This post is the first in a series giving practical advice to startups on understanding and negotiating a venture capital term sheet.
One of the most significant events in a startup company’s life cycle is raising its first round of venture capital. Up to that point, most companies have survived by owners “bootstrapping it” with perhaps some help from friends and family and maybe an angel or two. These earlier rounds of financing are usually relatively simplistic and don’t involve overly complex securities or intense negotiations with the investors. However, when the startup enters the venture world, all this changes dramatically: complexity and intense negotiation is the norm, and startups are now faced for the first time with concepts such as participating preferred stock, conversion rights, anti-dilution, and a whole host of other fairly new and complex topics.
In this series of blog posts we’ll try to explain, in relatively simple terms, many of the key concepts that arise in a typical venture capital transaction. Our goal will be to explain these concepts to those startups who are newcomers to the venture world. To do this, we’ll walk you through the National Venture Capital Association’s (NVCA) term sheet which is posted on their website at the link below and provide some commentary which we hope will be helpful:
However, before we get to the term sheet, we’d like to make one preliminary observation, which is that many startups find themselves in the unenviable position of being at the mercy of a single venture capital source as they seek financing without having tentative agreement on some basic terms. All too often it seems the startup is so eager or desperate to find financing that it locks in on a single VC firm and ends up with very little leverage when it comes time to negotiate the deal. The end result is often unfavorable terms or perhaps terms that are not as fair as could have been obtained. To avoid this result, it’s prudent to avoid, if possible, limiting your options to a single VC firm until you’ve agreed on many of the tentative deal terms that will be set forth in a term sheet. Or even better, if your startup is lucky enough to have multiple potential financing sources, it may be wise to get a signed term sheet before focusing on one source.
Turning to the NVCA model term sheet, in this first post we’ll make two main comments. First of all, it’s very important to note which portions of the term sheet are binding and which are not. We’ve discussed binding and non-binding provisions in a term sheet here, here and here. The preamble to the NVCA term sheet sets out the “No Shop/Confidentiality” provisions as binding and lists the “Counsel and Expenses” provisions in brackets indicating that sometimes they may be binding and sometimes they may not. We’ll get into the substance of these provisions in a future post but our purpose now is simply to illustrate that some provisions in the term sheet constitute a binding legal contract while others do not. Importantly, this model term sheet makes clear that it does not constitute a legal commitment by the VC firm to make any investment in the startup. Therefore, startups should recognize that execution of a term sheet, while a key milestone towards receiving funding, is mostly non-binding on the VC firm and is certainly not an assurance that any such transaction/financing will actually close.
Second, in some jurisdictions a term sheet that expressly states that it is non-binding may nonetheless create an enforceable obligation to negotiate the terms set forth in the term sheet in good faith. A startup that for some reason thinks it can get out of a VC deal (perhaps if it comes into a better offer) should realize that good faith negotiations may be required and that simply pulling out of the deal may result in legal liability.
In the next post in this series, we’ll discuss some of the basic offering terms set forth in the model NVCA term sheet, such as the pre-money valuation, capitalization table, and the price share for the stock to be sold.
© 2013 Casey W. Riggs — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.