Negotiating Terms with a VC

Dave Valliere, Ryerson University

Congratulations - you’ve successfully landed a venture capital investor who is interested in providing capital and assistance to help you expand your business. All those weeks sweating over business plans, honing “elevator pitches”, and shmoozing at investment fairs have finally borne fruit. Naturally, it is a “smart money” investor who is going to provide additional value in the form of management expertise, assistance, and access to networks. But ultimately the deal comes down to the structure of the financing, as detailed in the multipage Term Sheet the investor has just presented to you.

First off, you need to understand what all those clauses are for, and which ones you need to pay special attention to. Secondly, you’ll need to know the counter offers and arguments you can make to negotiate terms that are to your liking, but still have a reasonable chance of being accepted by the VC investor. Here is a quick primer on some key terms and issues. Remember, you will also need competent legal advice in negotiating a contract of this importance. So don’t rely solely on this.

Issue to be Negotiated	VC position	Entrepreneur position
Amount	Take enough money so you can concentrate on building the business, not fundraising. Use your most pessimistic estimate to get to the next major milestone, and add 3 or 4 months additional cash burn. Take that much money now.	I’d love to not be permanently fundraising. But on the other hand, it’s so diluting to give up a lot of equity so early on. But if I run out of cash before making the next milestone, I’d be in a really weak position.
Valuation	Naturally I prefer it low, so my money buys a large share. But also so we leave something on the table to attract the other future investors. I’d hate to see us starve in the future because you were stingy now. Why don’t you suggest an initial number, which I’ll adjust based on my comfort with your assumptions and my experience with financing strategies.	Naturally I prefer it high, so I don’t have to give up some much equity. I already have a financing strategy in mind. Here’s a proposed valuation based on my most optimistic forward sales and the price-to-sales ratio of my most successful competitor.
Share Class	I want preferred shares so I can have liquidation preference in case the business fails, and be convertible so I can get out cleanly at the IPO.	Not a problem, we plan to set up a different share class for each round of investment.
Dividends	My shares will have a cumulative X% dividend, which I expect the Board to never declare or pay out. It’s there only so if the business fails, I get paid my accumulated dividends, and therefore am guaranteed at least some very modest rate of return on my investment. That’s only fair since I’m investing cold hard cash.	If your rate is too high, there will be nothing left over for us common shareholders. And if you wanted a guaranteed return, why not just lend us the money as debt?
Conversion	I want the right to convert to common shares 1:1 at anytime. On most shareholder votes, I’ll have the same voting rights as common shareholders.	Good. We’re all in the same boat together, and our interests are aligned.
Liquidation Preference	If the business fails, I get my initial money back, plus any accumulated dividends, before I convert to being a common shareholder. If you are in a weak bargaining position, I may try to get double my money back before the common shareholders get any.	If you get preference, then why should you also get to convert and participate with the common shareholders in the leftovers?
Anti-Dilution	If the next future round of financing happens at a lower price, then it means I’ve paid too much this round. I shouldn’t be penalized for being nice to you on the previous valuation. Let’s agree we would reprice my previous shares at the new lower price. You could issue me more shares, or we could simply adjust my conversion ratio so I get more common shares upon conversion.	But I don’t get a reciprocal right if it turns out you paid too little? How about we compromise and we reprice your shares at the weighted average share price for the two rounds? That way, you get repriced only to the degree you are willing to step up with more cash in the second round of financing.
Veto	On most things I vote like a common shareholder. But some things are crucial to me, so I want veto over them. Here’s my initial list of things that can prejudice my ability to make a good return on my investment.	At some point, your veto may interfere with my ability to manage the business. So let’s take a few things off your list. Also, if you ask for too many vetos, you don’t run the same risk as us common shareholders, so you shouldn’t get to participate after your liquidation preference.
First Refusal	I get the first right to make any future investments in your company.	Good, I want you in for the long haul. But only if you can match your competitors’ best deals. If you are not competitive, I can go elsewhere.
Co-sale Piggy Back	We’re in this together. My money input is to help the company grow, not to finance someone else’s money withdrawal. I don’t want any other investors (including the entrepreneur) pulling their money out, without me getting the opportunity to get out too.	Okay, but let’s make it discretionary on your part. So, if I can convince you I have a valid need for some cash, you won’t automatically pull the plug.
Drag Along	If I arrange a purchaser for us, and most shareholders are happy to sell, no lone minority shareholders can put up roadblocks.	I know you need your exit. But it’s my baby, so any sale will require both of our approvals. And what if I want to sell, and you don’t?
Forced Liquidity	I do need my exit. If you stall it too long, I want the right to force the issue, through a committee of the Board that makes a binding recommendation re IPO or sale of the company.	But you can’t force it unreasonably quickly. Let’s discuss the minimum timeframe.
Break Fees	I’m already out of pocket, and this is meant to be a binding deal. If you walk now, you pay my expenses so far.	Hey, I’m out of pocket too. You should consider that your Cost of Sales (and build it into your prices). Will you pay me a break fee if the financing doesn’t close on your account?
Work Fees	I’m about to spend serious effort in Due Diligence, for which I want to be paid. And no, it isn’t built into my prices – my competitors don’t build it in either. And anyway, it would have made the valuation negotiations too confusing.	It’s not an unlimited tab you can run up. You have to clear major expenditures with me. And you have to stay within a guaranteed maximum that I can afford.
Conditions Precedent	The final hurdles. You guarantee the truth of key things you’ve told me, and agree to put some critical protections in place. This deal is binding, except I can get out if: - my Investment Committee says “no” (very rare) - Due Diligence uncovers a problem you haven’t been frank with me about (so I lose trust in you) - There’s a material adverse change in your business (such that it’s no longer what I think it is now)	I’ve been straight with you. Let’s close this deal. How soon can you issue the cheque?