company (not just the number of shares issued in the preferred round).
6. Legal expenses. Many entrepreneurs are horrified to learn that they will be asked to pay the legal fees of the investor’s attorneys who have spent a fair amount of time torturing the startup on due diligence matters and negotiations. However, many institutional investors and even some sophisticated angels have come to expect this as a standard condition of a term sheet.After you get over the shock, the best alternative might be for the company to negotiate a reasonable cap on such reimbursement of investor legal fees. If you fail to negotiate such a cap, you may be very sorry. Alternatively, in a small deal or in a deal involving individual angels, you have a chance of getting this left out. But, on balance, save your bullets here.
7. Dividends. Who has ever heard of an early stage company paying dividends? Exactly. You only need to confirm that dividends are non-cumulative at a reasonable rate like 6-8 percent, which means they do not accrue unless approved by the company’s board of directors. Most term sheets come this way. It is extremely rare for a startup to bother to declare dividends because it needs cash to grow -- not to distribute to shareholders.
8. Finder’s fees. A term sheet will often require that the party who retains a finder, such as someone who introduces a company to an investor, has to compensate that finder and hold the other party harmless. At the term sheet level, a company has no particular argument to resist this. Bear in mind that you will have to incur the full amount of the costs of any finder if you retain one. Better yet, don’t retain a finder unless you have no alternative. Oftentimes, you can find investors through business contacts, angel groups, attorneys and other professionals who will not charge you for such an introduction. You should resist any version of such a provision that requires you to pay the finder’s fee of the investor because this is not market and usually unfair given that this is their cost of doing business.
9. Proprietary invention provisions. Most term sheets will contain a term that requires the company to represent or prove that all relevant employees and consultants have signed confidentiality and invention assignment agreements (a.k.a. proprietary invention agreements). You can fight this one until the cows come home by claiming that you are out of touch with former employees and consultants that never signed one. But, you will not get too far, and you will look like you have done a lousy job managing your paperwork.From an investor’s standpoint, they want to make sure that the company owns and has restricted the use of its inventions and confidential information -- not too unreasonable if they are investing in you in part because of your innovations. Rather than trying to negotiate this out, it is better to have your house in order by requiring these to be signed by all employees, consultants and others with access to such information. At best, you might get isolated exceptions from this requirement for consultants and employees who did not touch the technology and are not a threat.
10. Standard vesting for ordinary employees. Many term sheets will require you to put in place four-year vesting with a one-year cliff on a “go forward” basis for ordinary employees. Although there will be heavy negotiating with respect to existing vesting schedules of founders and existing executives, it is a tough, and perhaps undesirable, to argue that ordinary employees on a “go forward” basis should not be subject to such vesting schedules.Indeed, such vesting schedules for ordinary employees incentivize them to put forth proper efforts and to stay with the startup to earn their equity. You may want to negotiate that the Board of Directors (including the vote of the preferred investor director) can make exceptions to this general rule on a case-by-case basis, e.g. to attract a desirable employee who will not agree to a four-year term. But, you will want to focus your negotiations on preventing re-vesting requirements on yourself or other key executives that have partially and legitimately earned their vested equity. There is enough to fight on without picking a fight that you cannot win.
Enough said. Now that you know what matters and what does not, please get the money in the bank so you can build your company and pay your employees! For more information about issues like these and to find more legal advice, visit LawPivot.
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