Term Sheet Terms Explained
My friend, Dave Broadwin of Foley Hoag, has a blog post today which is the first part of his discussion of venture capital term sheet terms that are worth negotiating over. Dave discusses dividends, partcipating preferred, founder representations, option plan and founder vesting, Board of Directors, and 'drag along'.
Dave's descriptions are clear, and his advice is sound. There are very few hard and fast rules about the structure of terms in a venture deal. Some of this comes down to firm style -- firms tend to like some of these structures, although exceptions can always be made if necessary to win a deal.
The best defense an entrepreneur has is to have options -- alternate offers, or a strategy, perhaps less desireable, that lets you put off fund raising. You can get VCs to make changes to their standard terms if they have competition. In the absence of competition, it could be tough.
One of the best arguments against terms like dividends and participating preferred in a series A financing is that it will probably be in the interest of the series A investor to keep these terms out of later financings when more money comes into the deal. If these terms are in Series A, they'll almost certainly be in later financings.
Dave didn't mention that one pressure that VCs face in eliminating these terms from their deals is the internal partnership dynamics. Although, in theory, everything is negotiable, if a firm normally gets participating preferred and you want it out of your deal, this may make it harder to get the deal approved by the partners who are on the fence. Don't assume that every partner in the firm has done a detailed analysis of the pros and cons of your deal and all the terms. Instead, a reluctant partner may vote No based on something simple like less favorable terms.
I always preferred the cleanest possible deal structure, baking everything into the valuation. Rather than paying a higher price for a deal and compensating for it with fancy terms, it's better to keep the price a bit lower and keep the deal as clean as possible. In the end, this works out better for both sides, particularly as more rounds are raised.
In the end, the best an entrepreneur can do is to understand all these terms and do their best to get the best deal they can. But, it's rarely worth letting a financing fall through because of a stubborn investor on these points.