In Search Of...The Ideal Term Sheet

Continuing with our discussion on term sheets (see "Some Thoughts on Term Sheets" and "Closing Term Sheets Quickly"), today a new "plain vanilla" term sheet was published by Adeo Ressi of TheFunded.com.

You can download it on docstoc here.

It is very basic (a good thing) and entrepreneur-friendly. Whether you'll be able to get a VC to actually use it is another question altogether...when the economy is tough and funding purse-strings tighten, investors will often seek to include various onerous terms to help mitigate their downside risk. Anyway, it's useful as a starting point for discussions.

Rather than comment on it directly, I am re-publishing sections from a post on TechCrunch:

"The key terms include the elimination of participation with preferred stock, a 1x liquidation preference, and single trigger vesting acceleration on acquisition.

What this means: VCs try to increase returns by asking for large liquidation preferences. A 3x liquidation preference, for example, means the VC gets to take out 3 times his/her initial investment before founders and employees get anything. So if you raise $10 million at a 3x liquidation preference and then sell for $25 million, founders and emplyees get nothing. With a 1x liquidation preference, the VC is only able to get the initial investment back before others take their share.

More importantly, participation is eliminated. VCs often ask for this. What it means: Participation rights means the VC gets to take a pro-rata share of money in a sale even after the liquidity preference. With it eliminated, the VC has to choose - either take their 1x liquidation preference or convert and share with common pro rata. For any large deal, they will convert and be treated like the founders and employees.

The single trigger vesting provision is also important. VCs like to keep their founders locked up so they have to keep working even after an acquisition. The provision, called double-trigger acceleration, usually requires a sale followed by a firing without cause. VCs want this because it’s easier to sell a company if the founders are locked into staying on. Founders don’t like it because it sucks.

Most importantly, though, is the cost savings. VCs really need to move to a deal structure that doesn’t burn up so much lawyer time negotiating provisions that are almost never used. I could write 10 posts on how this nonsense works, and may in the future. A term sheet like this can be closed with $10k - $20k in legal fees. When you’re only raising $1 million, that’s a big deal."

More on Seed Stage Terms
One more link while we're on the topic-- here is a new post from Caine Moss, an attorney at WSGR, on the changing face of early stage investing. He explores the difference between terms at the Series A stage and at the seed or "Series 1" stage. The main takeaway is that terms will differ, and entrepreneurs should avoid deals where Series A terms are used for a seed financing.

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?

Closing Term Sheets Quickly (+ Avoid the Co-Investment Term Sheet)

Here's an interesting post from the guys over at VentureHacks about closing term sheets quickly.

http://venturehacks.com/articles/closing-quickly

I like the advice...one of the biggest pains is to get VCs to move on your timetable. About a year ago, I was working with a startup raising a series A round; we had a ton of interest but a hell of a time getting the round to close.

On more than one occasion, we would have a solid bite from a VC who wanted to invest. They went as far as putting down a term sheet. However, they took a somewhat passive-aggressive approach by stating that they didn't want to lead the round-- just "co-invest."

In other words, they wanted to ride on another VC's coattails and wanted the entrepreneurs to bring them the coat.

This was highly disruptive for several reasons:

i) There were no-shop clauses in the term sheet, effectively giving the VC the right to approve or disapprove of who the co-investor would be. This limited (somewhat) our ability to drum up additional excitement for the deal and increase our bargaining leverage.

ii) The term sheet(s) always had an expiration date, and during that time, we would be engaged in the due diligence process with the VC. Even though we had our DD package ready-- as this article suggests-- it takes a huge amount of time, as each VC has a slightly different list of things they want to see. There is a lot of jumping through hoops, a lot of meetings and calls-- all of which can distract from the process of building the business.

iii) The fact that it was only a co-investment term sheet muted the excitement for the deal. In other words, when we would go out and meet with other interested VC firms about being the lead, they would invariably wonder why, if it's such a hot deal, the first VC didn't want to snap up the whole round (in this case the reason was valid...the 1st VC was a strategic investor-- part of a larger media company-- and rarely led deals).

In the end, it all worked out for my client; we successfully closed the round and are off to the races. But the net takeaway is, "beware the follower or co-investment term sheet" as it can really hinder the startup. For the VC putting one down, it's lke an option to invest that costs them nothing-- and it's always in their advantage to wait and watch the startup, versus cutting the check...