This article is a collaboration between Insignia Ventures Academy and Gunderson Dettmer
Gunderson Dettmer associate Jolyn Ang recently joined Insignia Ventures Academy, Southeast Asia’s first experiential venture capital accelerator to mentor Southeast Asia’s next generation of funders, founders, and leaders.
She led a workshop that was designed to address deal structuring, negotiation, and closing early-stage venture capital investments to help emerging managers and investors sharpen their understanding of what it takes to build and back great companies.
Jolyn, who works with top venture capital and growth equity funds in the region, designed mock scenarios for participants based on different investment theses. These scenarios helped participants consider the types of companies they would invest in and terms that they would prioritize based on the profile of the fund they represent.
We asked Jolyn to explain the role the term sheet plays in investment negotiations.
What is a term sheet, and why is it important to create a clear term sheet that evaluates the fund and the company?
Jolyn: The term sheet is the playbook for any venture financing and the negotiations that follow. It’s a non-binding agreement that acts as the foundation for the definitive documents and ensures that the founder and the investor are aligned on the key terms. When there is clear commercial alignment, it will be easier to draft the definitive documents, and often the time taken to negotiate them will be shorter.
There isn’t a one-size-fits-all solution for term sheets. A term sheet that works for a company in Series A may not work for the same company in Series D, E, or later rounds. A good term sheet should meet the needs of both the company and the investor. You need to understand the company’s stage of development, where the business is located, what the goals are for the current fundraising round, what the investor’s objectives are and what they have to offer. You can then create terms that suit both parties.
Good legal counsel is essential to help parties negotiate these various factors and make sure all the relevant details are captured.
Which important terms should investors know?
Jolyn: From an investor’s perspective, the business teams often focus on headline commercial terms. They spend their time working out a proper valuation, thinking about the dilution in the round, how much they want to have of the company’s post-money and capitalization. However, investors should know that the legal terms are also important and are there to protect them as they enter into a new investment. This protection is mainly on two fronts.
First, there are key terms that are meant to protect your economics. These would include liquidation preference, anti-dilution, and conversion.
Liquidation preference, in a nutshell, tries to protect your downside risk by giving you priority to redeem proceeds over the common in a liquidity event.
Anti-dilution aims to protect your ownership percentages in the company if funds are raised at a lower valuation in the future.
Conversion rights allow holders of preferred stock to convert it into common stock. Investors must be careful about what triggers automatic conversion as you lose all the above-mentioned protections attached to preferred stock upon conversion.
The second part concerns governance rights, which set the governance framework for your company. As an investor, you want to be a good partner to your portfolio of companies and create a good working relationship with management.
Governance rights set the rules for that relationship. Some investors may want to be consulted more with management decisions, while others just really want to be kept in the loop but are fine to give management more autonomy.
Of the various governance rights, information rights are vital for most investors as they are essential for investors to check if the company is on the right track. Protective provisions also ensure that the investors are consulted before management makes important business decisions, and investors who want to be more involved with management would typically negotiate for board or observer seats.
What are some best practices for negotiating legal terms?
Jolyn: During the workshop, participants were asked to role-play as one of three investors – each with a different investment thesis – and choose a startup to invest in based on how it fits their assigned characteristics, then negotiate terms based on these characteristics. I wanted to illustrate why it is paramount to know what the characteristics of the fund are when negotiating legal terms.
I’ll give an example here. An early-stage fund that invests mainly in seed and Series A financings is likely to approach liquidation preference rather differently from growth equity funds and strategic investors who participate in late-stage and pre-IPO rounds.
For early-stage funds, a stacked liquidation preference – where later series of preferred shares have priority over earlier series of preferred shares – may not be beneficial because very quickly, you could find yourself at the back of the queue.
However, if you are a growth equity investor who invests at a later stage, you may be confident that you would continue increasing your stake in and leading rounds at far higher valuations in the future.
If you are a strategic investor, you may have plans to accumulate shares and acquire the company. A stacked liquidation preference could be helpful for these types of investors to protect the downside risks in the later rounds.
Another good practice is to always keep an eye on the future. Everything you do in the early financing rounds sets a precedent for future rounds. Even if something makes sense in the early rounds, we encourage clients to consider an alternative solution that can grow with the company instead of quickly becoming obsolete.
For instance, if board seats were negotiated with investors, we would encourage board rights to lie with a certain class of investor instead of individual investors and encourage founders to think about burn-offs so that only your key investors remain on the board.
Conversely, on the investor side, you would want appointment rights for founder board seats to remain with founders currently providing services to the company to avoid any dead-hand issues.
What makes a term sheet investor-friendly or company-friendly?
Jolyn: Taking a binary approach to a term sheet is typically ill-advised; it’s not a winner takes all situation. The term sheet, which is like a prenup, allows you to work out what’s truly important to both the company and the investor, then agree on common ground. It’s similar to a marriage, so the ideal relationship should keep both parties happy.
Terms that are usually seen as investor-friendly can be company-friendly in certain circumstances. For example, it’s considered investor-friendly for investors to have governance rights because it gives them more control and oversight, but from the company’s perspective, it’s not just about whether investors have control and oversight; it’s about which investors have control and oversight.
In the early rounds, investor board seats could be viewed as being unfriendly to the company as it reduces the control that founders have over the board. However, in later rounds, when companies start taking investment from strategic investors, early-stage financial investors can become powerful allies to the founders in helping to counter any unwanted selfish behavior by strategic investors. They can also provide a different perspective as the interests of early-stage financial investors are often not fully aligned with strategic investors.
So instead of asking if something is investor-friendly or company-friendly, we think that more important questions to ask are: What are we trying to achieve here? What is the stage of the company? What do both parties truly care about (which goes back to knowing the characteristics of the fund, as mentioned earlier)? Then, get your lawyers in to make sure that the term sheet and legal terms are customized to the situation.
In summary, what are the key takeaways?
Jolyn: Term sheets signify the start of a long-standing, working relationship between a company and its investors. It can be an exciting moment for the two parties, especially when the terms are agreeable on both sides. Understanding your position and breaking down the key terms to understand the other party’s position to create a fair and equitable term sheet will allow the relationship to prosper for huge wins and returns down the line. Legal representation can be essential to gathering all the affirmative details to crafting a solid term sheet.
About Gunderson Dettmer
Gunderson Dettmer has more than 400 lawyers singularly focused on the global venture capital and emerging companies ecosystem, across ten offices in key venture markets throughout the world, including Silicon Valley, Ann Arbor, Austin, Beijing, Boston, Los Angeles, New York, San Diego, San Francisco and Singapore. The firm represents more than 2,500 venture-backed companies and over 450 of the world’s top venture capital and growth equity firms, with thousands of their underlying funds.
About Insignia Ventures Academy
Insignia Academy is Southeast Asia’s first experiential Venture Capital ‘VC’ accelerator to nurture the next generation of leaders, investors and entrepreneurs. Led by world-class VC and industry leaders, our 12-week immersive program is designed for aspiring venture capitalists, investors, fund managers, and ambitious founders where individuals will get to participate in investment committee meetings and invest in real-life businesses.
Individuals looking to break into VC will be given the opportunity to gain high quality investment experience through deal sourcing, conducting due diligence, navigating capital structure, participating in weekly investment committees, making 1-2 investments, and sharing in the financial upside on select deals with Insignia Ventures Partners. Join Cohort 3 starting this March by applying here.