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Considerations for Founders When Negotiating a Term Sheet

A term sheet first summarizes the material terms of a financing transaction. Term sheets are normally not legally binding (with certain exceptions, such as confidentiality and exclusivity) but they are generally thought of as morally binding. It is often difficult for a company to renegotiate something that it agreed to in the term sheet. Therefore, it is important to understand the impact that the terms set forth in the term sheet will have on the company and the founders after the financing, both with respect to economics and operational control. During our QuickLaunch University webinar on term sheet basics and negotiation best practices, we discussed some of the investor protections that founders should understand during the negotiation phase of the process.

Here are four considerations for founders during a term sheet negotiation:

  1. Preference: The liquidation preference is the amount that holders of are entitled to receive (often the amount invested plus accrued and unpaid ), in preference to holders of upon a liquidation event. A “liquidation event” in term sheet parlance includes not only the dissolution or winding up of the company, but also the merger or sale of the company, the exclusive license of key company intellectual property and other transactions involving change of control. The right to a liquidation preference is traditionally thought of as downside protection, but investors may seek significant upside guarantees by employing participating , which allows the investors to recoup their initial investment first and also participate in the of any remaining proceeds to the common stockholders. This can have a potentially disastrous impact on the value of the founders’ stock in an acquisition that does not a significant internal rate of return (IRR) over the amount invested. Companies should resist participating , or at least seek to limit its impact with an “IRR Hurdle,” such that the investor forfeits the right to additional sale proceeds once a specified return threshold is met.

  2. : Investors will seek positive and negative covenants, meaning that companies will have both an obligation to do certain things, such as deliver financial information, provide access to management and corporate records, and allow the investors to participate in subsequent financing , and to refrain from doing certain things. These negative covenants can result in the company not being able to take specified corporate actions without investor approval (usually through its board representative). Companies should attempt to minimize these covenants to allow management the flexibility to run the company.

  3. Class Voting Rights: Investors will seek class or series voting rights over specified corporate actions. Where a class vote is required, the company may not take the specified action without the affirmative consent of holders of a specified percentage of the preferred stock or a particular series of the preferred stock. This gives investors the ability to block important corporate actions, such as mergers or sales of stock or assets, issuance of additional shares of preferred stock, option and vesting schedules, incurrence of debt and sales or transfers of technology. Companies should attempt to minimize the list of actions that will trigger a class or series vote and should seek an end to class voting rights if preferred stockholders have less than a certain percentage ownership of the company.

  4. Board Composition: One of the major ways that investors can exert control over a company is through representation on the board. Investor representation on the board usually tracks with how much money has been invested. Therefore, the lead investor will often have a designee on the . It’s important that companies negotiate to have management, or the founders, represented on the board and try to maintain control of the board (for example, having three directors designated by the holders of and two directors designated by the holders of preferred stock make up the board post-financing). Investors may also want to include at least one independent director on the board (unaffiliated with investor or management). Founders should seek a say over who the (s) will be, so that they can ensure that the independent directors will have the right industry experience and that they will be receptive to the founders’/management’s perspectives. The right independent director can provide valuable guidance and open many doors for a company, but an “independent” director that is too friendly to the investors can significantly undermine the founders’ control over the direction of the company.

To learn more about term sheet negotiation best practices, watch the recording of our QuickLaunch University webinar or download the materials.