Negotiating Term Sheets: Should Entrepreneurs Focus on Valuation or Everything Else?

To some, liquidation preference may sound like a bankruptcy term of art and drag along rights may sound like a move in mixed martial arts.  Venture finance term sheets consist of many unique terms and moving parts, some of which will sound foreign to an entrepreneur raising outside capital for the first time.  Whether by design or misfortune, however, entrepreneurs consistently get hung up on one particular term – valuation.  They resemble a grizzly bear defending its cub. 

But with all things, entrepreneurs need to put valuation in perspective.  There’s more to a venture round than just valuation and to focus solely on that issue will come at a great cost.  That’s not to say that you ignore valuation, not by any means.  An entrepreneur should always make sure that the valuation resides somewhere within a reasonable range (those that see frequent deals, such as accountants and lawyers, can help with this) and then expend the balance of their leverage negotiating the remaining terms.  Valuations are subjective, but the other terms are tangible and could have a far greater impact on the overall economics of the deal.

Here are some examples of classic mis-steps:

The inexperienced entrepreneur downplays the liquidation preference believing a higher valuation (i.e., resulting in a larger stake in the company) means more money upon exit.  One thing, and one thing alone, has the greatest impact on how sale proceeds are divided:  the almighty liquidation preference.  If you fail to properly negotiate the liquidation preference, I don’t care how high your valuation is – your take of the proceeds will suffer.  Run the numbers yourself and you’ll see the impact a liquidation preference can have.  In particular, when you enter the realm of participating preferred rounds (where venture firms get a multiple of their investment and then share pro-rata in the balance along with the common stock holders), the impact can be greater.  This isn’t to say that the venture firm may not deserve the liquidation preference, but as an entrepreneur you need to understand its result.  Valuation may be rendered irrelevant.

The entrepreneur fights hard for his/her high valuation, thus retaining a large stake in the company (everyone’s dream), only to find out in the next round that he/she was dead wrong on valuation – oh yeah, it’s down round time!  Be careful what you wish for, you might just get it.  If you manage to obtain an excessive valuation the excitement may be fleeting if, following a less than stellar execution of your business plan, your next round of financing is a down round (i.e., at a lower valuation then previous rounds).  A down round will trigger anti-dilution provisions for earlier venture investors and could significantly dilute the founders and everyone else below the venture investors.  You might wish you had spent more time in the earlier round negotiating for a weighted-average anti-dilution provision instead of just accepting a full ratchet.  A more reasonable valuation alone in the beginning might have avoided the later down round.  Even if it didn’t, your weighted-average anti-dilution provision would have at least softened the impact.  You need to take future financing plans of the company into consideration when negotiating that first round valuation. 

While focusing so closely on valuation, the entrepreneur neglects to understand the impact of including the option pool in the pre-money valuation.  As you can see from the previous examples, it pays to focus on how certain provisions in a term sheet are drafted.  You might also want to see if your option pool is included in your pre-money valuation.  Venture firms like to include those shares in the pre-money valuation because they don’t want to be diluted later by such issuances.  In addition, including the option pool lowers your actual valuation (by including more shares in the calculation, the actual price per share effectively goes down).

For sure, more time could be spent on this subject, but the simple fact is that you should not waste all of your negotiating capital on valuation – fight the urge.  Build a great business and a great valuation will naturally follow.

You may ask - if I follow your advice and focus on the other terms, which of those terms take some priority?  Terms like registration rights (which are hardly ever exercised) and redemption rights (if you ever reach a point in time where a venture firm wants to be redeemed, it’s likely there’s no money left to conduct such a redemption anyhow), in my opinion, have little or no impact and should fall to the bottom of the negotiating priority list.  Spend more time negotiating the following provisions (I’ve put them in my own personal order of importance):

  • Liquidation preferences – as you’ve seen above, this can make or break you.
  • Anti-dilution provisions – this may never get triggered, but if it does you’ll wish you had read it.  Back in the early 2000′s when the first bubble burst, every venture-backed company that was raising money was doing a down round or a cram-down financing.  For the first time, in a long time, everyone was taking out the anti-dilution provisions to see how they worked.  For some, it was a real-life education.
  • Protective provisions – this provides a level of control above and beyond your level of stock ownership.  Absolutely worth negotiating.  The list of protective provisions tends to be fairly standard, but there are ways of softening their blow.
  • Board seats – is what it is, but always an issue of control.
  • Drag-along rights – these aren’t in every deal, but if they are I’d include them in what you negotiate.  Again, experienced venture lawyers have techniques for softening the blow of these provisions.
  • Dividends – everybody seems to pick a number between 8 – 10%.  Focus less on the number and more on whether they are cumulative, compounding, etc.
  • Rights of First Refusal/Co-Sale Rights – these tend to read the same in almost all deals, but they should still be reviewed thoroughly.

My last piece of advice would be to hire a lawyer with solid venture finance experience (ignore the bias here on my part – this truly is an important point).  The right lawyer can help you understand the relative importance of certain terms as they exist in your term sheet.  The value such an attorney brings greatly exceeds his/her cost.  Hire such an attorney before you even incorporate – do it right from the start and they will make sure your entity and all the formation documents are prepared in a manner that venture firms are familiar with.  It will save you time and money in the long run – you don’t want to delay your venture financing because you need to do some housekeeping.

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    [...] – But the “Promote” Does.  It is a great add-on to my previous entry entitled Negotiating Term Sheets:  Should Entrepreneurs Focus on Valuation or Everything Else?  Jeff proffers a new term he calls the “promote,” in an effort to communicate the real [...]

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    [...] – I would like to thank Bob Fesnak of Fesnak and Associates for this Mistake #14.  You can see my earlier post for more information on this subject.  I place higher negotiating priority on liquidation [...]