Feeling Nibbled

In the home stretch to close an equity financing round for an early-stage startup, it can start to feel like each refining interaction is just another hunk of flesh nipped away. The key to navigating this stage is never to take your eyes off your goals or let your emotions get the best of you.

Someone once said that the best deals are when both sides feel they have given more than they wanted. If either side feels they have unilaterally “won,” it is likely not a properly balanced transaction. While the anatomy of the terms of a funding round is far too complex and situation-specific a topic for a blog post, the feelings that play out when doing early-stage fundraising as a founder/startup CEO seem to follow some common patterns.

You work terribly hard to build a business with an associated fundraising story that is high potential enough to attract sophisticated venture capital investors. This takes many months of hunting, enduring seemingly endless “no’s,” and alternating waves of hope and despair.

And then, one day, someone actually gets the vision that you are painting. They get excited and start asking questions. The conversation progresses, and they get others involved to take a look. Due diligence progresses. They begin to signal that they are interested in leading an investment in your company. In an ideal world, multiple potential leads emerge simultaneously, allowing you to have the negotiating power benefit of choices.

Your breath catches when the VC partner, who has been your primary contact, conversationally suggests the broad outlines of some terms to gauge your reaction. Assuming you are familiar with fundraising terminology, you furiously try to grasp what they are suggesting and figure out how you should respond to signal that you want to keep moving forward while also nudging gently on whatever the most problematic term might be. Often this is the pre-money valuation, and you might even suggest that perhaps you had been thinking of something incrementally higher to see how firm the VC’s position is. If you push too hard, the conversation may be over. Depending on your options or other traction, that may be ok, but most early-stage companies are not so fortunate as to have investors beating down their doors, so you tread carefully. Once you have a verbal handshake on a few key terms, the VC promises a written term sheet will be forthcoming soon. You try not to get too excited as a possible end to the slog may be emerging from the fog.

The VC delivers the term sheet, and you and other stakeholders (at minimum, your corporate attorney, plus existing investors, CFO, etc., if you have them) review it carefully. Some aspects seem plain vanilla – or at least your attorney explains they are. The biggies are often the size of the proposed round, the amount of the round the lead investor proposes to provide, the pre-money valuation, the broad outlines of the type of security, assumptions about the size of the option pool, the Board of Directors composition, and a list of due diligence hurdles that will need to be cleared before closing. There is also that lovely catch-all sentence pertaining to additional “usual and customary terms.” Back-and-forth ensues as you decide what your most essential counter-proposals will be and what you can live with. This is a delicate dance with plenty of posturing on both sides, but hopefully, you find common ground and agree to sign the term sheet and move into the next stage of due diligence. It is an exciting milestone, and it feels like you have gotten engaged. As part of signing the term sheet, you will definitely agree to not “date” other people as both sides proceed in good faith to plan your corporate “wedding.”

At this stage, the high-level agreement from the term sheet starts to take on the final form. Now the “nibbling” begins. Legal due diligence begins with endless checklists, a data room full of documents, and much digging around in the details. IP is put through the wringer. Every important contract is reviewed. The financing documents are drafted. The VC’s lawyers develop lists of issues that need to be addressed. We want the founders’ stock to vest; the option pool to be taken out before the investor money comes in, and the employment contracts to be updated to meet “usual and customary” standards. Non-compete clauses are required to be added. And the list goes on and on.

At every turn, it feels like you are giving something up. The reality is that, in many cases, you are. Experience may have helped you know what to get nailed down during the term sheet phase because that is when both sides are still selling one another on the benefits of getting engaged. Still, once the looming threat of you choosing an alternative deal goes away because you signed this one, all the details will seem to accrue to the investors’ benefit under the umbrella of usual, customary, and standard practice. They are not lying. It is usual, customary, and standard because investors do far more of these deals than founders do, so they get to shape what those terms are over many deals until the investor-friendly position is the default.

You have two potential defenses:

1. The more you know about “usual and customary,” the more you can get negotiated specifically at the term sheet stage. If you are not as experienced as you wish, ask for help from your attorney and any other experienced mentors available to you.
   
   
2. The better and more attractive the business you have created, the more investor interest you can attract. You will get the best deal terms when investors fear someone else may get a deal they want instead of them. When you have exciting momentum blowing in your sails, you have the power of negotiating leverage and can sometimes dictate the terms in your favor.

Unfortunately, even when experienced, you may not have enough leverage. At that point, you need to keep your eyes firmly on the prize, which is getting the funding your company desperately needs to build value and success. Most of these term tweaks are tolerable and will not make that much difference in the end. Rely on your lawyer and mentors to let you know if you are indeed outside the realm of “normal.” While I have walked away from VC term sheets occasionally, it has been a relatively rare thing because VCs know what is normal, have their reputation to be concerned about, and must be careful about what precedences they set for future rounds. Ultimately, they are investing because they believe in the business’s potential and want the management to have the right incentives and skin-in-the-game to align everyone’s interests.  

With that in mind, ask yourself if you want the deal or if you want to abandon all the work you have put in and all the potential you believe in? If you believe, then keep your focus on only the deal-killers. If the VC asks for something so onerous that you will abandon your company, then do it. Otherwise, consider it a nibble, and let it go in the interest of getting the fuel you need to drive for success. That nibbly investor will be on your side as soon as the closing has happened, trying to help you turn their money into your joint success.