Negotiating Venture Terms: Two Essential Things to Understand

It’s been eighteen months since you founded your startup. You’ve long since discovered product-market fit, and there’s a steady stream of revenue from customers. You need money to hit that next milestone—launch the upgraded version of your product and scale into new markets. 

When you started, you raised some money from family members, friends, and angel investors, but now it’s time to hit the big leagues. You need to raise venture funding and have received your first term sheet; what should you do? You know you need a lawyer and maybe a financial adviser, but where do you start with this term sheet you have just received? 

This is a conundrum many startups find themselves in, and we hope we can give you two bite-size pointers to help you navigate it.

Ownership & Economics

Shares and valuation are two critical terms negotiated to determine ownership and economics. The number and type of shares will determine how much of your company an investor owns. When there is a windfall, e.g., an exit, these two factors also determine the order of distribution of the windfall, in other words, who gets what first.

Typically, an investor will negotiate to hold a certain number of shares and ask that the shares carry preference rights. Venture Capital investors do not usually own the majority of shares in the businesses they invest in (unlike private equity investors). 

However, they still own enough shares to get a healthy return on investment, usually 7-35%, depending on the stage of the company. The conversations on the number of shares also determine the company’s valuation. Valuation is a topic that deserves an article of its own, so we won’t do a deep dive here. 

For now, you need to note that valuation is the process of determining the company’s worth, which is then used to calculate the number of shares that will be issued and the price at which they will be sold. The company’s valuation is a crucial metric for investors, as it will determine their return on investment. 

In addition to the number of shares, an investor will usually negotiate that the shares carry preference rights. Preference rights imply that when there is a distribution of money in the company, the shareholders that have these rights get their money first, before other shareholders. Other nuances apply to preference shares, like liquidation preference, among other issues, but we will address that in another article. But for now, the things to note are that you and your investor would need to negotiate on the number of shares and preference rights attached to the investors’ shares.

Control & Voting Rights

The board of directors of a company controls the company and makes decisions on strategic and operational matters. Venture Capital investors usually request a board seat or board observer rights. These rights give them visibility into how the company is run. They also get a seat at the table and can influence decisions. When investors have board observer rights and not board seats, they cannot vote on board matters but can attend board meetings.

In addition to general board rights, control is exerted through reserved matters. Reserved matters are specific issues that require the explicit vote or approval of the investors. These are typically significant matters like selling the company, changing the company’s business, and accepting an acquisition offer, among other things.

As a founder, when you get a term sheet, these two essential things are what you want to understand and negotiate carefully. When negotiating, ensure that your goals are aligned with the investors and that all parties leave the negotiating table with terms in the company’s best interest.