What are traps to avoid in term sheet negotiations?

Takeaway: Not being clear on control provisions (e.g., board composition, voting thresholds, protective provisions) is typically the biggest trap because it creates room for different interpretations by the parties when negotiating the long-form documents. This results in higher legal fees because the terms need to be negotiated and can end up with terms that one of the parties didn’t think they were agreeing to.

Raising Series A funding is a significant milestone for startup founders, providing the necessary capital to scale their businesses and pursue new growth opportunities. However, the negotiation process surrounding term sheets can be fraught with potential traps and pitfalls that can negatively impact a company's trajectory. In this post, we'll discuss some common traps founders should avoid during Series A term sheet negotiations to ensure they secure the most favorable terms possible for their startups.

Over-optimizing Valuation

While securing a high valuation is undoubtedly a priority for founders, over-optimizing valuation at the expense of other important terms can lead to undesirable consequences. A sky-high valuation can result in increased pressure to meet growth expectations and may make it challenging to raise future funding rounds at an attractive valuation. Founders should strike a balance between securing a favorable valuation and managing investor expectations for sustainable growth.

Ignoring Dilution and Anti-Dilution Provisions

Dilution is an inherent part of raising capital, but founders should be mindful of the potential impact on their ownership stake. Anti-dilution provisions, which protect investors from having their ownership diluted in future financing rounds, should also be carefully negotiated. Founders should aim for broad based weighted-average anti-dilution provisions to minimize dilution and maintain control over their company.

Overlooking Liquidation Preferences

Liquidation preferences determine the payout order in the event of a liquidity event, such as an acquisition or IPO. Investors often receive a liquidation preference, which ensures they are paid before common shareholders. Founders should carefully negotiate the liquidation preference multiple to strike a balance between protecting investor interests and preserving the value of their own equity in the event of an exit.

Neglecting Board Composition and Control

The board of directors plays a crucial role in a company's strategic direction and decision-making. Founders should avoid giving away too much control to investors by ensuring a balanced board composition that includes founder-appointed directors, investor-appointed directors, and independent directors. Maintaining control over the board can help founders preserve their influence over strategic decisions and minimize potential conflicts with investors.

Overlooking Protective Provisions

Protective provisions grant investors certain veto rights over major corporate decisions, such as mergers, acquisitions, or changes to the company's capital structure. While protective provisions can provide necessary safeguards for investors, founders should be cautious about giving investors too much power over the company's decisions. Negotiate for reasonable protective provisions that allow for collaboration without hindering the company's ability to adapt and make critical decisions.

Failing to Consider Legal Fees and Expenses

The legal fees and expenses associated with a Series A financing can be substantial. Founders should ensure that they have a clear understanding of the allocation of these costs and negotiate to minimize the financial burden on the company. This includes setting caps on the company’s obligation to reimburse the investor’s legal fees.

Overemphasizing Speed at the Expense of Thoroughness

While closing a funding round quickly can be appealing, founders should not sacrifice thoroughness in the negotiation process. Taking the time to carefully review and negotiate the terms of a term sheet can help founders avoid unfavorable terms that can have long-lasting consequences for their company.

Conclusion

Successfully navigating Series A term sheet negotiations requires a delicate balance of securing favorable terms while avoiding potential traps that can hinder a startup's growth and success. By being aware of these common pitfalls and approaching negotiations strategically, founders can secure a strong foundation for their company's future and foster a collaborative partnership with their investors.