In my last article, I highlighted the 8 mistakes often made by entrepreneurs when presenting to venture capitalists. Once an entrepreneur has been successful in attracting a Term Sheet from one or more investors, then negotiations begin.

Too often entrepreneurs focus solely on the valuation and are dismissive of other key terms, which can often have a greater impact on the company than just the valuation. A few lucky startups that are "hot" will find the negotiation quite simple since they have a choice of firms. However if you are unable to attract multiple Term Sheets then your leverage on terms is relatively low unless you can afford to walk away.

My recommendation to entrepreneurs is to focus on investors with industry expertise, preferably with direct experience such that they can be value add shareholders. Smart VCs understand that management must retain enough equity (20%) to be motivated over the long run and that extremely harsh or lopsided terms will eventually be a problem. Below are the 8 questions you must ask yourself when considering Term Sheets:

  • Do you have enough capital to allow for at least 6 months of slippage in your business plan? Also, can you close as quickly as possible since market conditions can change, especially if you are running low on cash?
  • Do the investors get their money back and are the proceeds split ratable? You must understand the key terms such as Liquidation preference and Redemption rights.
  • What happens on future rounds of financing? Is it easy for a new investor to come into the company?
  • What is the shareholder voting structure?
  • What is the board structure and how many seats do the investors have as well as the approvals?
  • If the investors are unhappy, can they redeem their shares and at what price?
  • Can the investors unilaterally replace the management team?
  • Has the firm completed their due diligence? The Term Sheet will have a "no shop" clause for the company, but the agreement is non binding for the VC so be wary to sign a Term Sheet without a firm that still needs to make customer validation calls and is early in the diligence process.

If you make valuation the key issue, you may lose in the long run. Too many times, entrepreneurs focus solely on valuation only to find out in 18 months or 2 years that they made a mistake and that the structure and the investor's protective provisions are important. Take the time to educate yourself with online resources, such as the National Venture Capital website. Additionally leading Silicon Valley law firms such as Wilson Sonsini (www.wsgr.com) and Cooley on the Go (www.cooley.com) have sample documents online for a Series A round of financing with suggestions for market terms.