Negotiating Term
Sheets
Oregon Graduate Institute
Real World Entrepreneurship
Ted Bernhard
July 26, 2005
Ted Bernhard
• Corporate and securities attorney in Stoel Rives’ technology
venture group
• Law practice focused on representing:
– Venture Capital and Private Equity Investors
– Startup and Rapid Growth Technology Companies
• Prior life:
– Partner with a seed stage venture capital fund called Cascadia
Partners focused on seed stage technology investing in the
Northwest.
– Strategic Consultant with Booz Allen Hamilton in NYC.
• Negotiated, drafted, or been directly involved with well over 150
term sheets over the past 16 years.
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Overview of the Discussion
• Go through the term sheet in the order usually prepared
– Definition
– Underlying Goal of the Provision
– Alternatives
– Recent Market Trends
– Typical Mistakes made in Negotiating
• Negotiating Tips
– Overview of the terms in rough order of importance
– Specific Tips
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Understand the Stage of Your
Company
• Pricewaterhousecoopers MoneyTree definitions:
• Seed/Start-Up Stage - The initial stage. The company has a concept or product under
development, but is probably not fully operational. Usually in existence less than 18 months.
• Early Stage - The company has a product or service in testing or pilot production. In some
cases, the product may be commercially available. May or may not be generating revenues.
Usually in business less than three years.
• Expansion Stage - Product or service is in production and commercially available. The
company demonstrates significant revenue growth, but may or may not be showing a profit.
Usually in business more than three years.
• Later Stage - Product or service is widely available. Company is generating on-going
revenue; probably positive cash flow. More likely to be, but not necessarily profitable. May
include spin-outs of operating divisions of existing private companies and established
private companies
• Match your investors to the stage of your business
– Self
– Friends and Family
– Angels
– Venture Capital
– Strategic Investor
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– Public Markets
Understand the motivations of
your investor(s)
• Venture Capitalist:
– A professional fund organized for maximizing IRR or ROI for
it’s limited partners money by working as hands on investors
– Want highest reward (even if it means high risk) – 45-55%
IRR on each deal
– Expect a large exit via IPO or Acquisition
– Long term investment horizon (funds last 10 years)
• Angel:
– Investing their own money
– Have a passion or strategic interest they are pursuing
– Want to minimize risk, even if it means lower reward
– Different liquidity horizons
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What is a Term sheet?
• An indication of two parties wanting to try to come to an
agreement sometime in the future
• Goals:
– Articulate the basic provisions and terms of a potential deal
that can be used to draft the actual definitive agreement
– Sometimes lock down the negotiations between the
Company and Investors for a period of time
• Risks:
– Company relies on a term sheet before it should.
(Expression of intent – not a deal until the money is the
bank!)
– VC’s risk getting sued by a disgruntled entrepreneur if deal
doesn’t come together
• Can be really dangerous because of the often mistaken
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perceptions that surround them
Term Sheet Overview
C A T E G O R Y IN T E R M W H E R E IT S H O W S U P IN
S H E E T F IN A L L E G A L
D O C U M E N T A T IO N
• T a r g e t c lo s in g d a t e In te rm sh e e t o n ly
( e x p ir a t io n o f t e r m
sh e e t)
• E x c lu s iv it y
• C o n f id e n t ia lit y
d u r in g n e g o t ia t io n s
• T y p e o f S e c u r it y P u rc h a se A g re e m e n t o r
• G e n e ra l T e rm s S u b s c r ip t io n A g r e e m e n t
( N u m b e r , P r ic e )
• R e p s a n d W a r r a n t ie s
a b o u t C o m p a n y
• A tto rn e y ’s F e e s
• D iv id e n d s C o rp o ra te C h a rte r:
• L iq u id a t io n A r t ic le s o f I n c o r p o r a t io n
P r e fe r e n c e (O re g o n )
• R e d e m p t io n C e r t if ic a t e o f
• C o n v e r s io n I n c o r p o r a t io n ( D e la w a r e )
• A n t i- d ilu t io n
• V o t in g
• S u p e r m a jo r it y o r
C la s s V o t in g
P r o v is io n s
• B o a rd S tru c tu re a n d S h a r e h o ld e r s A g r e e m e n t
M e m b e rs ( V o t in g A g r e e m e n t )
• P r e - e m p t iv e r ig h t s
• R ig h t o f F ir s t N o t e : F ir s t R e f u s a l a n d C o -
R e fu s a l s a le m a y b e in s e p a r a t e
• C o - S a le a g re e m e n t
• R e g is t r a t io n R ig h t s I n v e s t o r s R ig h t s A g r e e m e n t
• F in a n c ia l a n d
I n f o r m a t io n
C o v e n a n ts
• D r a g A lo n g D r a g A lo n g R ig h t s
A g re e m e n t
• E m p lo y m e n t R e la t e d • E m p lo y m e n t
A g re e m e n ts fo r K e y A g re e m e n t
E m p lo y e e s • S t o c k O p t io n s o r
R e s t r ic t e d S t o c k
P u rc h a se A g re e m e n t
• C o n f id e n t ia lit y a n d
T e c h n o lo g y
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Who issues a term sheet?
• Like everything else, it’s a function of
relative negotiating power
• Varies by type of financing:
– Venture Capital Financing – the VC’s will
deliver it to Company
– Angel Financing – Often Company will
prepare standard terms and circulate an
offering document and invite people to
participate.
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Things to be careful of between
Term Sheet Signing and Closing
• Expiration Date (may have to negotiate
and decide very rapidly)
• “No Shop” Provisions
• Confidentiality
• Due Diligence (likely to become more
intense)
• It’s not a deal yet!
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Choice of Security –
Convertible Debt
• Convertible Debt + Warrants:
– When used: bridge financing or by angels
– Watch out for:
• bridge to somewhere?
• You do have to repay at a fixed time or lose your company
• Warrants that accumulate over time
– Advantages:
• Additional Security for Investors with upside equity participation
• You don’t have to set a price for your shares and can maintain
flexibility with stock incentive plan and future investment
• Interesting to note that PWC Moneytree doesn’t even include debt
financings as “rounds.” Angels seem to love these types of deals.
• Common warrant coverage ratio is 25% up to 50% in extreme
circumstances
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Choice of Security –
Convertible Preferred Stock
• When used: The “standard” venture capital financing security
• Advantages:
– Equity investment not debt
– Voting rights for investors
– Preferences to investors
– Allows for maintaining low pricing for options
– Familiarity by Investors and their LPs
– Set’s Value for Company
• Disadvantages:
– For investors, they have less ability to pull the plug
– Company can be structured in a way that puts investor
shareholders interests at conflict with founders and
employees who hold common.
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Choice of Security –
Common Stock
• When used: seed and very early stage rounds
• Advantages:
– All for one and one for all (everyone treated equally)
– Simplicity (keep those legal costs down!)
– Low barrier to educate people about them
• Disadvantages:
– VC’s probably have to justify why they are violating common
expectations of Preferred to their LPs
– Can seriously mess up your stock option pricing (FMV or
greater)
– Likely to be unfair upon liquidation in the near term
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Choice of Security
• Typical Negotiating Mistakes:
– Trying to convince a VC to take an angel-
style deal or vice versa
– Treating the advice from any single person
as “the” way to do it
– Making yourself an LLC or a Partnership.
VC’s do not like and are often prohibited
from investing in an LLC because of the
attributes passed through to their own LPs.
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General Terms
(Price, Shares, Valuation)
Recent Market Trends:
Price Change Q1 2005
Price Q1 ‘05 Q4 ‘04 Q3 ‘04 Q2 ‘04 Q1 ‘04 Q4 ‘03 Q3 ‘03 Q2 ‘033
Change
Down 31% 28% 32% 21% 30% 45% 53% 56%
Flat 10% 12% 15% 12% 19% 13% 12% 4%
Up 59% 60% 53% 67% 51% 42% 35% 40%
Most common Negotiating Mistakes:
• Getting too hung up on valuation – it’s just supply and demand
• Failing to take into account who bears the dilution from the
option pool
• Failure to contemplate long term fundraising plan
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Reps and Warranties
• Usually term sheet just says “standard reps and warranties”
• Which means:
• Section 3. Representations and Warranties of the Company
• 3.1 Organization and Qualification
• 3.2 Capitalization
• 3.3 Subsidiaries
• 3.4 Authorization
• 3.5 Valid Issuance of Preferred and Common Stock
• 3.6 Consents
• 3.7 Litigation
• 3.8 Intellectual Property
• 3.9 Confidentiality and Proprietary Rights Agreement
• 3.10 Compliance with Other Instruments
• 3.11 Agreements; Actions
• 3.12 Registration Rights
• 3.13 Title to Property and Assets
• 3.14 Employee Benefit Plans
• 3.15 Taxes
• 3.16 Labor Agreements and Actions
• 3.17 Employees
• 3.18 Related-Party Transactions
• 3.19 Permits
• 3.20 Financial Condition
• 3.21 Insurance
• 3.22 Minute Books
• 3.23 Section 83(b) Elections
• 3.24 Qualified Small Business Stock
• 3.25 Brokers
• 3.26 Environmental and Safety Laws
• 3.27 Disclosure
• Be Prepared – Get your corporate clean-up done BEFORE HAND.
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Dividends
• Definition: The rights to receive dividends (i.e. cash
distributions) from out of the profits or cash flow of the
Company.
• Underlying Philosophy: Investor’s have to get their cash back
somehow.
• The Reality: Except for tax reasons or because the company
has failed, Investors look for a return through a single time
liquidity event (IPO or acquisition) rather than siphoning off a
recurring revenue stream.
• Things to pay attention to:
– Mandatory or discretionary (almost always discretionary)
– Cumulative or non-cumulative (very few cumulative these days)
– Ability to make “in-kind” dividends
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Liquidation Preference
• Definition: The priority scheme of how money that gets paid
upon liquidation to certain groups of shareholders
• Liquidation includes a Merger or acquisition!
• Underlying Philosophy:
– 1. He who puts up real cash gets cash back before others
who didn’t.
– 2. LIFO – he who puts in real cash most recently gets his
money back first.
• Variations:
– Single or Multiple Preferences
– Participation or non-participation
– Capped or non-capped
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Liquidation Preferences
Recent Market Trends:
Liquidation Preferences Q1 ‘05
• Percentage of Deals having a liquidation preference: 50%
• Percentage of Deals having multiple liquidation preferences: 12%
• Percentage of Deals with a particular multiple: 1-2X – 100%; 2x-3x – 0%; 3x –
0%
• Percentage of Deals having participating preferred: 73%
• Percentage of Deals with uncapped participation: 51%
Source: Fenwick and West
Typical Mistakes made in Negotiating:
– Failure to contemplate the “sideways” exit scenario
– Failure to contemplate the cumulative affect of adding the preferences on top of each
other.
– Structuring the deal in a way that in encourages reckless behavior on founders and
executives part
– Remember that while “double dipping” may be the norm now, it is still double dipping.
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Redemption
• Definition: The repurchase of stock by the company
at some time in the future at a predetermined price.
• Common confusion: put (investor favorable) or a call
(company favorable)
• Underlying Rationale:
– Put: if company doesn’t succeed at generating a
liquidity event within a finite period, investors
should have the right to demand to be bought out
– Call: if investor/shareholder is causing harm to
the company, the Company for its long term sake
should be allowed to buy out and get rid of
investor
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Redemption Provisions
• Recent Market Trends
– Q1 ’05 30% of deals; Q2 ’03 40%
Source: Fenwick and West
• Typical Negotiation Mistakes:
– Not making reciprocal
– Investor mistake: capping its upside
– Company mistake: effectively handing over control of Company if
short of cash when comes due.
• Generally avoided these days in VC deals because:
– It puts incredible pressure on cash strapped companies
– Investors (call) don’t want to have upside limited
– Why if it is in there at all should not it be reciprocal?
– Larger dollar amounts involved lead make one time “buyouts” more
difficult
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Conversion
• Almost all debt financings are convertible into common or
preferred stock
• Almost all preferred financings are convertible to common stock
• Conversion is usually 1:1 (unless adjusted)
• Voting is on as if converted basis
• Other things to watch:
– Is interest convertible?
– Can you be converted against your will by a group vote?
– Mandatory vs. Optional Conversion
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Anti-Dilution
• Definition: Provisions designed to compensate current investors
in the event of a future “down” round of financing
• Underlying Goal: Protect Investor from the economic dilution
resulting from future down rounds of financing
• Different Alternatives:
– Full Ratchet
– Weighted Average
– None
– Very unusual: Lock in a particular investor at a fixed
percentage
• Mechanically this can be done by altering the conversion ratio or
by granting additional shares
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Anti-Dilution Provisions
• Recent Market Trends:
– Anti-dilution provisions Q1 ’05:
• Full Ratchet: 9%
• Weighted Average: 87%
• None: 4%
Source: Fenwick & West
• Typical Negotiating Mistakes:
– Spending too much time and effort on this
– Failure to take into account additional complexity
these provisions add
– Accepting a full ratchet for any reason
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Voting Rights
• Shareholders have right to elect directors and
approve all major transactions
• Shareholder’s agreement contractually
obligates people to vote a certain way
• Majority of all shares on an as converted
basis is generally required
• Exception: Special Voting Approval
– Supermajority percentages
– Separate Class Voting
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Voting Rights
• Recent Market Trends:
– In almost all preferred stock deals these days – fairly
standard list of items requiring supermajority(see attached)
– Shareholders agreement is typical in all but the earliest
stage rounds
• Typical Negotiating Mistakes:
– Treating this laundry list as “boilerplate” and just signing off
on it
– Effectively signing away right to influence on future
transactions
– Locking in veto power to specific voting blocks
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Typical Items requiring
special consent
• Protective Provisions: Without the approval of the holders of at least a majority of the
Series A, the Company will not take any action that (i) effects a sale of all or substantially all
of the Company’s assets or which results in the holders of the Company’s capital stock prior
to the transaction owning less than 50% of the voting power of the Company’s capital stock
after the transaction, (ii) alters or changes the rights, preferences or privileges of the Series
A Preferred so as to materially and adversely affect such shares, (iii) increases or decreases
the number of authorized shares of Preferred Stock or increases the number of shares
reserved under the company’s option or stock plans, (iv) authorizes the issuance of
securities having a preference over or on a par with the Series A Preferred, (v) redeems
shares (excluding Common Stock repurchased at the lower of fair market value or cost upon
termination of an officer, employee or director or consultant pursuant to a restricted stock
purchase agreement), (vi) changes the number of directors, (vii) amends the Articles of
Incorporation or Bylaws of the Company so as to materially and adversely affect the rights of
the holders of the Series A Preferred or, (viii) authorizes payment of any dividends,
distributions or similar action, or (ix) authorizes any secured borrowing or any borrowing or
guarantee by the Company of an amount or obligation in excess of $500,000 on a
cumulative basis.
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Board Structure
and Members
• Definition: Board of Directors oversees and
directs all actions of the corporation, subject
only to 1.shareholder votes on major
transactions and 2. Authority they specifically
delegate to executive officers or others.
• Elected by the shareholders annual, unless
staggered terms
• Complete flexibility in terms of number as
long as there is one or more
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Board Structure and
Members
• Most Recent Trends:
– Increasing Number of Independent Board Members,
independent chair
– Smaller, less cumbersome boards (5 members or less until
the later stages)
– More active participation and oversight being demanded
• Typical Negotiation Mistakes
– Trying to keep all founders on the board
– Allowing VC’s to stack the board just because they are
writing checks
– Adding too many board members, too soon.
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Pre-emptive Rights
• Definition: The right to participate in future offerings by the
Company.
• Underlying Philosophy or Goal: Allow all investors willing to
make new investments to participate on the same terms in order
to avoid dilution.
• Alternatives:
– Some countries or states included these as a default
provision
– Most do not, so need to be put into documentation
• Whether or not the rights get hardwired into the agreements:
– Company will almost always want to take the money
– It’s good practice to offer participation to everyone to avoid
future claims of self dealing
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Right of First Refusal
• Definition: The right of either the company or the other
shareholders to purchase that are proposed to be sold by a
founder (or other current shareholder)
• Underlying Goal: Unlike Pre-emptive rights, this is about
maintaining control and avoiding undesirable shareholders.
• Alternatives:
– Have the provision or not (almost always put in)
– Order of the rights (company first or investors first)
• Drawbacks:
– Delays the potential sale; could risk losing buyer because of
the delay
– Makes it more difficult to raise cash quickly when needed
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Co-sale Rights
• Definition: The rights of investors to participate in the
sale of a founder or other shareholders shares to a
third party buyer.
• Underlying Goal: To prevent a founder from profiting
at the expense of the remaining shareholders by
selling his shares at a very high price to a third party.
• Kicks in usually after parties elect not to participate in
the right of first refusal because:
– Don’t have cash
– Purchase price is inflate and don’t want to pay
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Co-sale Rights
• Most Recent Trends: Virtually
ubiquitous.
• Typical Negotiating Mistakes
– Too long of a combined time frame
between ROFR and Co-sale
– Granting the right to others beyond just the
new investors
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Registration Rights
• General Definition: Lock in ahead of time specific contractual
rights that will allow the investors to sell their shares once the
company gets to IPO and beyond
• Typical Rights granted to investors:
– Demand Registration:
– Piggyback Rights
– S-3 Short Form Registration
– Expenses of Registration
– Limits on Future Registration Rights
– Market Standoff (Lock Up Period)
– Termination of Rights
• Can be useful, but more often then not the I-Bankers will do
whatever they want.
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Registration Rights
• Most Recent Trends: Fairly standard these days, driven by very
specific securities laws (Rule 144, 1933 Act)
• Typical Negotiating Mistake
– Getting fed up with the 17 pages of registration rights
language and throwing them out completely
• You probably won’t get the opportunity to get them later
• They really do matter when you try to sell your shares on
the open market and cash out
– Spending too much time haggling with this -- investment
bankers fight hard to keep the selling volume to a minimum
and they control the purse strings at IPO time and therefore
who gets what rights
– Failure to get the company to covenant to keep its SEC
reports current
34
Financial and Information
Covenants
• Most recent trends (fairly standardized)
– Audited annual financials as soon as
Company can afford, maybe sooner.
– Quarterly P&L, Balance Sheet, and Cash
Flow, plus quantitative description of
business operations
– Monthly unaudited financial statements
– Reasonable access to information for
investors
35
Drag Along Provisions
• Definition: Require minority shareholders to
voluntarily cast their vote in favor of that
which is approved by the majority, regardless
of how they would like to vote.
• Goal: Prevent obstructionist minority
shareholders from killing an acquisition or
merger.
• Remember to distinguish from “Tag Along
Rights” (slang for Co-Sale Rights)
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Drag Along Provisions
• Recent Market Trends:
– They exist now and are put in separate
agreements
– Probably more common than not
– 5 years ago, they didn’t exist at all
– Result of a VC market evolving to where
acquisition is the preferred exist, not IPO.
• Typical Negotiating Mistake
– Underestimating the significance of them with a
substantial preferred investor – signing away the
decision to merger or not to the investor without
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recourse.
Employment-Related
Agreements
• In a technology company or a start-up usually, the people are
the most significant asset.
• Common Employment Agreements:
– Employment Agreement
– Options vs. Restricted Stock
– Vesting Provisions
– Intellectual Property Assignment
– Confidentiality
– Non-solicitation
– Non-Compete
• Board Seats for Founders
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Employment-Related Agreements
• Most Recent Trends
– 15-20% of Outstanding Equity Set aside for option pool
– 3-4 year vesting
– Deferred compensation and option accounting rules impact
structure of compensation
• Typical Negotiation Mistakes
– Making IP related documentation (I.e. non-competes) so
oppressive that you can’t attract quality employees
– Failure to adequately motivate employees
• Number of shares
• Vesting
– Failure to articulate who bears the dilution of the Incentive
Pool
39 – Not setting up your capitalization table to make the options
look attractive
A Subjective Prioritization Importance to Frequently
Company/Founders Disputed?
Target Closing date Medium No
Exclusivity High No
Confidentiality during negotiations Medium No
Attorneys Fees Medium No
Type of Security High Yes
General Terms (Number, Price, Valuation) Medium Yes
Reps and Warranties Medium No
Dividends Low No
Liquidation Preference High Yes
Redemption Medium Yes
Conversion Low No
Anti-dilution Medium Yes
Supermajority or Class Voting Provisions High Yes
Board Structure and Members High Yes
Pre-emptive Rights Low No
Right of First Refusal Low No
Co-Sale (Tag Along) Low No
Registration Rights Medium No
Financial Information and Information Covenants Low No
Drag Along Medium No
Emloyment Related Agrements High Yes
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Conclusions and Things to
Remember as You Negotiate
• It’s a gigantic balancing act between all of the moving parts and --
prioritize what you care most about
• Intellect doesn’t carry the day -- It’s a free market (this is capitalism in
it’s purest form!).
– Market forces governs (once you are educated)
– Get multiple term sheets
• Don’t get fixated on valuation.
• It really is not zero sum – the moment the deal is done, you all have
should have very interests in making the company succeed (or else the
term sheet is structured wrong).
• Don’t get emotional
• Don’t get intimidated – the fact that you got a term sheet at all from a
VC is something to be happy about
• Get advice from others who have been through it before
• If you like the people who are going to be investors, just “get the deal
41 done.”
Final Thoughts…
• The “Adversarial” Conference Panel Story
First words out of the entrepreneur’s mouth: “me and X (Venture
Capitalist, the other panelist) have done this three times before
and, by now we could literally hammer out the term sheet for our
next company on a napkin in a bar in15 minutes over a beer.
• The term sheet negotiation should not be painful!
• Behavior is during this process is a really good indicator of what is to
come in the “partnership.” As a VC, I and my partner walked away from
deals where we had “agreed” on the terms just because of the way the
entrepreneur behaved towards the negotiation and us and what it made
us envision what our “marriage” to the entrepreneur for the next 10
years would be like.
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