What to look for in a term sheet as a first-time founder

Securing funding is a stressful endeavor, but it doesn’t have to be. We recently sat down with three VCs to figure out the best way to go about spinning up an investing network from scratch and negotiating the first term sheet.

Earlier this week, we featured the first part of that conversation with James Norman of Black Operator Ventures, Mandela Schumacher-Hodge Dixon of AllRaise and Kevin Liu of both Techstars and Uncharted Ventures.

In part two, the investors cover more specifics about what to ask for in a term sheet and red flags you should look out for.

(Editor’s note: This interview has been edited lightly for length and clarity.)

Why should you know what’s going to be in a term sheet before you see it?

Mandela Schumacher-Hodge Dixon: Do not wait until you get a term sheet to start going back and forth. The term sheet should be a reflection of what was already verbally agreed upon, including the valuation. Don’t wait until you get that legal agreement in your inbox to begin pushing back, because it’s really annoying, and it starts to affect how they feel about you.

I’ve even seen investors pull the term sheet. No one is bulletproof, but you really want to be as bulletproof as possible in every stage of this. That requires preparation and clear communication.

James Norman: As you plan out your whole fundraising process, lean into it and start to see what the market is thinking, you want to have a bottom line in terms of what you’re willing to accept. At some point, you may need to capitulate, but be convinced about [that bottom line] and have a reasoning for it.

VCs are trying to invest in leaders, so they know there’s going to be a power dynamic here. How you manage that and move things forward [impacts] how they think you’re going to do other things like hire employees and land customers.

Which mechanism is best to use at the outset?

Norman: Once you get the term sheet, the game has really begun.

Regarding terms, you want to make sure that you’re getting an agreement that is at parity with the level you’re at with your company. You don’t want to end up with an angel investor trying to give you some Series A Preferred docs or anything of that nature.

If you have a pre-seed or seed-stage startup, 99% of time, you should be using a SAFE (a Simple Agreement for Future Equity agreement that Y Combinator devised in 2013). It’s got all the standard language that you need; no one can argue with it. [If they do], be like, “Go talk to Y Combinator about that.”

[Sometimes, you’ll encounter a] most favored nation [MFN] clause [wherein subsequent convertible securities are issued to certain future investors at better terms. It falls away on conversion of the SAFE into company stock], but it’s not a big talking point. Because the documents have been so standardized, the conversations become limited, which saves legal fees and time, and gets the money wired faster.

Kevin Liu: Largely, at least from the data I’m seeing, it’s still largely SAFEs that [pre-seed and seed-stage founders] are using. [These] convertible notes make a lot of sense. You don’t have to have complicated conversations about equity pricing at that stage. You can also layer on different SAFEs for a little bit, so push out the conversation [about how much the startup is worth to investors].

How much equity is distributed at each level of early-stage fundraising?

Norman: I think in today’s market, 10% sounds about right for seed-stage rounds. Valuations were out of control 12 months ago, so [seed investors] might have gotten less ownership [for the same investment today], but 10% today is pretty fair. And 20% makes sense for Series A rounds.

Schumacher-Hodge Dixon: But not more than 20%. Hold on [if you are a founder and don’t budge on this].

What’s a red flag in a term sheet?

Norman: If I see [terms around] exclusivity, it’s a red flag. Non-founder-friendly anti-dilution clauses…

Liu: Liquidation preferences…

Norman: Another thing to think about is someone’s ability to veto a future round of funding. Sometimes, people want to make sure they’re not going to be diluted, so that’s something else to look out for. Anybody who is trying to position themselves to have veto power over some aspect of the next round of funding [is someone to avoid].

Liu: One point on that: Especially for founders who are international, if they take money from investors who are not based here or used to market terms here, sometimes they offer terms that will prove prohibitive for you as you seek the next round. That’s something to be aware of, especially if you’re a company that’s looking to flip to the U.S. at the Series A or B stage. If your investor wants to include language that’s more protectionist to keep you in the country or region, you might want to consult a lawyer early on.

How should founders think about valuation when it comes to that first term sheet?

Schumacher-Hodge Dixon: It’s all storytelling. You’re building off a set of assumptions and some data, and everyone on both sides of the table knows this. Everyone knows that you’re doing the best you can to figure this out as you go, and that the next story will be iterated accordingly. But you don’t want to have too much divergence [between stories], because that’s when investors start to look at you differently and you become less of a reliable source of leadership and information for this market.

Norman: As a founder, one thing to keep in mind is: Higher valuations are not always better. Building a company is hard. I’ve actually sat down with companies that raised a certain valuation in the pre-seed round that weren’t making money and wanted a $10 million valuation on a $750,000 round.

But you can’t build that much with $750,000, so you’re going to have to raise more money. When you do, if you didn’t hit a certain milestone or create a certain level of momentum, you will not be able to raise another round or extension above that valuation. Now you’ve killed your whole momentum, which degrades your ability to raise capital.