Negotiating VC Term Sheets: Fundamentals and Recent Trends

As a result of the significant tightening of venture capital (“VC”) financing in 2023, there have been considerable changes in deal terms and bargaining power between startups and the VC funds that finance them. It is crucial for founders to stay well-informed about these latest developments to successfully navigate the changing landscape.

A recent panel titled “Negotiating VC Term Sheets: Fundamentals and Recent Trends,” hosted by the NY Tech Alliance and Paul Ellis Law Group, discussed the topic, including critical deal terms, the VC process, and negotiating strategy. Panelists included:

• Alan Wink, Managing Director of Capital Markets, EisnerAmper;
• Chris Yoo, Managing Director of Xcellerant Ventures; and
• Paul Ellis, Managing Partner, Ellis Law Group.

Q3 Market Update

The current VC market is a challenging landscape for founders and VCs alike. Capital availability is the lowest it’s been since 2019, with only $126 billion in venture capital invested through Q3. Exits have begun to pick up, with $36 billion generated in this quarter, but levels throughout the year have been far below those seen in 2019 - 2021. Fundraising has slowed considerably alongside the slowdown in the exit market and VCs have not been able to return a lot of capital to their limited partners. In the current market, investors are taking fewer risks, looking for higher quality companies with a clear runway to profitability and exit. Over the last couple of years, founders have had leverage over investors, who had the fear of missing out on the best deals. However, with the current slowdown in VC dollars invested, VCs have the upper hand in negotiating deal terms with founders. EisnerAmper has an in-depth Q3 capital markets update here in an on-demand webinar.

Identifying and Choosing VCs

To identify a VC that is the best fit for your company, you need to do your homework. VCs often have a focus when it comes to industry type, check size, or developmental stage. You can determine if your company fits within that focus through resources like online listings, attorneys and accountants, and other entrepreneurs. Speaking to other companies a potential VC has invested in is also an important factor to determine if they’re a good fit for you. Companies need to know that their investors will be there to offer support but still be constructive. Additionally, it is essential to be aware of which investors are actually writing checks when time and money are so tight.

Preliminary Considerations for VC Negotiations

The level of due diligence among investors has increased within the current market, so finding the right investor and negotiating a deal is taking more time. It’s crucial not to underestimate the amount of time it will take to close a deal; firms need to devote sufficient resources to their deal during this period. This includes identifying who’s on your internal deal team as well as who’s driving the company forward, so you don’t run out of money. As deal negotiations take place, it’s important to have principals involved alongside their lawyers so they’re informed about where the deal is going and when to use their leverage. Even in this competitive market, don’t be afraid to use your bargaining power and walk away from a bad deal.

Current Negotiating Trends

The three most common types of securities used in early-stage company investments include: simple agreements for future equity (“SAFEs”), convertible notes, and preferred stock. SAFEs and convertible notes are easier, faster, and cheaper to negotiate than preferred stock, but they are not what VCs will look at first. The majority of venture investments and many sophisticated angel deals are done with preferred stock. With preferred stock, there are preferred investors that have privileges over common shareholders. Those privileges include anti-dilution provisions, liquidation preferences, protective provisions, and board compensation rights. VCs are interested in preferred stock because the privileges they receive help lower investment risk and provide more control over the direction of the company.

To mitigate the possible downsides of preferred stock for the company, founders need to be well informed on how it’s structured and how it behaves. Surrounding yourself with a team of professionals who understand the terms of the deal and know the line between business decisions and legal considerations is key. In a down market, you want to be able to negotiate the best possible deal and you need an experienced team to do so.