19 May 2009

Some Thoughts on Term Sheets

I am often asked by the startup companies I work with for a "typical" term sheet they can use as a benchmark when negotiating with investors. It's a logical question, but a hard one to answer...the distribution curve, if it could be plotted, would show a huge dispersion around any "typical" mean.

So many factors come into play-- the macro environment, the team, the level of traction, and other intangibles such as how "hot" a given deal happens to be at a particular moment in time-- it becomes hard to find a boilerplate term sheet that works.

Yet we have to start somewhere, and this link provides a good case study of expected terms from both an entrepreneur's view and an angel investor's view:

http://blogs.wsj.com/venturecapital/2009/05/18/what-is-an-acceptable-term-sheet-these-days/

You have to give the entrepreneur credit for his chutzpah in the "ask," but there are definitely a few items that would raise red flags from investors and that have probably hindered his efforts to raise money. Among them:

#1: The salary he asks for ($225k). I build financial models that startups use to pitch investors, and one of the main cost inputs are the salary lines we plug in for both founders and employees. In almost every instance, I need to talk the founders into plugging in lower amounts for themselves, and higher amounts for key outside hires-- VP of Sales, VP Engineering, etc.

The first piece of advice is often hard for them to swallow, but it is key, as investors want the founders to stay hungry and work to build something big-- and the motivation to do so is greatly reduced if he's pulling in a fat $225k. Indeed, I know the founders of one startup that raised close to $40 million, and the VCs set the Founder/CEO's salary at $80k. He was hungry.

In addition, the implied understanding in almost any VC deal is that everyone is working toward the big payoff down the line...IPO, acquisition, etc...and that the salary is mainly just a vehicle to keep a roof overhead and food on the table until that happens.

#2: The option pool. The founder is looking to carve off 8.3% of the company to incentivize new hires. This potentially signals a couple things; either: a) he doesn't believe he'll need to hire many people; or b) he doesn't believe he'll need to raise more funding.

This ties back to the point made above-- the premise of the funded startup is that its future path will be binary: it will either fail or go big, fast. Investors do not want what they call the 'walking dead'...companies that plateau at a few million in revenue but never really grow. The subtext is that to grow fast, you'll need the best people-- and these folks usually want to have some meaningful equity skin in the game. An 8.3% option pool is not going to be enough to "pay" these people what they want.

I don't have an immediate issue with the valuation he's seeking...this is usually a function of how hot a deal is, and can take all kinds of forms. However, it's worth noting that many series A investors will seek a minimum of 30% of the company.

A few other resources for startups dealing with the term sheet process:

Terms Sheets & Valuations by Alex Wilmerding. This book is a few years old (published 2003) but it's already a classic, in my view. At 106 slim pages it's easily digestible, and for each negotiated item in a term sheet, the author presents a "Company Favorable," "Middle of the Road," and "Investor Favorable" variation of the particular term.

Wilson Sonsini's Term Sheet Generator. This is a great resource and a fun website to play around with. Essentially, it is an online questionnaire that guides you through the process and then spits out a sample term sheet based on your answers. It gets a bit technical at times, but it has good explanatory details, and it's far better to muddle through the esoteric details now, then when you're in the middle of a round and paying your attorney to 'educate' you.

What am I missing? What other resources have you found that have helped you with your term sheet negotiations?

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