Term Sheets: Contentious Issues and Lawyers

For my 40th birthday, I got a couple of cool t-shirts with photos of me substituted for Jack Bauer on 24.  The only thing disconcerting was the image of me holding a handgun.  I was pondering how ripped I looked (on Jack’s torso) when two questions on term sheets came in from someone at Ernst & Young.  Being the excellent delegator that I am (much better than Jack, if you know what I mean), I forwarded the questions on to Jason who promptly answered them.  They are as follows:

1. What would you deem the most hotly contested points of the term sheet? The most hotly negotiated term (after price) is the liquidation preference. In a Series A deal, it is between the company and the investor. While it’s often an intense negotiation, it’s straightforward because there are only two interests to consider (the founders and the Series A investors). In later stage, the negotiations become even more interesting. Take a situation where you have a Series D deal with each Series (A, B, and C) having different prices. By definition each of the different Series investors will have different payouts on their previously purchased stock and the Series D investors will be negotiating with several sets of interested parties (the founders, the Series A investors, the Series B investors that are not in the Series A, and the Series C investors that are not in the Series A / B).  Of course, the notion of participating preferred plays into this negotiation also.

2. In your view, how has the role of legal counsel changed over time during the deal process (in the past 10 years or so)? Legal counsel is relied on more heavily these days to be a business arbiter, rather than a “take no prisoner negotiator” who must win every last deal point. These deals aren’t rocket science and any good lawyer knows that.  As a result, legal counsel (at least good legal counsel) is now much more of a deal maker than hard ass negotiator.

  • In regards to #1, I always wondered if the company got as far as a Series D, wouldn’t be on the interest of all participants to simplify everything by “normalizing” preferences on previous deal? This is, would A/B/C investors be willing to re-work their deals and making A/B/C identical in terms of liquidation preferences?
    The other thing that is also very puzzling, is that each new Series has higher liquidation preferences than the previous one. This is unnatural — the biggest risk taker (Series A) should be the biggest winner.
    Maybe I’m incorrect in that some deals do reflect the natural order of things.

  • Jason

    It’s really a “free for all” when it comes to reworking deals. If you can imagine it, it’s happened. I’ve not seen anyone very eager to rework their deals and normalize preferences, because at this point there is a finite pool of capital people are arguing about. Your comment that the Series A should get the biggest return due to biggest risk is well taken, but unfortunately not how the business goes. What you see are larger money / bigger players / institutions / strategic investors come in later, call the shots and demand the preferences go their way. I’ve never seen a deal where the Series A gets anything better than pari passu on preferences and this is very rare, especially these days.

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