14: Term Sheets & VC Negotiations
14: Term Sheets & VC Negotiations
NOTE: Please read the assignment carefully. This assignment is different from our typical Tuesday class. If you encounter unfamiliar terms when reading the financial aspects of our case studies and related articles, there are useful glossaries of related terminology available at http://www.investopedia.com/dictionary/ and https://pitchbook.com/blog/private-equity-and-venture-capital-glossary and https://www.cooleygo.com/glossary/.
Our focus for today's class is Term Sheets. This class builds on our discussion of the Venture Capital Method and shows how the terms proposed and agreed to in venture capital investments serve to protect investors (and occasionally, entrepreneurs) from the uncertainty and risk inherent in hi-tech ventures and investments. The assignment has three parts:
- Required readings/video (plus optional readings that you may find useful)
- VC Negotiation Exercise - Preparation (prepare and submit as an individual prior to class)
- VC Negotiation Exercise - In-Class Negotiation (done in teams in-class)
REQUIRED READINGS/VIDEO
Review the article, “You Can Negotiate with Venture Capitalists” (HBR #87207) . The article is rich in content, though the tone is overly adversarial with respect to the investor-entrepreneur relationship.
As you study this article, think about the following questions:
- The three most important issues when structuring transactions between venture investors and entrepreneurs are generally regarded to be valuation, type of securities (i.e., preference), and control. What should the entrepreneur realistically hope to achieve in each of these elements?
- What additional elements are likely to be included in the structure of a venture financing package? To what extent should the entrepreneur be concerned about these elements?
- What provisions will venture investors likely require with respect to their ability to cash out when they feel the time is appropriate? To what extent, if any, are these of concern to the entrepreneur?
- What are the potential areas of conflict of interest between entrepreneurs and venture capitalists?
- How can you build trust in the relationship between entrepreneurs and venture capitalist?
To allow more time for our in-class negotiating exercise, I have recorded a 16-min introduction to Negotiations lecture. Watch the Negotiating Skills video lecture to learn basic principles of effective negotiations (video is available on Canvas under “Class Recordings”).
Finally, read The Importance of Various Terms on a Venture Capital Term Sheet. Peter Wendell of Sierra Ventures. This document provides insight as to which terms are negotiable and which are standard and basically not negotiable. This reading will be particularly valuable in helping you focus on preparing for your negotiation assignment and in-class exercise.
OPTIONAL READINGS:
The following readings are not required for the assignment or class discussion. However, you may find that they help you better understand term sheets and the complex relationship between founders and investors.
The article "Founders, don’t trust your venture capitalists… or should you?" provides an interesting perspective on the VC-Founder relationship and trust. Open the “Venture Capital Term Sheet” folder under Files\Readings and study the two related documents, and Concepts in a Venture Capital Transaction by the Cooley Godward law firm Then, study how the several term sheet issues raised by these three sources are addressed in the sample Benchmark Term Sheet, National Venture Capital Association Model Term Sheet, Kleiner Perkins' 1-page term sheet, and Fox Rothschild SAFE.pdf also posted in this folder. From your perspective as an entrepreneur in search of funding, does this Term Sheet appear reasonable? Which terms do you feel are most important and would be central to your negotiations?
VC NEGOTIATION EXERCISE
Review the following instructions carefully and then submit a brief (1-page negotiation strategy) together with your completed cap table. We will use this information to conduct our in-class negotiation.
The in-class, team exercise is intended to reinforce the principles and calculations of venture investing through a negotiation exercise. Prior to the exercise, participants should be familiar with the following concepts:
- Revenue, earnings, runway (for ventures)
- Investment strategy, ROI, returns (for early-stage investors or funds)
- Accelerators
- Pre-Seed, Seed and Series X funding rounds (where X is a designated letter indicating sequence)
- Priced versus unpriced investment deals
- Simple Agreement for Future Equity (SAFE) and convertible debt (or convertible note)
- Founders, common, preferred, and participating preferred stock, including liquidation preferences
- Pre-money and post-money valuation
- Discounts and valuation caps
It may be helpful, but it is not necessary, for participants to understand generative AI (or any other technology mentioned). Instead, focus on the background and plan for the venture as well as the terms of the investment proposal(s).
This exercise has three different roles: entrepreneur, investor 1, and investor 2. Your study team is assigned a specific role; however, to prepare for the in-class exercise, EVERY student should do the following (NOTE: all content on Canvas):
- Watch the Negotiating Skills video lecture to learn basic principles of effective negotiations
(video is available on Canvas under “Class Recordings” - Review the Venture Overview document,
- Become familiar with the Cap Table Template (Excel XLSX file)
- Review your role-specific supplement(s). Teams assigned to each role will have the following additional document(s) sent via Canvas email:
| Teams | Assigned Role | Documents |
|---|---|---|
| 1,2,3 | Entrepreneur | Entrepreneur Supplement, Investor 1 Supplement, and Investor 2 Supplement |
| 4,5,6 | Investor 1 | Investor 1 Supplement |
| 7,8,9 | Investor 2 | Investor 2 Supplement |
PLEASE DO NOT SHARE INFORMATION WITH CLASSMATES ASSIGNED DIFFERENT ROLES. The in-class exercise will have five (5) key elements:
- Intro & discussion term sheets (15 min)
- Team Role preparation – create your team’s negotiation plan based on discussion of your individual preparation (15 min)
- Negotiation – teams engage and negotiate (30 min)
- Prepare final deal – summarize parties and terms of negotiated deal (15 min)
- Debrief and discuss learnings (15 minutes – next class)
Times are estimates.
REQUIRED INDIVIDUAL ASSIGNMENT DUE:
DOC/DOCX: Please prepare and submit a 1-page negotiation strategy. You should include negotiation objectives, must-haves (non-negotiables), bargaining points, and walk-away values. There is NO ESSAY due today, only the 1-page negotiation strategy.
XLS/XLSX: In addition, all participants should complete the cap table based on your assigned role – entrepreneurs calculate values in a cap table for each investment proposal, and investors calculate values in a cap table for only your own investment proposal.
As in real-life, entrepreneurs should not share specific terms of one investment proposal with another investor to negotiate a better deal. However, you may certainly negotiate a term sheet based on the knowledge you have of multiple offers. To maximize the learning from the exercise, please do not share specific details of supplements across roles.
Prepare and submit your notes and cap table individually based on the following assigned roles.
If you are in study teams 1,2,3, prepare from the perspective of the Entrepreneur. Identify those terms that are most important to you and how the offers vary.
If you are in study teams 4,5,6, prepare from the perspective of Investor 1. Be prepared to defend your terms sheet and explain the rationale for your terms.
If you are in study teams 7,8,9, prepare from the perspective of Investor 2. Be prepared to defend your terms sheet and explain the rationale for your terms.
Rubric
Some Rubric (9)
| Criteria | Ratings |
|---|---|
| Terms: Thorough review and explanation of terms and if appropriate, comparison between term sheets | 4 pts |
| Nego Positioning: Clear summary positioning and which terms are negotiable – varies depending on role | 2 pts |
| Nego Process: Suggestions on how to negotiate with clear indication of must-haves, bargaining points, and walk-aways | 2 pts |
| Cap Table(s): Cap table calculations | 2 pts |
| Total Points: 10 |