When you are out VC fund-raising, getting a term sheet from a VC firm is the crystallizing moment of your relationship with that firm. If you sign it, you are very close to getting the funding. But before you sign it, you need to negotiate it.
Negotiating a term sheet is difficult, largely because you don’t know what the real market value of your company actually is. How do you establish that? The VCs see lots of deals, they know the market better than you do. How can you equalize that position? There is only one solution to this problem:
Unless you have multiple term sheets on the table at the same time, you have no way of assessing what the real market value of your company is. Also: being able to walk away from a deal will put you in a much stronger negotiating position.
Imagine it like looking for a new job. Ideally, you want multiple job offers at the same time, so you can choose the best one. It is the same with VC funding.
The secret to successfully raising funding is that all communications that you have with VCs must lead to a point in time where all the different people give you a term sheet. In the best scenario, you get them all on the same day. If not, then you get them in the same week. Getting them all in the same month is most likely too far spaced apart. In order to be able to receive multiple term sheets at the same time, you have to start talking to VCs at the same time. Ideally in the same week. Pursue VCs in parallel, not in sequence.
For all other aspects of how to negotiate a term sheet, I suggest you visit Venture Hacks. I think the picture below speaks more than a 1000 words about how useful that site is for ‘hacking’ a term sheet, enjoy:
The presentation to all partners in a VC firm wil decide whether that firm will issue you a term sheet. This pitch is just as important as the pitch you give to the one partner that you have been working together with for the last few months, if not more important. However, the emphasis of the pitch is different to the first pitch that you gave. The partner pitch has to prevent the partners from saying NO, not to make them actively say YES.
In order to understand why the partner presentation is so important, you need to understand that most VC firms are partnerships. This partnership, an investment partnership, makes the investment decisions as a group. It is extremely common practice that if one partner is really unhappy about a deal, the deal is not done, regardless of what the other partners think.
So, during due diligence, you have made the partner whom you have have been working together with so excited and confident, that now she is happy for you to present to all the other partners. In a sense, she is now your sponsor in that group of people. Also remember that most of the partners will not be experts in your area. The expert is the partner you have been working together with for the last few months. The others are likely to listen to the opinion of the expert in the group, unless they can find some real flaws in what you are pitching.
So, you and your sponsoring partner will walk in the room and you will get to know all the other partners. The partner who is sponsoring you has already been pitching all the other partners about you several times. They are all pretty agreed that the deal you are offering is very exciting. Your job in this pitch is not to convince them that this deal is exciting. They are already excited. Your only job is not to screw it up at this stage. Your job is to prevent one partner vetoing the deal:
So, whatever you do, don’t do any of the following things:
No surprises. They might not like whatever it is that you pull out of the hat (well, unless it is good news, e.g. “We just closed our first customer” or “The technology works twice as fast and twice as well as we thought”)
Don’t change your pitch. The partners there are sold on your pitch already, never change the winning story.
No unnecessary details. Whatever they are, they might not like them. Keep it simple.
Overall, your job is to give the same pitch, removing some of the finer detail, that you gave to the partner who is now sponsoring you.
Focus your attention on the biggest naysayers. One person who dislikes your deal is enough to kill it. Focus your attention on that person and win her over.
Overall, pitching to many partners is like doing a PhD viva. You have already been doing all your work. Your supervisor has proof-read your dissertation and has submitted it with her approval to her peers for peer review. The peers don’t actually need to love your PhD. Or at least not enough to be happy to sponsor it. But if they dislike it, they will make you go back to do some more work. And you really don’t want to do that.
The same is true for VCs. You really don’t want to fail at this stage, after having gone through all the due diligence.
After a successfull partner presentation, the VC firm is likely to offer you a term sheet, which I will talk about in Part 7 of this series. This article is part of a series, you can find the Index of the VC Fund Raising Manual here.
“Generally, due diligence refers to the care a reasonable person should take before entering into an agreement or a transaction with another party.”
For the hackers amongst you, due diligence is similar to code review, but for companies:
Most deals, M&A as well as investment deals, are done on the basis of several different types of due diligence:
- Commercial: looks at business environment of the company
- Financial: is concerned with the financial forecasts of the company
- Technical: looks at the technology of the company
- Accounting: looks at the accounts (or the financial ‘past’ in other words)
- Legal: looks at legal agreements and legal risks
In a VC deal, the investor would usually conduct the due diligence in the order that I have outlined above. When you are entering due diligence, the VC will clarify who will work on the deal. This is usually a partner who is supported by an Associate.
In a first step, the VC will talk to existing or potential customers, as well as industry specialists about your company to confirm that the company has a strong commercial position. In the vast number of circumstances, a VC will not hire an investment bank to help with the financial due diligence, but she will look at the numbers herself. There will be a lot of questions regarding the business model and the financial forecasts that you will have to be able to answer. Depending on the technical background of the VC, she would either conduct technical due diligence herself, or, more frequently, she would ask an expert in the field (e.g. a professor) to take a look. There will be various requests for documentation from the VC and the technical expert throughout the due diligence process.
Once the VC is really happy with the commercial and financial prospects as well as the technical underpinning of the company, the next step is Full Partner Presentation and if that works well, a term sheet.
It is only after you have signed an exclusive term sheet that the VC will start to conduct accounting and legal due diligence. The reason for this is simply that these two steps are very cost intensive. The VC wants to have the knowledge that they are very close to doing a deal before incurring these expenses. Also, a term sheet has one binding aspect: you, the start-up company, will have to pay the costs of the due diligence when the deal completes. You may not necessarily have to pay the costs of the due diligence when the deals does not complete, but that depends on how well you negotiate the term sheet. To be clear: you will almost always have to pay the VC’s due diligence cost, if the deal completes. Should the deal not complete, then as a minimum, you obviously have to pay your own expenses, but you still may have to pay the VC’s costs, too, even when they end up not investing, unless you have managed to negotiate that part of it away.
Due diligence pre Full Partner Presentation usually takes some 8-12 weeks. During this period of type, you will have some very extensive contact with the VC firm and will be talking to them on a very regular basis (say 2-3 times a week). There may be several meetings with various people to discuss various aspects of the company and the deal.
Overall, this phase is there to solidify the original impression of the parter that this is an interesting deal. The partner is trying to poke holes in your story. It is your job not to let that happen. For you as a founder/manager, this is a great opportunity to get to know the people at the VC firm and understand whether you think you can work with them going forward.
As a side note: I strongly suggest that you use the time during which the VC does due diligence on you to do due diligence on the VC. By far the best way to do this is to talk to current and past CEOs who have taken money from the VC firm. You want to understand how the individuals at the VC firm reacted when the going got rough at a company. Were they supportive or did they just fire the management and put somebody else in? Or when a company received an offer to get acquired for only 2x money invested, how did the VC react? There are many questions like this that will clarify whether the partner and the VC firm in general seem like a good fit.
I suggest you do this when you are in due diligence, as you will have little time to do this in the next phases which are Full Partner Presentation and Term Sheet.