How to Negotiate a Term Sheet
You are about to enter into a contract. Knowing how to negotiate the term sheet might seem daunting, but a little preparation can go a long way in closing the best deal.
Perhaps your pitch to a venture capitalist led to expressed interest to fund your start-up. Maybe you are working with a consumer goods firm that wants to license your patented invention, manufacture and distribute it. There are many scenarios involving contracts and many variables to consider. These considerations will eventually be captured in the form of a legal contract, but contracts are not written from scratch. They begin with term sheets.
What is a Term Sheet?
A term sheet is a pre-writing tool legal professionals use to build the outline for a contract they are preparing to write. It is a non-binding list of bullet points detailing the negotiable elements of the future contract. When the term sheet is signed, or executed, it is forwarded to the legal experts who will then convert the term sheet into a more complex legal document, the final agreement, or what is typically referred to as a contract. The agreements you negotiated on your term sheet are not binding until the contract is signed.
The Art of Negotiation
Negotiation is all about preparation and evaluation. Figure out your targets, what you want, and figure out theirs. Two experienced parties in a negotiation will usually derive at what we all know as the win-win scenario. You however are out to get the best deal possible for yourself. You are perhaps up against a venture capitalist who has done this same negotiation over 100 times before. To level the playing field you will have to prepare.
First, it is highly recommended that you hire a lawyer with experience in your field of venture. Like hiring a real estate agent, this professional should have knowledge of the particular marketplace for what it is you are selling. Having a grasp on what the market is willing to pay for your venture or patent will help you begin to consider what your negotiable and non-negotiable items are – your targets.
What do you want? What are you willing to give up for it?
Focus on how much you are willing to forfeit on the negotiable items. For example, in a patent licensing agreement you might demand no less than five percent revenue per unit. You are willing to give up the rights to your patent for anywhere between ten and fifteen years, but you prefer ten. This gives you five years of space to negotiate on the term. Simplified, your rock bottom offer is five percent, fifteen years. Your target is five percent, ten years. Now your objective is to get a deal as close to your target as possible.
Negotiations take time, so along the way you might uncover information about what is important to the other party. In the venture capital space, many new entrepreneurs want to focus on valuation, or how much stake in the company they relinquish to the investors in exchange for the funding. They tend to only want to listen to the conversations on this topic.
What most entrepreneurs fail to realize however, is that many venture capitalists are keenly interested control, the rights their shares provide. Venture capitalists do upwards of 20 to 30 deals a year. They have a pretty good idea as to what your venture is worth on the very unpredictable start-up market. What they do not know, nor what anyone knows, is how successful the venture will be. For this reason, venture firms are very interested in how much control they get. That way, if they need to step in as managing partner or worse yet, liquidate, they have their own interests in mind. Given the volatility of their business, control is important to them. What is important to you is money, but remember, they already have plenty. What they want to negotiate is control. So as a start-up, consider your price, stick to it, and negotiate around the control and the rights attached to the preferred stock. That is your bargaining chip.
The best term sheet for you, no matter what kind of agreement you are preparing to enter will always come down to understanding your targets and theirs. During negotiations both parties will attempt to lean the deal towards their own targets. The better you understand both what you want and what the other party probably wants is the path to successful negotiation for you. Information is key, so preparation and evaluation are of utmost importance. Along the way, listen. Fill in as many information gaps as possible.