This post discusses term sheets for raising a first round of financing. This might be called an "angel round", a "seed round" or a "friends and family round." The key points are to keep the deal simple, and to (ideally) only take money from "accredited" investors.
Our technology law Link List series collects useful startup guidance from around the internet. As always, this is advice worth reading, but it may not be advice that’s right for your startup.
Ideal First Round Term Sheet?
A founder-friendly term sheet. Sam Altman, 2013. A founder-friendly term sheet has no option pool, no expiration, no confidentiality agreement, no participating preferred, and the investor agrees to pay her own legal fees.
VC Rights: Up, Down, and Know What the Fuck is Going On. Brad Feld, 2012. “VCs only need three rights: Up, Down, and Know What The Fuck Is Going On.” Up = Pro-rata rights. VCs want to invest in next round to maintain their ownership in growing companies. Down = Liquidation preference. VCs want to get their money out first when the company isn’t growing. Know What The Fuck Is Going On = Board seat.
Negotiating the Term Sheet
Upside Risk. Sam Altman, 2013. Angels make their money from investing in rare companies that deliver 100x returns. The the real risk for angel investors is missing out on that outstanding investment, not failing to get their money back on their non-unicorn companies.
Horses, rabbits and poker: How to raise money from venture capitalists. Ted Wang, 2014. Some negotiation tactics to get a better term sheet from VCs. For example, “I’d love to meet you in n weeks, but I have a second partner meeting at another firm next week, so I’m concerned that things might have progressed by that time.”
When not to be Mr. Wolf. An important negotiation tactic for entrepreneurs. Ted Wang, 2014. When to move quickly, and when to slow down.
A Quick Hack for Speeding up Term Sheet and other Negotiations. Mark Suster, 2012. Throw a “signing party” where everyone flies to a single location, and stays in a hotel together until the deal was completed.
I don’t give a fuck that you always get this provision. Doesn’t mean shit to me. This deal will be the first time you don’t get it if you don’t explain why you need it.
Later, Fred basically agrees: “Nothing is standard. You either need it or you don’t. Explain why you need it and most of the time you’ll get it or something like it as long as both sides really want to make a deal.”
Exploding Offers Suck. Sam Altman, 2014. Investors and accelerators should not use time-pressure to prevent founders from exploring their alternatives. [Note: on the other hand, reasonable time limits on an offer are often appropriate.]
No Shop Clause
Don’t shop your term sheet. Chris Dixon, 2009. Shopping a term sheet around might get you a better deal once, but creates repetitional risk. Better to discuss the deal with several investors verbally, before you get a term sheet.
An example from VC Fred Wilson:
Let’s say you start a company, bootstrap it for a year and then raise $1mm for 10% of the company [a $10mm valuation]. Three months later, you’re offered $8mm for the company [note: lower than the $10mm valuation when the VC bought in]. You decide to take the offer. If the VC bought common stock, she gets $800k back on an investment of $1mm. The VC loses $200k while you make $7.2mm. But if the VC buys preferred stock, she gets the option of taking their money back or the 10%. In that instance, they will take their money back and get $1mm and you will get $7mm.
Pro Rata Rights
The Many Flavors of Seed Investor “Pro-Rata” Rights. Jose Ancer, 2014. Pro rata rights give early investors influence over the next round of financing. The more follow-on investment rights founders grant to their seed investors, the less flexibility founders will have to bring in larger (potentially better) VCs in the Series A round.
Brad Feld’s Term Sheet Series (2005)
Brad Feld of the Foundry Group detailed all of common term sheet provisions in this 2005 series of blog posts. He published an updated version in his 2012 book, “Venture Deals.”
Anti-Dilution - protects investors from dilution in a down-round by (essentially) issuing them more shares. A “full ratchet” anti-dilution provision is a red flag.
Board of Directors - Does the VC fund get a seat or two on your board? This is about control of the company.
Employee Pool - What percent of the equity is reserved for employee stock incentives? Remember that the size of the pool affects the founders dilution in a financing. See “option pool shuffle.”
Drag Along - A subset of investors can drag the other investors along into a sale of the company. This is about control.
Liquidation Preference - If there’s a modest exit event (not a home-run acquisition or IPO), the investors will get paid first. Will there be any money left over for the founders?
Protective Provisions - Gives VCs a veto over certain types of company actions. This is about control.
Price - What is your company worth? This is the most important term.
Vesting - When will you fully own your shares? Will a sale of the company trigger automatic vesting of your shares?
Assignment - Allows VC funds to transfer your shares between funds and make distributions to their limited partners.
Conditions Precedent to Financing - Startup doesn’t actually get money until after the VC gets its due diligence information. Terms are often standard, but there are some to watch out for.
Co-Sale Agreement - If founders get to sell shares (before an IPO) then the VCs get to sell a proportionate number of shares. No one wants to be left holding illiquid assets.
Conversion - The VC can convert its preferred shares into common stock.
Dividends - likely to add unnecessary complexity to an early stage deal.
Founders Activities - Founders agree to spend 100% of their work time on the startup.
Information Rights - what type of business statistics and info does the startup need to give the investors?
Indemnification - Does the startup need to buy “Director and Officer insurance” (D&O)?