12 Nov Term-sheet etiquette and other rules of capital raising
Good entrepreneurs learn the ins and outs of venture capital term sheets before entering into term sheet negotiations (a good place to start is the annotated term sheet available from the National Venture Capital Association). Just as important, but often overlooked, is the etiquette of the term sheet negotiation: who should present the first draft of the term sheet, and when? Should a term sheet be given to anyone that asks for one? Should you include it in the initial investor package?
A good starting point for approaching term sheet etiquette is whether the term sheet should be included in the selling document. Rule #1: In general (and all of the ideas offered in this column are subject to rule-proving exceptions), if you are using a private placement memorandum (PPM), you should include a term sheet in the package. If you are using a business plan, you should not include a term sheet in the package. Which, of course, begs the question: when should you use a business plan and when should you use a PPM?
Which brings us to Rule #2: If you are approaching less sophisticated and/or experienced individuals (let’s call them “Widows and Orphans”), you should use a PPM, and it should include a term sheet. If you are approaching professional venture capital investors (“VCs”) or sophisticated, experienced and wealthy amateur investors (let’s call them “Angels”), a business plan, sans term sheet, should suffice. So, know your audience, and plan accordingly.
So, let’s say you are going the business plan route, and will be approaching VCs. Rule #3: Don’t presume to offer a VC a term sheet on your own initiative; VCs almost always want to decide when it is time to talk terms, and want to do the honor of providing the first draft. Entrepreneurs that presume to present term sheets on their own initiative to VCs, whether in the business plan or otherwise, are sending a not-so-subtle message that they just don’t know how the VC game is played.
Business plan route
Now, let’s say you are going the business plan route, and targeting angel investors. While angels seldom insist on seeing a term sheet in the business plan, they often look to the entrepreneur to take the first shot at the term sheet, and may ask for it prematurely (more on that in the next paragraph). So, Rule #4: when targeting angels, the entrepreneur should have a draft term sheet ready at hand when needed.
The different expectations of VCs and angels regarding the timing of and responsibility for presenting a term sheet can be a problem for entrepreneurs, a problem that is further complicated by the difference between “lead” and “follower” investors. Leads make deals happen, while followers come along for the ride. Lining up followers is fun, but unless and until you find a lead, you’re not going to see any follower money. Which leads to Rule #5: Don’t negotiate a term sheet with a follower – whether a VC or an angel. At best it is a waste of time and effort, and at worst it can complicate the subsequent negotiation of the term sheet with a lead, who will invariably want to negotiate the term sheet him or herself. It’s part of the job description for a lead.
A final complication: VCs almost always require substantially tougher terms than angels, even in the (rare) case where their valuation expectations are comparable. As a result, a term sheet negotiated with an angel will likely be more pro-company than a term sheet acceptable to a VC. So much so, that an entrepreneur who proposes a term sheet negotiated with a friendly angel as a “done deal” to a VC will, once again, be sending the “I haven’t done this before” message to the VC.
So, Rule #6: Don’t negotiate a term sheet with an angel if you think you are also going after VC money, unless the angel indicates that it is interested in leading the financing and you conclude that the angel is in fact a qualified and credible lead for the financing – with or without VC participation.
Now I know what many of you entrepreneurs are thinking. What do you say to an angel (or, less likely, a VC), who asks for a term sheet but is not a willing and/or qualified lead investor? Simple. Just say no. Actually, say no, but qualify your answer. Tell the prospective investor that you will not negotiate the term sheet until you have a credible lead.
Now, if a follower (and that’s what every prospective investor is until they affirmatively say they are interested in and capable of leading) still wants a term sheet, ask them if there are specific issues that they are concerned about – typically valuation. While you don’t want to negotiate valuation with anyone but a lead, it is okay, if pushed, to assure the investor that your valuation expectations are reasonable (assuming they are).
Say something like “while we will negotiate the valuation when we identify a lead investor, we are reasonable people, and depending on who the lead is, what they bring to the table and market conditions, we figure the pre-money will be somewhere north of $X and south of $Y.”
If that doesn’t satisfy your prospective follower, it’s time to ask yourself whether this particular investor is really an angel, or just a Widow/Orphan with a bank account and an ego. In either case, it’s probably time to refocus on finding a lead.
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