The Best Term Sheets Align Interests Of Founders And Investors
When anybody hands over several million dollars to a couple of people—often exceedingly young ones who may have just met, having only shared a handful of conversations with them, it's unsurprising that the cash may come with strings attached.
These strings come in the form of legal documents that can grow well into the hundreds of pages, requiring both sides to retain and pay teams of lawyers to ensure they're getting the best and fairest deal possible.
Some of the legal rigmarole can be avoided, and much goodwill between parties preserved, when both investors and founders understand what is currently accepted, normal and fair within these covenants that we call term sheets.
Term sheets basically define anything and everything within a startup investment, even things such as founders’ salaries. Different terms can radically alter the nature and value of an investment.
Not every $3 million series A at a $12 million post-money valuation is created equal.
The best term sheets do something simple and intuitive: they align the long-term interests of investors and founders.
Terms that overreach and impair one side prevent the alignment of interests, and ultimately aren’t conducive to the long-term health of the startup.
"As a generality, in my experience, I would say that most investors would rather not use complicated terms, but typically do so in circumstances where there is a disconnect between the valuation a company desires and the valuation the investor is willing to pay," says Brian Neider, partner at Lead Edge Capital, a New York VC.
Entities that have gained authority in the startup space—such as Y Combinator—have created widely accepted documents for things like convertible notes, and even series seed investments. These templates tend to be fair for both sides, and form the accepted legal norms for early startup investments in the Bay Area and other startup hubs.
Standardized term sheets for investments at the Series A level and beyond, however, are less common and not as widely circulated.
The seminal parts of a term sheet fall into one of two categories:
- Financial Terms - valuation, liquidation preferences, pro rata rights, anti-dilution measures.
- Control Terms - board seats, rights of first refusal for both financings, and acquisitions.
More attention is given to the former group, but terms from both categories can derail a startup’s momentum.
FundersClub, being both a venture capital investor and a startup at the same time, occupies a unique perch in the space. We've drawn from our own experience, and talked to other founders and investors about the terms that are most important, and the ones that should alarm either side.
Note: For any kind of major investment that isn't utilizing standard SAFE documents, hiring a law firm with deep experience in closing startup investments is an absolute necessity. Some of these firms include:
- Wilson Sonsini Goodrich & Rosati
- Gunderson Dettmer
- Goodwin Procter
- Fenwick & West
We will spare readers from a complete rundown of what comprises an ideal term sheet. Instead, we will focus on the terms that are most important, and stipulations that can be troublesome for either side in the investment.
Things to avoid
Perhaps more important than anything else for both founders and investors is to avoid a set of clauses and instruments that are fairly common in the industry, but which produce circumstances stilted enough that we believe they should be avoided.
1. Tranched rounds / milestone-based financing
These have largely fallen out of favor in most agreements involving blue chip investors and tech companies that hail from major tech hubs, but they still do pop up from time to time. Founders should avoid these terms, and investors should as well, as they're generally considered unfair, says Adrian Fortino, a partner at Mercury Fund, an early stage VC in Houston with $200 million under management.
The idea with these kinds of terms is to change circumstances of the financing deal according to how the company performs. So, for instance, if the company were to not achieve annual revenues of $1 million in the year following the financing, valuation of the company could be reduced from $12 million to $9 million, effectively giving investors more equity for their money.
Another common scenario is a tranched round where part of the total investment amount is invested upon closing, with the remaining paid upon accomplishment of certain milestones. However, quibbles over whether or not these milestones were in fact met can arise down the road, or an investor might cite materially adverse circumstances that have come to light later, leading to delays or non-payment of the second tranche. Effectively the investor is getting a free option to pay today's valuation for a more mature company later, with the company having no sure guarantee of receiving funds later.
2. More than 1 investor board seat for the current round
Any investor asking for this either doesn’t understand current norms within the top tiers of the VC industry, or is simply getting greedy. Giving any investor multiple board seats can limit a company’s options for financing in the future, as many prospective investors won’t view the board’s makeup as constructive. Early on, giving away this many board seats to one investor also dilutes the founders’ ability to control the company.
3. Ability to force sale by X date
The problems here is academic: It’s impossible to predict the exact trajectory of a startup. Even companies that end up reaching $1 billion valuations can take circuitous paths to get there. Forcing a sale by an arbitrary date in the future will almost certainly create major problems for everybody involved, founders and investors. And when acquirers know that a company has to sell—that usually marks a sale as distressed, which is when assets are often sold at a deep discount to their true value.
A similar provision to this involves redemption rights, which allow investors to redeem their stock by a given date, usually five to seven years out, at a given multiple. It could be 2x or 3x. This term can be buried in a term sheet and often dismissed by founders due to rightful optimism, explains Mercury Fund’s Fortino, but it shouldn’t be.
"A substantial cash outflow back to an investor can cripple a company still trying to find their path to profitability, and many times is a deathblow," Fortino says.
4. Treatment favoring one investor over all others
Terms that lead to this kind of condition create clear problems for getting future investors on board. Most investors won’t want to enter a situation where one preferred stockholder holds dominant terms. So by securing this kind of clause, an investor actually subverts herself by handicapping the startup’s future ability to lure more money, as well as possibly blunting the interests of the company’s founders, which can be a death knell.
5. Right of first refusal on future financings
On its face, this term sounds reasonable. The lead Series A investor feels strongly about a startup’s prospects and merely wants to ensure, in writing, that she can continue to lead future financing rounds. The problem, however, is that with this term in place, it will be very difficult for a company to draw interest or term sheets from other investors, as they know their own offers could be easily usurped by the investor with these rights. This can give the early investor an undue amount of control of the startup’s future.
6. Right of first refusal on future acquisitions (for strategic investors)
Strategic investments are tricky no matter how they’re done, and this term makes them more difficult. Investors with this term have the right to match any acquisition offer that comes in the door—a situation that, naturally, discourages other companies from actually making an offer. This drives the potential exit value of a startup down and gives too much control to a strategic.
Warrants aren’t common in equity rounds, and they should be avoided, as should just about anything that makes an investment more complicated. In most cases, warrants give their holders—usually investors, advisors, or board members—the right to buy equity at a fixed price in the future. Warrants operate like options, but they typically don’t expire when somebody’s relationship with the startup ends; they have fixed time periods and expirations. Warrants also don’t count against the option pool, so when they’re exercised, they further dilute everybody, including founders and employees.
8. Participating Preferred / Liquidation Preferences > 1.0x
When a company is sold, it's normal for investors to get their invested money back before any other cash is distributed. The most standard term here is called 'non-participating preferred,' which gives the investor the option of either getting 1x of their investment back first, or converting all equity to common stock. The investor, obviously, will choose the option that nets her more.
‘Participating Preferred,’ works differently, allowing an investor to get her 1x investment back, plus her proportional share of any cash that remains after that. This term discounts the equity of common stockholders and founders.
On more rare occasions investors may ask for multiples greater than 1x in liquidation preferences, which is a nonstandard term.
"In these early rounds, it is usually not in the investors’ best interests to ask for richer preferences, because those richer terms may be then imposed on and disadvantage them in later rounds when new investors come in," says Blake Ilstrup, the lead lawyer in Orrick's Seattle Tech Companies practice.
Founders with leverage (multiple, competing term sheets) may push for a term sheet with no liquidation preferences at all, but that is anathema to the very nature of a preferred equity investment, which gives debt holders—the investors—priority in being made whole first. The standard venture agreement has founders and common shareholders in line behind investors.
Valuation certainly receives more scrutiny from founders, and investors, than anything else within a term sheet. This is the number that the media, to the degree that there is any media interested in the investment, talks about.
Certainly, all parties involved should spend time thinking about the right valuation. But it is often terms having nothing to do with the valuation that can be most troublesome in the future for both sides. A valuation that's below market won't hobble a company or really even strain its founders, if the company is ultimately successful.
Airbnb rather famously tried to give away 10% of its equity for just $150,000, tagging the company with a $1.5 million valuation, but the founders couldn't find any takers. The company eventually took a $600,000 investment from Sequoia, but the founders didn't have a lot of options, and so the valuation terms weren't considered optimal. But that early valuation, at this point, has made little difference to the lives of Airbnb's founders or the company itself.
For founders, it's often best to close a deal quickly with a trusted investor, and a fair valuation, and simply get back to work. Over-optimizing a valuation often isn't worth the time and goodwill that it eats up. Good investors also know that the best investments aren't worth quibbling over a $12 million valuation versus a $11 million one.
Just as important as the number in a valuation is how it's calculated, points out Orrick’s Ilstrup.
"The real action with a valuation is in the calculation of the per-share price," Ilstrup says.
For example, is the unallocated option pool included in the denominator when calculating share price? If the option pool is being increased post-closing, it can push the dilution primarily onto the founders, which is something they should be aware of.
A larger option pool with a larger valuation can sometimes be a worse deal for founders than a smaller valuation and a smaller option pool.
Experienced counsel will ensure that both founders and investors get widely-accepted and fair terms on valuation, but it's important to remember that what goes into the number is just as important as the number itself.
FundersClub has an excellent, detailed example and explanation of how these things can play out within its education center.
Some investors will push for terms that seek to preserve the value of their ownership stake in the case of a down round, when company's subsequent funding assigns its shares a lesser value than the previous round.
Such terms are fairly common in investments led by VC firms.
A form of this term that fully preserves the value of an investor's stake, issuing her additional shares to make up for the lost value, is referred to as a 'full ratchet.'
Full-ratchet anti-dilution rates are considered by many to be too punitive to founders and other shareholders, as it can egregiously eat away at their percentage ownership in the company and erode their interests going forward. This can be detrimental to not only the founders, but also investors, who are counting on founders to remain motivated to run and grow the company.
More accepted forms of anti-dilution rights use what are known as broad-based and narrow-based calculations, which award a preferred equity investor additional shares in a down round, but not to the same degree as a full ratchet, and thus are generally accepted as fairer for all parties.
Pro rata rights
These are also known as preemptive rights in some cases, and are often lumped into a list of term sheet stipulations dubbed 'Major Investor Rights.'
Pro rata rights allow past investors to maintain their percentage stake during future financings, usually up-rounds where the value of the company and its shares have increased.
When the company brings in more investment money, it dilutes older investors' percentage stakes, even when the value of the company has sharply increased. Pro rata rights allow investors to buy more shares to keep their ownership percentage stakes roughly the same.
These rights typically get conferred to the lead investor in a round, but they can sometimes be granted to all investors in a given financing.
Pro rata rights can get troublesome when they take the form of 'super pro rata,' which allows investors to increase their stake in subsequent rounds.
For instance, this would give an investor with a 25% stake a chance to push that to 30% in the later round, so it amounts to a free option to acquire more equity for an investor. Such terms can turn off future investors and potential leads in later rounds.
There are base expectations as to how founders’ equity will be structured and how it will vest. Delving from those basic constructs sends a bad signal to investors.
A fantastic outline of all of the nitty gritty on founder’s stock can be found at Cooley’s blog.
The key things to remember:
Founders’ stock, often issued early, before major investment, is usually ‘purchased’ at a nominal price, something like $0.0001 per share.
Founders’ are subject to a vesting schedule, usually four years long. This protects investors by ensuring that founders remain engaged and fully committed to their company. It also protects founders from each other, as one founder can’t walk away after a year with their full share of equity.
The four-year vesting schedule usually contains a one-year ‘cliff,’ which precludes a founder—and most any employee—from vesting any equity until the one-year mark, at which point 25% of the individual’s equity is vested.
We mentioned above that awarding more than one board seat to a single investor usually isn’t wise, especially early in a startup’s life. Founders should expect, however, to yield a board seat to the lead investor from each major round of funding, beginning with the Series A. Investors during angel and seed rounds typically aren’t given board seats, although some VCs that lead larger ‘seed’ rounds topping $2 million may end up on the board, as these financings are more akin to a traditional Series A.
Rights of First Refusal, terms that give investors control of exits, debt, financings
Many of these were covered in Terms To Avoid, above, but we note them here because they are control terms, not financial terms.
The rule of thumb here, as always, is to align the interests of all parties. If a term gives undue influence to investors or founders, it can often lead to less-than-optimal results for the company, its prospects and its eventual exit.
Controlling against tilted terms in either direction is within the better interests of all equity holders.
In rare cases some investors will push for clauses that ask for terms that, in effect, give them complete control over a company's future. Protective provisions can stipulate that there is to be no issuance of securities on parity or senior to the VC's shares. The VC can waive this right, obviously, but it's an onerous hurdle for founders when planning the next round of funding.
"Effectively, the company cannot raise any more money without the consent, approval, and endorsement of the VC, which is not an ideal situation," says Steve Brotman, managing partner at Alpha Venture Partners, based in New York.
Term sheets can be incredibly complex things to navigate. Having a lawyer who is experienced in the latest machinations of venture financing is critical. They will protect both sides from entering an agreement that does not meet that ultimate goal: aligning the interests of both parties.
Beyond that, the most important thing to remember about term sheets is that they should be as simple as possible. When things become complicated, it usually means that one side has gained leverage, which, more often than not, leads to suboptimal outcomes for all people involved in a startup.
Just as with any business deal, the best term sheets are those that feature no sleights of hand or buried language that could alter the investment in a seminal way.