Term Sheet Negotiation Tells

Oct 31, 2011

I recently negotiated and signed a term sheet with a company I am very excited about working with.  I’ll talk about that company later but for now wanted to talk about the process.

Now that I have been a venture capitalist for over five years I’m able to recognize more patterns and one is around term sheet negotiation.  This last negotiation was a breeze.  The founders were tough, but they knew what was important to them.   I also know what is important to me and we were able to have a set of frank, open, and friendly conversations about it and we were able to sign inside of 48 hours.

In my experience this is likely to mean that my experience with these founders will be similar.  We’ll likely have frank and open discussions around the issues in the business but always be able to work together in a friendly way to get to a positive conclusion.  I’m excited.

I’ve had a few term sheet negotiations that have been less than satisfying.  They took forever to get closed, if ever, and we spent as much time on the nits as on the substantive issues.  One founder wanted to negotiate out of having to pay $10K in lawyer fees.  Said just because it was always done that way doesn’t mean we had to do it that way this time.  Turns out that person wanted to rewrite the book of convention on every decision he made.  I can’t tell you that’s why his company failed but it sure didn’t help.  Another person didn’t want preferred shareholders to have any preferred rights.  He never should have taken investor money and probably won’t again.  My favorite was the guy who wanted a relocation bonus….to move his boat to the bay area.  Not a boat he lived on, mind you, but one that he sailed occasionally.  That term sheet was never signed and it was probably best for both of us.

This doesn’t go one way, either.  The investor who spends hours browbeating you to avoid a tiny reduction in the option pool will also be tying up board meetings for an hour to talk about an assumption on line 18 of the revenue model submitted for discussion.   Is she too-clever-by-half, developing complex financial structures that even your lawyer can’t understand?  Expect to hear from this investor every time you are in contract with a customer as she tries to tell you how to structure that deal.  Does he wait until the day of close and then call you and tell you that he found out you have a competitor and is going to lower the valuation by 30% now that you are in a lockup?  This person is always going to be trying to find and exploit any leverage they have over common.

People are who they are and will show their colors early.  When you take investment you are entering a long term relationship where there will be ups and downs.  Be sure to read the signs in that first negotiation and make sure this is someone who you want to have that relationship with.  And so will I.

Discussion and Comments

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  1. Alon Rotem says:

    Good post.u00a0 The term sheet negotiation is an important part of setting the tone for the interplay between a founder and their investors going forward.

    Commented on October 31, 2011 at 10:59 pm
  2. Zeljko Dakic says:

    I kind of understand a guy who didn’t want to overspend on lawyers.u00a0

    Commented on November 1, 2011 at 12:59 am
  3. Adrian Scott says:

    Great points… These tells are important.

    Commented on November 1, 2011 at 1:20 am
  4. Anonymous says:

    I should have made this more clear. u00a0For whatever reason it is standard for term sheets to require that the company pay investor legal fees out of their investment proceeds. u00a0Fair or not, it is in every single term sheet I have ever seen. u00a0I personally think there are 20 terms that are more important to discuss, but this guy wanted to negotiate those 20, the legal fees, and then about 20 other terms. u00a0It was excruciating.

    Commented on November 1, 2011 at 1:38 am
  5. Jessica Darko says:

    Since you don’t care whether this is fair or not, you are not a reputable person to do business with. u00a0It should have been a no brainer for you.nnInstead, you put your foot down on your desire to stiff your business partner.u00a0nnThat tells me you’re a piece of shit.

    Commented on November 1, 2011 at 1:48 am
  6. 40z.com says:

    I couldn’t agree more. Tough negotiation is one thing, and red flags are another. Often reveals character issues that will surely resurface again.

    Commented on November 1, 2011 at 1:57 am
  7. Fallingmeat says:

    Wha?! He is giving them an opportunity and they’re negotiating how much that will be…quite different than a question of character. If they don’t like it, they shouldn’t sign. A contract is an understanding, not an opportunity to sneak small print into a deal.u00a0

    Commented on November 1, 2011 at 1:59 am
  8. Jessica Darko says:

    So, why are you defending the person who’s trying to sneak small print– like making the victims pay for his lawyer?nnI’m guessing you’ve not worked for a startup before. It’s not like you work real hard and then suddenly, you’re lucky and an Venture Capitalist comes around and “gives you an opportunity”. u00a0Not at all. u00a0You work really hard and you create that opportunity for yourself. u00a0 When venture capital comes around, you’re literally dealing with old men who know nothing about technology, but are just following trends and investing retirement money of teachers, et. al, who also know nothing about technology.nnThe reason they want these BS terms– like liquidation preferences– is because they are incompetent, and know they are incompetent, so they want to skew the playing field in their favor in every way they can…. so that, once you take their money, they control you.u00a0nnI’ve seen the results of this many times– forcing companies to shut down profitable lines of business (making them more dependent on outside investment)… making them spend half the investment amount on software from another portfolio company, to the detriment of the company, etc.

    Commented on November 1, 2011 at 2:04 am
  9. Jessica Darko says:

    Yes, and this blog post reveals a lack of charter on the part of its author.u00a0

    Commented on November 1, 2011 at 2:05 am
  10. Fallingmeat says:

    I’m not defending anyone. There’s an easy solution to this, don’t sign the agreement. The recipient has no obligation to do so. Obviously this was not a match made in heaven…that doesn’t make the investor a bad person.u00a0nnnTake someu00a0responsibility, Jess. Read it and feel free to say ‘no.’

    Commented on November 1, 2011 at 2:11 am
  11. melvinram says:

    I haven’t had experience with investors yet but this definitely applies to customers. I’ve noticed that whenever I’ve had a customer sweat details on a contract for hours, it ends up being a painful experience because they are more interesting in finding “gotchas” than getting value for their business. Unless the order size is in the hundreds of thousands, spending hours on a contract usually is a red flag for me. Also, if they decide to as for a little extra right at the end of the deal after everything has been decided, they are going to continue tou00a0negotiateu00a0all the way through their customer life.

    Commented on November 1, 2011 at 2:12 am
  12. Nick says:

    Unless it’s an angel investor spending their own money, the VCs are spending other people’s money and they probably can’t expense various legal fees or other disbursements associated with closing a deal, so it gets baked into the funds. u00a0You should value the deal accordingly and take all of this into account. u00a0Should the VCs be out of pocket for having a lawyer go over something that is to the business owner’s benefit? u00a0It’s a bit like buying a house using a mortgage from a bank and expecting the bank to cover your home inspection fee and property transfer taxes out of their own pocket.

    Commented on November 1, 2011 at 2:25 am
  13. Guest says:

    How does it get accounted in books? Paying a lawyer some fee for having done some work for a (some) VC?

    Commented on November 1, 2011 at 3:27 am
  14. Bill says:

    Interesting post, but those negotiations tell more about the VC than the founder. Most founders raise money very infrequently, many have never done it before, and the company and its employees who are affected by a financing are like their first child so I can forgiveu00a0over protectiveness. u00a0Founders definitely need to know when to drop points but it is at leastu00a0forgivableu00a0for them. u00a0nnVC’s are professionals at investments though and every action should be taken as telling of their future pattern. VCs who want to grind away and take advantage on every point are the people who will not be with the company when the days turn dark…they will be firing management and bringing in a new team or not re-upping in a difficult financing.u00a0

    Commented on November 1, 2011 at 3:30 am
  15. anamax says:

    > It’s a bit like buying a house using a mortgage from a bank and expecting the bank to cover your home inspection fee and property transfer taxes out of their own pocket. nnIt depends on whose legal fees we’re talking about.u00a0 If it’s the VCs legal fees, why shouldn’t the VC pay them?u00a0 Surely they’ve done enough deals with comparable terms that those fees will be minimal….nnIt’s like the garbage fees on mortgages.u00a0 They do nothing but piss off people.n

    Commented on November 1, 2011 at 3:43 am
  16. Russ Wallace says:

    Definitely makes sense to start a business relationship thinking “win-win.”u00a0nnThis post makes me think about a book I read recently, “Venture Deals,” which I think every startup founder should invest in. Would likely make everyone happier once it comes time to discuss terms.

    Commented on November 1, 2011 at 4:27 am
  17. Rob says:

    Wow. I bet you do lots of negotiation.

    Commented on November 1, 2011 at 4:33 am
  18. Russ Wallace says:

    I used to practice law in the Valley, so I totally agree that overspending on lawyers is an issue. But I think the point above was with reference to who pays, not how much is paid. And for venture financings, I’ve never even heard of a case where the VC paid instead of the company.nnAnother thing I’ve never heard was a VC who felt good when their portfolio company had a huge legal bill. It benefits neither party; after a financing,u00a0the VCs are shareholders, so they want the company to use its new cash productively.u00a0So to the extent that legal fees become an issue, both the VCs and the founders should be working together to make the lawyers get the deal done cheaply.

    Commented on November 1, 2011 at 4:35 am
  19. Peter Wang says:

    Either you’re saying nothing, or you’re agreeing with Jessica in the most roundabout way possible.nnOf course both parties in the negotiation can walk away. u00a0That’s tautological. u00a0The original post implied that a founder was wrong or small to negotiate for $10k in legal fees, because that’s “conventional” for VC term sheets. u00a0Jessica merely contested this point, saying (as you do) that it’s just part of the negotiation like anything else. u00a0She went one step further and asserted that most “conventional” VC term sheets are optimized for VCs, and not necessarily for founders. u00a0That is also fairly plausible on its face, since VCs go through way more term sheets than a typical founder, and so they will attempt to homogenize terms as much as possible to reduce their administrative overhead.nnTen thousand dollars is not chump change. u00a0It may be small compared to the size of the funding round, but that’s irrelevant. u00a0(Personally I’d be leery of any businessperson who was so irrational about money as to fall into that perceptual trap.)nnOverall I agree with the sentiment of the original post. u00a0Sharing equity is a long-term deal, and people show their true colors early. u00a0Sadly, most VCs (especially in the highly competitive arena of SV) seem to optimize for deal flow. u00a0Caveat emptor for founders.

    Commented on November 1, 2011 at 5:04 am
  20. ceonyc says:

    Having worked with Rob, I can tell you first hand that he has more charter than just about anyone in the industry–and the founders he works with will tell you that.u00a0 They’ll even speak to his character, too.nnI’d be really careful about questioning someone’s character after one blog post, especially about a topic–venture financing–that clearly you don’t have a lot of experience with.u00a0 I’m not here to debate whether or not 10k for lawyers is fair or who pays them.u00a0 The larger point, which should be obvious, is that there are certain things in a venture term sheet that are standard, and while it may be worth writing a blog post about why or speaking up at an industry conference to get them moved,u00a0 aren’t worth trying to move the industry on during a single negotiation.u00a0 I don’t like paying an extra fee at the gas station for using a credit card versus cash, but I’m not going to brow beat the attendant about it, because I know he can’t change the industry.u00a0 It would be more effective, if I thought it was worthwhile, to take that argument somewhere else.u00a0 nnHowever, if you’re being pragmatic about it–you could also just negotiate for a pre-money valuation of 10k more and raise an additional 10k, so that, effectively, the VC wound up paying anyway.u00a0 As an entrepreneur, you’ve got to focus on what moves the needle.u00a0 Entrepreneurs that do that have greater success, undoubtedly–and seeing what they think moves the needle on a term sheet negotiation is the point that is obviously trying to be made here.u00a0 nnGo Occupy some other VC blog.u00a0 Rob’s not your fall guy here.

    Commented on November 1, 2011 at 10:23 am
  21. Jessica Darko says:

    Right, because I point out this revelation about his character, it must mean I’m not experience.nnThis is exactly the same form of argument he used in his post, the one that revealed his character. You doing it shows that you’re testimony about his character is like a used car salesman telling me his lawyer is has my best interested at heart!nnThis is the thing that you guys don’t get– by insulting me, by insulting the guy who didn’t want to write a blank check to irresponsible people– instead of addressing the issue, you prove that it really is a lack of character.nnIf you had nothing to hide, you’d address the issue, instead of me. nnI have more experience with term sheets than you do, by the way.

    Commented on November 1, 2011 at 6:06 pm
  22. Jessica Darko says:

    Pretty much the definition of violating fiduciary responsibility, isn’t it?u00a0

    Commented on November 1, 2011 at 6:11 pm
  23. Jessica Darko says:

    I love it! It’s in the VC’s interest to not steal too much via legal fees? u00a0nnThe fact that they expect the company to pay, not only their own legal fees, but the VCs legal fees, is proof positive that they do NOT have the companies interests in mind.nnThey’re just interested in taking as much as they can, in every way they can.

    Commented on November 1, 2011 at 6:11 pm
  24. Jessica Darko says:

    nVCs pay themselves directly out of these funds via “management fees”. u00a0There’s nothing to stop them form covering legal fees as well, as a course of business. u00a0The idea that these are sacred funds that cannot be touched is absurd.u00a0nnShould I be out of pocket to have a lawyer go over a document where the VC has put in a bunch of disingenuous and dishonest terms?u00a0nnAlso, consider this– if it were a restriction of the funds, then he’d have just said that. u00a0Instead he just said “for whatever reason its standard”… he doesn’t care about whether its “fair or not”.u00a0nnInteresting that, you’re *speculating* on a justification for this to try and defend the avoidance of giving a reason for doing it. u00a0If he’d given an explanation, I would have never posted anything.nnBut the people who say “these are standard terms” about this, are the same people who will try to rip you off and pretend like its “standard”.nnI’m sure it is, for suckers. u00a0Its no wonder VCs destroy more companies than they make successful… and you pussy sycophants can’t bear to hear someone stand up to them, even when they’re hiding behind an evasion like “its just standard”! u00a0Amazing!nnEither Rob is too ignorant (as he implies) to know why this term is there, or he’s too dishonest to be upfront about it, and instead used it as an excuse to bash anyone who doesn’t just bend over for “the way its always done”. u00a0 Whichever is the case doesn’t matter– Rob is not someone you can trust with money.

    Commented on November 1, 2011 at 6:16 pm
  25. Jessica Darko says:

    When you only deal with ethical people– as I’m advocating here– you don’t need to do nearly as much negotiation.nnYou’re able to focus on the bigger picture, and the bottom line issues, rather than having to go thru paperwork with a fine tooth comb to make sure the other guy isn’t trying to cheat.

    Commented on November 1, 2011 at 6:22 pm
  26. ceonyc says:

    Yes, anyone with the initials C.E.O. who lives in New York is clearly a liar. Thank you for your response… I’m done here and will not be responding further.nn- Charles (Charlie) Eric O’Donnell

    Commented on November 1, 2011 at 8:31 pm
  27. fnazeeri says:

    One of the coolest things I’ve worked on recently was writing a case with Harvard Professor Noam Wasserman on term sheet negotiations. u00a0The idea originated with a blog post I wrote a few years ago and then Noam suggested we dig through his database of over 10K startup companies and their investment terms (we also got input from WSGR partner Yokum Taku). u00a0 Bottom line, the data support much of your anecdotal experiences. u00a0I recommend folks going through the negotiations (particularly for the first time) spring the $5 to buy the case (despite the fact that yours truly doesn’t see any of that money!).

    Commented on November 2, 2011 at 9:02 pm
  28. fnazeeri says:

    The reason has to do with fees and expenses. u00a0If the VC paid the fees, it would not be reimbursable to LPs….so basically the GPs would have to foot the bill (or at least their pro rata part of it). u00a0By having the companies pay the legal fees, the are essentially passed on directly to LP investors and other investors/owners of the company (pro rata). u00a0It’s essentially an economic reason why GPs don’t pay.

    Commented on November 2, 2011 at 9:05 pm
  29. Jeff Giesea says:

    Sitting on the entrepreneur’s side of the table, I agree that it’s important to start a VC relationship with a win-win orientation, shoot straight, and avoid nit-picking. The only thing I’d add is that the signaling works both ways. For ex, if a VC leads with super-aggressive terms on liquidation prefs and anti-dilution, that can send a really bad message the other way. Fortunately, this seems less and less common. Thanks for a great post.

    Commented on November 3, 2011 at 5:58 pm
  30. Deal Lawyers says:

    The article was useful and reminds us that a jerk at the term sheet phase stays a jerk throughout the process.u00a0 The point of the article was not, I would say, legal fees.u00a0 To the extent any of the commentators were distracted by that reference, it suggests that they will in the population of entreprenuers the authors saysu00a0to avoid.u00a0 Remember, lawyers are not the ones creating the big legal bills in most cases; it is usually the people who want to “rewrite the book of convention on every decision he made” as the author says or those who over-promise or over-bombast.

    Commented on November 4, 2011 at 3:15 pm
  31. Jamesmarchington2009 says:

    ‘One founder wanted to negotiate out of having to pay $10K in lawyer nfees.u00a0 Said just because it was always done that way doesnu2019t mean we hadn to do it that way this time.’nnHa! I certainly wouldn’t want to give my money to some tech entrepreneur that challenged convention or tried to save his company $10,000.u00a0 nnI want to know he’s the kind of guy that is a stickler for doing things the way they’re always done and sprays his cash at suppliers and lawyers – not goes around penny pinching for a mere $10,000 and bitching that he risked his shirt to build his paltry start-up from nothing.

    Commented on November 4, 2011 at 7:39 pm
  32. Nikhil Kalghatgi says:

    Thanks, Jeff :)

    Commented on November 4, 2011 at 10:00 pm
  33. Anonymous says:

    Its not $10,000, its $.01 per share. u00a0Any entrepreneur who spends any serious time and energy trying to remove a market term worth a penny a share is more likely to occupy Wall Street with Darko than to be a successful CEO.

    Commented on November 5, 2011 at 1:28 pm
  34. Perpetuous says:

    As much as i’d like to side with rob and you, i can’t.n”This is standard” is just not an acceptable answer. You’re not even answering the points raised but indulging in ad hominem arguments, which anybody knows, are pointless, if not deceptively trying to shift focus and reframe the issue.The analogy at the gas station is fallacious because each deal is negotiated individually, unlike the price paid at the gas station; in other words, there is an opportunity to change a specific term without having to change the industry; the deal maker is not just an attendant without prerogatives.nnI don’t know if VCs have been ripping off startup people for decades as Jessica states (and I doubt they have, to be honest, but I just have no opinion), but the points she raised are valid. And the point somebody else raised about the possible violation of fiduciary duty is valid as well too. So you can state your opinion, say you have no opinion or not answer, but just saying “it’s standard, deal with it” is really not convincing or trust-inducing.nnIn addition “being pragmatic” as you suggested can go both ways – why should it be exclusively at the detriment of one side? Why should the founder take the hit or add 10K in the pre-money valuation and not u00a0the VC agrees to taking the lawyer’s fee hit (he clearly can).u00a0

    Commented on November 6, 2011 at 4:01 pm
  35. Anonymous says:

    The funny thing is, most startups would love to be in the position when they receive a term sheet offer from a VC, let alone to negotiate it — and this is the main reasons why VCs and LPs rule; it is a buyer’s market. But this is true mostly for the seed money or the first round. When a startup negotiates a second round, suddenly everything changes. Suddenly the VCs from the first round are like the founders and every penny not only the “standard” legal fees matter.nnSo, Jessica is correct, it is not a standard or convention; it is who has more leverage and can get more of a deal in a given situation. Startup should be smart and prepared to walk out with the term sheet in hand, of course. Then, go to another VC and start from a different level. Soon you will know for sure if the first VC was impressed by your business or he just thought he’d found another sucker to pay for his overhead.

    Commented on November 13, 2011 at 6:59 pm
  36. Christopher Erckert says:

    I LOVE the boat relocation deal. It hurst to know he even got that far with investors when there are founders out there living in basements and surviving on 99 cent specials seeking just a conversation with investors.u00a0nnThanks for posting this “frank and open” post on the topic.u00a0

    Commented on November 14, 2011 at 7:51 pm
  37. Roham Gharegozlou says:

    It’s so counterproductive for VCs to burn entrepreneurs on the terms, but the same goes both ways.. u00a0As you said it’s a partnership and both sides need to feel well-treated and incentivized to make it happen.

    Commented on November 16, 2011 at 2:51 am
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