Gunderson Dettmer: How to understand a startup term sheet for venture capital

Hozefa Botee and Wes Watts

Founders raising venture capital have lots to think about. Not only is it essential to score meetings with investors and convince them of your pitch, but it’s also important to make sure the terms they’re offering are favorable.

Some founders go into negotiation with a fair amount of experience. They’ve raised money before at other companies, are in subsequent funding rounds, or have experience in venture capital financing. Others may be raising funding for the very first time. 

No matter your level of experience with venture financing, the fund giving you the term sheet will almost always have more experience than you. After all, informational asymmetry is baked into the process. A firm sending you a term sheet is likely negotiating several other term sheets that week, whereas you may only receive one every few years. Plus, even if you’ve done it before, there may be intricacies or nuances in a new term sheet to understand and explore.

Thankfully, you don’t have to be in the dark. We sat down with two top corporate lawyers from Gunderson Dettmer (Hozefa Botee, a Corporate & Securities partner in the firm’s New York office, and Wes Watts, head of the firm’s Austin office) to find out what founders need to know about their first term sheets. 

Gunderson Dettmer is a Silicon Valley-based law firm with nearly 500 lawyers specializing specifically in the innovation economy, helping emerging tech companies with their legal needs from the very beginning, to initial public offerings, and beyond. In fact, Gunderson Dettmer has done more venture financings than any law firm in the world.  

Here’s what Hozefa and Wes want you to know:

What is a term sheet?

A term sheet is a summary or distillation of the key terms for an investment deal. According to Wes, it’s basically a conversation tool. “A term sheet is a way for parties who are considering entering into a transaction to get on the same page,” he said. “By looking at the term sheet, you can understand if you have enough agreement on the major business and economic terms to make a decision to move forward and enter into full-fledged legal agreements.”

The National Venture Capital Association (NVCA), a trade group for venture capitalists, has a set of model financing documents for venture capital transactions, including a model term sheet. This NVCA model term sheet is robust with a lot of terms, but according to Wes and Hozefa, many VCs pare this down to make it a bit simpler.

What does a term sheet look like?

The format of a term sheet varies depending on the venture capitalists. A standard term sheet template typically includes information such as 

  • the amount of funding offered, 
  • the company's valuation, 
  • the liquidation preference, 
  • the investors' rights, 
  • the board structure, and so on.

Shorter, more digestible term sheets have been a trend over the last decade, especially as VCs have been competing for deals in the past several years. The more approachable and understandable they can make the term sheet to the founder, the more likely the founder will be able to grasp what they’re offering and move forward with a deal. Some first-round term sheets can be as short as one or two pages, and term sheets are generally not legally binding (although some may have binding exclusivity and confidentiality clauses).

A term sheet template prepared by the investor and serves as a preliminary agreement that outlines the key terms and conditions of a potential investment, merger, or acquisition deal.
Example of a Series A term sheet (Source)

How to read a startup term sheet?

Below are 6 tips to consider.

1. Assess the price

Term sheets cover a number of different things, but the one that tends to get the most attention is obvious: the valuation of the company. This essentially determines the price the investor is paying for the amount of ownership they’re purchasing. 

When assessing the price, you have to ask yourself if the amount of the company that you’re being asked to give up feels right for the amount of money that you’re raising. Are you getting enough money to be able to take the company to the next milestone it needs to hit the next inflection point before you’ll be able to successfully raise another round of venture capital? 

According to Hozefa and Wes, there's a strategy to decide how much money to raise and at what price. Ultimately, this amount can make a real difference for companies and potentially save them some challenges down the road if they're looking to keep that growth trend headed in the right direction. It also determines how much of the company founders will still own at an exit event. 

When it comes to valuation, note that it's not a one way street. The right price is not necessarily the highest price you can possibly get. “In some cases, startups can shoot themselves in the foot by agreeing to a valuation that's so high that it can make it hard to beat that valuation by enough to show the kind of growth to get the valuation that you want at the next round,” said Hozefa. 

2. Look out for unusual or non-standard terms

These days, there are a variety of economic terms that are more standardized than they used to be. But if you see off-market, non-standard economic terms in a term sheet, that can be an indication that the investor may be a bit more aggressive. 

For example, non-standard terms you might see include things like cumulative dividends, participating preferred stock or multiple liquidation preferences instead of a more typical 1x liquidation preference, non-participating preferred stock. “Those are some features of the stock itself that have fallen out of favor and we don't see very much anymore, particularly from top tier VCs,” said Hozefa. “If you do see those kinds of terms in a term sheet, it can be a red flag.”

One thing to watch out for is excessively restrictive provisions that require investor approval over normal business operations. “These aren’t included in every deal, but some VCs want various approvals over operational matters as part of their terms,” said Wes. “This is something to watch out for as you don’t want to cede more control of your day-to-day business than necessary or inhibit your ability to effectively operate the business.”

3. Avoid "negative control” pitfalls

As a founder raising funding, you want to make sure you’re in the driver’s seat. You are the best possible person to grow your business. No matter who you partner with for funding, you need to ensure you still have an adequate amount of control to be successful.

When it comes to the term sheet, you need to look out for provisions that give investors “negative control,” where you’ll need to get approval from your investors to take certain actions. Basically, that means you need to make sure that the provisions will give you enough freedom to grow the company in the way you think is best. 

For example, a term sheet may specify certain activities (like taking out a loan or changing the company’s principal business) that require the approval of your investor directors on your board. There may also be protective provisions in the company's charter, which require your investor’s vote as a stockholder to approve of certain actions like raising another round of financing or selling the company.

Excessive control rights in a term sheet could be a sign that this is an investor who has been burned, doesn't trust the founder, or simply wants more control than the founder could potentially get with another VC.

“You’ll need to assess how much negative control, or veto rights, this investor is going to expect,” said Wes. “You want to understand to what degree they’re going to micromanage the founders and management team versus seeking basic economic protections for their investment. The term sheet can give you a glimpse.”

4. Recognize the VC negotiation approach

A founder gives a pitch to the VC. If the VC is interested, they then offer a term sheet. This is the beginning of the negotiation. But the way in which the VCs handle the beginning of the negotiation tells you a lot about what it will be like to partner with that VC. For example, if a VC is ringing your phone off the hook throughout the process, they’ll likely to do so for the better part of a decade as they sit on your board. 

“The whole process is a bit like dating,” said Hozefa. “You want this to be a long term, happy relationship, but there can be warning signals early on that show you it might not be a good fit for the long haul.”

It can be tempting to take a term sheet no matter what, especially since founders suffer inordinate amounts of rejection throughout the fundraising process. To get a term sheet is to be in a fortunate position, but you don’t want to take something without careful consideration that could lead to pain down the road.

When it comes to examining how the VC negotiates, be cognizant of their style. When you push back, are they explaining their position? Do they still seem collaborative and like they want to work together to get to a good place? Alternatively, does it feel more like it’s zero sum and they’re trying to steamroll you?

When building a company, there’s going to be conflict. The VCs you partner with will be helping you make decisions about what happens with the company. Note how they approach initial negotiations. Then, choose wisely.

5. Stick to standard terms

Founders are norm breakers and innovators. In many areas of their lives, they don't want to do things the way everybody else has done it. Oftentimes, they come to negotiating terms with the attitude that they can come up with a better way of doing it. However, their subject matter expertise usually is not raising venture capital. 

Hozefa and Wes have seen many founders create custom instruments and bespoke rules for how the company ought to operate, which are very different from what you might see in other companies. “Most of the time the cost of implementing and managing those far outweighs any benefit,” said Wes.

Hozefa echoed the same sentiment. The more time founders spend trying to innovate in their fundraising process, the less focus and attention that they have for actually building their business,” said Hozefa. “The goal of fundraising should be to get it done as efficiently, safely, and quickly as possible so that you have the money in hand to then go build your business.”

6. Rely on trusted legal support

As noted earlier in this article, there’s huge informational asymmetry between founders and VCs when it comes to raising funding. “VCs are repeat players who give term sheets all the time– they know what they typically see,” said Wes. “Founders, especially first time founders, may be seeing a term sheet for the very first time.”
Thankfully, trusted legal support can guide you through the process. “As startup lawyers, we see even more term sheets than VCs do,” said Hozefa. “We work with many VCs and thousands of companies.”

Startup lawyers play a role in helping to train founders. Sometimes founders think a certain provision is unusual or ridiculous, and the startup lawyers will share that it’s, in fact, very common. They’ll also be able to share why it’s included and explain how it plays out over time. 

If founders try to go through the process without solid legal support, they might waste time arguing over terms that aren’t important. But more importantly, they wouldn’t have an experienced party in their corner with their best interests in mind.

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