» Venture Capital Term Sheets – The Mumbo Jumbo

Understanding the core principles of a Venture Capital deal can be quite the challenge.   For starters, you need to know that VC money can be smart money but its real expensive money too.

There are different stages of funding but today I’m going to be discussing an early stage term sheet.  Also, you need to know that east and west coast deals work differently.  West coast deals seem to have better terms than East coast – this is primarily due to the investment banking type of mentality you find in places like New York and Boston.   First question that probably comes to mind is why shouldn’t I just get west coast funding?  Well, it’s not that easy, West coast VC’s tends to want to have you in their backyard.  So unless your geographical located in Silicon Valley, this will be a challenge.

The most common mistake entrepreneurs commit is that they get completely blinded by a valuation and forget about the terms.  Whatever you do, make sure you get a good lawyer that knows about these things.  If you have a friend who’s already been down this road, don’t be afraid to ask them for a referral to their lawyer.

The most obvious point – if you need money, they’ll know it and the VC firm will try to lock you down so you don’t shop the deal.  Be careful, because it isn’t uncommon for them to change the deal more in their favor before closing it – yes, it’s kind of a bait and switch tactic.  With these types of situations, you always sit better when you don’t need the money.

There are a lot of components to a term sheet but if you can understand the following terms, you’ll be in good shape.

Valuation – this is the obvious one that everybody knows.  Try to get the highest valuation as long as it doesn’t sacrifice the other the terms.

Dividends – the thing to ask for is no dividends.  VC firms, especially on the East coast, will try to negotiate dividends that are cumulative and compound over time.  They accrue from year to year until there is some sort of liquidation event.  So let’s say you give up 30% of the pie – if you don’t sell your company for 10 years, you might find yourself in a situation where they now own 90% of the pie.   Be extremely careful of the dividends, they can really effect what you ultimately get.

Liquidation Preference – in a perfect world you want to ask for 1x non-participating.  Typically, venture capital’s will want to ask for 1x or 2x participating.  Let’s assume a venture capital firm invests $10 million for 20%.  1x participating would mean that they get first 10 mil out and then 20% of whatever is remaining.  It’s kind of like double dipping.

Antidilution – the standard for this term is generally weighted average.  This basically means that if the economy takes a downturn after you receive financing, you can go out and raise a down round at a lower valuation then the first.

There’s obviously a lot more to it than these four terms but if you understand the basic fundamentals of what a VC is looking for, you won’t get taken advantage of and hopefully you’ll sit in a much better place.

One last thing – don’t let some VC firm impress you with a few successes.  You need to find out which companies they financed that ran in to some trouble along the way.  How were those companies treated on that bumpy road?