171. Key Terms for Founders Negotiating Term Sheets

VC Minute
AJ provides valuable insights on term sheet structures, evolving clauses, and understanding investor motivations. He offers practical advice on managing tight decision timelines and creating negotiation urgency.

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AJ Bruno:

What should the structure of a term sheet look like and of all of the agreements and the voting agreements, so on and so forth.

In 2018, probably to 2022, we had very clean terms that were given to founders. Founders would wake up with term sheets in their inbox. And that did happen from lots of funds that will go nameless. And they had very clean terms.

What does clean terms mean? Well, we have participation rights, and liquidation preferences, and the liquidation stack, preference stack. All of those things are things that you will want to learn about.

Ultimately those terms have somewhat changed and a lot of funds now have their unique, hot button topic.

That term, that hot button term is usually from scar tissue. Somewhere where they along the way had an issue and like, we’re putting this term directly in our term sheet because we mean business. You will have a lawyer flag that, as all good lawyers do and say, “hey, this is a little irregular.” And then you go have the conversation and discussion and just try to figure out what’s the backstory.

What are they trying to solve for? That’s what I ultimately think for any of these terms that are popping up. What is it that the investor is trying to solve for? What are they trying to see differently or happen differently?

Participation rights and the preference stack is something to consider and think about.

In one X participation, which has been part of clean terms, let’s say you raised 50 million and you sell the company for 60 million. Then the investors would get all of their money back that they invested. And then that 10 million is usually split up between the common and the preferred at that point in time.

There’s obviously a lot of caveats and the acquiring company can have earnouts and all of these things. I’m trying to keep it as simple as possible, but they’re just things that as founders you should know.

A liquidity event, when you sell the company, might feel really far off in the distance, but you have to think about those things now.

It’s one of these Catch-22 situations where founders think about liquidity and M&A events all the time, but then they don’t necessarily think about them when they’re getting these terms and what these terms means , because they see the cash and they just want to get the deal signed as fast as possible because that term sheet is a ticking time bomb.

That’s the other thing that I’ll state for founders. You will always see that explosion date of time. And last year that time was like 12 hours. You have 12 hours to decide. Like what? 12 hours? How, how am I supposed to decide a life changing event for the company and myself in 12 hours? I’m not. That’s a term you can push back on for sure.

And no shop clauses, of course, are very common, even still today. And those are basically saying that you can’t take this term sheet and go to a different fund and say, hey, I have this in hand. Of course, the expectation is that you’re going to talk about, I have a term sheet that has an offer, I need to get back to them within the next three to four business days, and we need to talk now.

And so that should be creating a compelling event and create urgency. If you don’t have another term sheet and you’re trying to create a compelling event, I had one founder, his wife was about to have a baby, and so he used that as the compelling event .And it worked.

There’s always different ways to think about life events and what’s going on. Personally, summer might be coming up holiday, whatever the case may be, that you want to have this working backwards timeframe and say, hey, I need to get this deal done by X.

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