As managing director at General Catalyst, I meet with 15 new companies every week and will invest in up to four companies a year. With nearly eight years at the firm, I’ve been involved with dozens of investments, from Atrium to Snap.
Needless to say, I’ve seen my fair share of term sheets, and I know how quickly simple mistakes can sink a potential deal during the negotiation process. Hiring the wrong lawyer or getting stuck on a term that really isn’t all that important can slow down or even kill what would otherwise be a great investment.
Here are some ways to avoid the most common mistakes I see.
Only hire experienced lawyers
Lawyers who don’t have experience with venture financings often cannot understand or explain the nuances of the funding process. Why is this a problem?
It’s the inexperienced lawyers who end up pushing for things that just don’t matter — or at least shouldn’t matter to the startup founder. During these early stages, the relationship of trust that’s getting built between the investor and the founder is so important, and having a lawyer who doesn’t get what’s important can create an atmosphere of hostility and destroy the kindling of that relationship.
A good lawyer will focus on the stuff that actually matters. What does that include? Usually terms such as:
- Pre-money valuation
- Post-money valuation
- Size of the equity pool
A good attorney will educate you on the various terms and what they mean from a practical standpoint. Do you care more about control of your company? Do you care about dilution of your equity?
Different founders value different things. An experienced attorney helps founders understand which of the terms can directly influence those things so you are a more informed negotiator.
On the flip side, founders should try to determine what the firm/investor is trying to optimize for no matter the reputation of the firm. The best negotiators can read what the other side wants, and it’s a question of give and take. Make sure you and your attorney understand your true motivations and then think about what motivates the investor in this deal.
The good news is that in Silicon Valley at least, there’s no shortage of lawyers experienced in venture financing.
Keep things simple
Quality in, quality out. If you work with high-quality venture capital firms, the term sheets should be clean with no surprises. It’s often when you engage with less scrupulous investors that you encounter outrageous terms that are outside the norm.
For example, let’s say a startup is raising a seed round. A reputable firm would produce a term sheet that’s only one or two pages and formatted from the Y Combinator SAFE (Simple Agreement for Future Equity) that’s widely used in Silicon Valley.
Know that negotiating within new industries is tricky
If your startup operates within an industry that’s still mostly uncharted territory — the crypto space comes to mind — then that makes negotiating a term sheet much more complicated since there’s very little precedent to refer back to.
In those cases, there’s certainly a learning process for the investors. What’s critically important in these scenarios is to ask around the margins and see which law firms have worked on similar projects. Try to work with them. Otherwise, the legal bills are going to be high given the number of billable hours that will go into basic research of your industry (assuming the law firm operates on an hourly model). The process can be frustrating for both parties.
Avoid inefficient legal costs by sharing counsel
Speaking of legal bills, they can really add up. Historically, companies that are getting financed are required, upon closing the deal, to pay not only for their own counsel but their investors’ counsel as well.
If you have multiple investors who are drawing up term sheets for a startup operating in a new/unusual industry, then you could be facing hundreds of thousands of dollars in legal fees.
How can you avoid this? By asking your investors to share counsel. Rather than each investor retaining their own law firm, there can be a single firm that represents all the investors.
Steer clear of any unnecessary due diligence
If you open Pandora’s Box and, at such an early stage, pay specialists to scrutinize a deal for any discrepancies, you’ll find yourself with a huge bill at the end of it.
Let’s say your startup is in the labor market space, and the investors want to ask a lawyer who’s an expert in that industry what they think about potential legal and regulatory risks. You may want to have a conversation with the investors where you say, “OK, let’s do the due diligence, but let’s try to constrain the problem and understand what basic questions you’re trying to answer. Because if we have to dig really deep and pay countless hours for expert attorneys, that’s not a good deal for either side of the equation.”
It helps to know the motivations for why the investors want the due diligence. Is it because they’re just checking a box? Is it something that they want to learn more about so that they can be more helpful as board members? Given that your lawyers will want nothing more than to rack up more hours, operating with specific goals in mind is key.
Momentum is everything
Whether you secure an investment round is entirely dependent on if you can excite investors, and nothing can drain the excitement from the room like a negotiation going on for far too long. In the world of venture capital, there’s no shortage of shiny objects. And as I mentioned before, a funding round is just the beginning of what should be a long, productive relationship.
There should ideally only be between a 24 and 48 hour period from the time the investor sends you a term sheet and when you finalize it before you sign it. When the term sheet arrives, try to spend some time with your lawyer to identify the top problem, and then ask your lawyer about the best tactics for moving the needle to something you’re more comfortable with. And then you can quickly have that conversation with the investor to reach a compromise.
Remember: everybody wants to see the deal close. Do everything right, get the dollars in the bank, and get back to work.
The best part about my job: working with people who are ridiculously ambitious and eager to build a category-defining company. Helping build great companies is what we’re all here to do. Fundraising is a prerequisite for doing the actual work — it shouldn’t be a blocker.
When it comes to term sheets, focus on what matters and make sure you have good counsel so that you can get back to doing what you do best.
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