SUMMARY
As a startup founder, it's essential to understand the most common terms used in venture capital negotiations to navigate funding rounds successfully
Founders must understand what each term means, why it's important, and what they can do to make sure they're on the same page as their potential investors.
Remember, negotiations are not about winning or losing; they're about finding a mutually beneficial agreement that sets the stage for growth and success
If you’re reading this, chances are you’re interested in startups and entrepreneurship. And if you’re interested in those things, you’ve probably heard of venture capitalists (VCs). VCs are the people who invest in startups, hoping to make a big return on their investment when the startup takes off.
But here’s the thing — getting funding from a VC isn’t as simple as asking nicely. There are negotiations, agreements, and lots of terms and phrases that might be unfamiliar to those new to the startup game. That’s why we’re here to break it down for you.
In this article, we’re going to talk about the five terms that VCs care about the most in startup funding negotiations. We’ll explain what each term means, why it’s important, and what you can do to make sure you’re on the same page as your potential investors.
Whether you’re a founder looking to raise money for your startup, or just someone who’s curious about how the process works, this article is for you.
Term Sheet
Let’s begin with understanding this simple term. There are two types: binding and non-binding. A binding term sheet means that both parties are legally obligated to follow the terms and conditions outlined in the document. This is preferred by investors when they want an exclusivity period in which they can negotiate and finalise the transaction.
On the other hand, a non-binding term sheet is an agreement that outlines the terms and conditions of a potential investment, but the parties involved are not legally bound to follow through with the agreement. It is usually used as a starting point for negotiations and allows for more flexibility and negotiation between the parties involved. So, whether a term sheet is binding or non-binding depends on the circumstances of the deal and the preferences of the parties involved.
Voting Rights & Board Seat
To understand this, let’s say you’re a founder and you’re considering taking on an investment from a venture capital firm. As part of the investment, the VC firm might want to negotiate voting rights and a board seat.
Voting rights give the investor the ability to influence important decisions in your company. For example, if you’re considering a merger or acquisition, the investor will have a say in whether or not it goes through. It’s important to keep in mind that the more shares the investor owns, the more voting power they have.
On the other hand, a board seat might also be a part of the negotiation. It means the investor gets to be a member of your company’s board of directors, which is responsible for overseeing the company’s management and making important decisions. This might sound spooky, but it has proven to be beneficial for founders. Having a board member with experience in your industry can bring valuable expertise and resources to your company.
Ultimately, the details of voting rights and board seats should be carefully negotiated between you and the investor. You don’t want to give up too much control over your company, but you also don’t want to miss out on the potential benefits of having an experienced investor on your team.
Founder Vesting Period
Founder vesting period is a common practice in startups where a founder’s shares are subject to a specific schedule over a period of time before they can be fully owned by the founder.
Vesting is designed to ensure that the founders are committed to the business for at least a few years and to capitalise on the sweat equity of founders. After a specified time period, a founder may keep all or a certain percentage of their stock shares even after leaving the company.
However, shares that are not vested may be repurchased by the corporation, often at a lower value than would be commanded on the open market. Even though a founder doesn’t own all their shares on day one, they are still entitled to voting rights for the unvested shares.
For example, if Ram gets 100K stock shares as a cofounder of a business and leaves right at the one-year mark, he gets to keep 25K of these shares. These shares are considered earned because of his 12 months of service. The company has the right to repurchase the remaining 75K shares at the pre-agreed price.
Liquidation Preferences
In the world of venture capital, liquidation preferences play a crucial role in determining how exit returns are distributed between investors and founders. A liquidation preference clause in a term sheet gives investors preferential pay-outs in the event of a liquidity event, such as the sale of the company.
For instance, an investor holding preferred stock with a liquidation preference might receive their share of the returns before common stockholders, including founders and employees. This provision is designed to protect investors from the risk of failure and determine the order in which investors get paid back after a liquidity event. The liquidation preference stack, also known as the deal’s “seniority structure,” defines the order in which preferred stockholders get paid out during an exit.
Let’s understand with an example. If a company is sold for $50 Mn, but the investor has a 2x liquidation preference, they would receive $100 Mn, and the remaining $50 Mn would be distributed to other stakeholders.
Liquidation preferences are one of the most important clauses of a term sheet for VCs and founders, and the seniority structure can vary based on the type of agreement, including standard, pari passu, and tiered structures. It is essential for founders and investors to carefully negotiate the liquidation preference clause and its seniority structure to ensure the interests of all parties are aligned.
Right Of First Refusal
Venture capitalists often negotiate deals with startup founders that include a “right of first refusal” clause. This gives the VC the option to invest in future funding rounds before any other investors are offered the opportunity. For example, if a startup raises another round of funding, the VC with a right of first refusal can choose to invest before other investors, even if they offer better terms.
This clause provides the VCs with a level of control and protection, as it allows them to maintain their ownership stake in the company and potentially prevent dilution of their equity. However, it can also limit the startup’s ability to attract new investors or negotiate better terms, as the VC with the right of first refusal may decline to invest and prevent others from doing so until the clause expires.
Typically, these clauses are time-bound, meaning that the party with the right of first refusal i.e., VC has a specified amount of time to decide if they want to invest or not. Overall, the right of first refusal clause is a powerful tool used by VCs to maintain control and protect their investment, but it should be carefully negotiated to ensure that it does not hinder the startup’s growth and fundraising efforts.
In conclusion, as a startup founder, it’s essential to understand the most common terms used in venture capital negotiations to navigate funding rounds successfully. Terms like pre-money valuation, dilution, founder vesting, liquidation preference, and rights of first refusal are just some of the key terms that can make or break a deal. VCs will often prioritise these clauses in a term sheet, so it’s crucial to have a solid grasp of what they mean and how they can affect your company’s future. Remember, negotiations are not about winning or losing; they’re about finding a mutually beneficial agreement that sets the stage for growth and success.
