Post Category → Advisors

Don’t Rush a Term Sheet

TL;DR: No matter how many blog posts and books are out there (many of which I recommend) attempting to explain the mechanics of VC term sheets in simple terms, the reality is that VC term sheets are complicated, both in terms of how their math works and in how the various control-related provisions will impact a founder team over time. Take time to understand them, and don’t rush to sign, even if investors make you feel like you have to.

Background Reading:

Similar to the ‘automation delusion’ that I’ve written about in Legal Technical Debt, which has led some very confused founders to think that most of what startup lawyers do is getting eaten (as opposed to supplemented) by software, there’s a sentiment among parts of the founder community that VC deals have become so standardized that the only kind of analysis needed before signing a term sheet should look something like:

“$X on a $Y Pre?”

“5-person Board, with 2 common, 2 Preferred, and 1 Independent?”

“Great, here’s my signature.”

Take this approach, and you are going to get a lot of ice cold water splashed on your face very quickly, and not at all in a good way. I’ve seen it many times where founders run through a VC deal, so excited about how awesome their terms were, only to realize (sometimes at closing, sometimes years later when things have finally played out) that there were all kinds of “Gotcha’s” in the terms that they failed to fully appreciate. Having solid, independent, trustworthy advisors to walk you through terms before signing is extremely important, and it needs to be people whose advice you take seriously. See: How to avoid “captive” company counsel and Your Best Advisors: Experienced Founders. 

Some simple principles to follow before signing a term sheet are:

A. Fabricated Deadlines Should be Pushed Back On – It is very common for a term sheet to end with something like “this term sheet will expire on [date that is 48 hours away].” That deadline is very rarely real. It’s just there to let you know that the VC expects you to move quickly.

It is unreasonable to sit on a VC’s term sheet for weeks without good reason. By the time they’ve offered you a term sheet, they’ve likely put in some real time diligencing your company, and the last thing they want is for you to take their term sheet and then “shop” it around to their competitor firms to create a bidding war.  Doing so is not how the relationship works, and will almost certainly burn your deal. So expecting you to move somewhat quickly in negotiating and then signing is fair, but if a VC is pressuring you with anything remotely like “this needs to be signed in 24/48 hours, or the deal’s gone,” what you have there is a clear picture of the kind of power games this VC is going to play in your long-term relationship.

Move quickly and be respectful, but make sure you’re given enough time to consult with your advisors to fully grasp what you are getting into. It should be in everyone’s interest to avoid surprises long-term.

B. Model The Entire Round – VC Lawyers are usually the best people to handle this because they see dozens of deals a year and will be the most familiar with the ins-and-outs of your existing capitalization, but having multiple people running independent models is always a good idea, to catch glitches. You want to know exactly what % of the Company your lead VC expects for their money, before agreeing to a deal.

I have seen many situations where founders get distracted by a ‘high’ valuation, but when everyone is forced to agree on hard numbers they realize that the VC’s definitions were very different from what the founder team was thinking.  This is absolutely the most crucial when you have convertible notes or SAFEs on your cap table, because how they are treated in the round will significantly influence dilution. The math is not simple. At all.

C. Understand The Exclusivity Provision – Most term sheets will have a no-shop/exclusivity provision “locking you up” for 45-60 days, the amount of time it typically takes to close a deal after signing a term sheet. This is reasonable, assuming it’s not longer than that, to protect the VC from having their terms shopped around. But it also means that if you are talking to other potential VCs, the moment one term sheet arrives, everyone else should be told (without disclosing the identity or terms of the TS you have in hand) that it’s time to put forth their terms, or end discussions. Because once signed, your job is to close the signed term sheet.

D. Focus on Long-Term Control/Influence Over Decision-Making – Thinking through the various voting thresholds, board composition, and consent requirements is extremely important. Will the board be balanced, with an ‘independent’ being the tie breaker? Then being extremely clear on who the independent is, and how they’ll be chosen, is crucial. Will one of the common directors have to be the CEO at all times? Then understanding exactly how a successor CEO will be chosen is crucial, because usually at some point it’s not a founder.

If X% of the Preferred Stock is required to approve something, then you need to know (i) what %s of the Preferred will each of your investors hold, and (ii) who will the other investors be? Usually the Company gets discretion as to what money gets added to the round apart from the lead’s money, ensuring there are multiple independent voices even within the investor base, but some VCs will throw in a provision requiring that only their own connections fund the round. That heavily influences power dynamics.

There will be many situations in the Company’s life cycle where everyone on the cap table doesn’t agree on what’s the best path for the company. Ensuring balance on all material decisions, and preventing the concentration of unilateral power, is important, and yet not simple to understand without processing terms carefully. 

E. Shorter Term Sheets are Not Better – There is debate within the VC/VC Lawyer community as to whether shorter, simpler term sheets are better than longer, more detailed ones. I fall squarely in the camp that says you should have clarity on all material terms before signing and locking yourself into exclusivity; not just the economic ones.  That means any sentences like “the Preferred Stock will have ‘customary’ protective provisions” (meaning they will have the right to block certain company actions) should be converted into an exact list of what those provisions will be. I can guarantee you your counsel’s perspective on what’s ‘customary’ is going to differ from their counsel’s.

The view among those who prefer shorter term sheets is that you should sign as soon as possible, to avoid ‘losing the deal’ (as if VC investment is that ephemeral). I don’t buy it. The moment you sign a term sheet, you are going to start racking up legal fees, and you are now bound by a no-shop/exclusivity. That means your leverage has gone down, and you are much more exposed to being pressured into unfavorable terms to simply ‘get the deal closed.’ Politely and respectfully negotiate a term sheet to make it clear what all of the core economic and control terms are. The alignment and lack of surprises on the back end is well-worth the extra time on the front end. 

In short, the core message here is know what you are signing. Make sure your VCs know that you are committed, and aren’t going to play games by shopping their terms. But also make sure you are talking to the right people to ensure that the deal you think you’re getting is in fact the one in your hands.

Separate but related note, make sure the counsel helping you negotiate the term sheet doesn’t have conflicts of interest with the VCs who delivered it. See: When VCs “Own” Your Startup’s Lawyers.  It’s not uncommon for VCs to suggest their preferred lawyers to a founder team, claiming that they’ll be more “efficient.” Whatever nickels and dimes you “save” by using their preferred lawyers will be completely negated 50x by the fact that those lawyers will really work for them long-term, and not the common stock.

Your Best Advisors: Experienced Founders

TL;DR Nutshell: While great advice for a founder team can come from all kinds of sources, nothing comes close to matching the value of advice from other founders (preferably local ones) who have been through the exact same fire themselves, and made it to the other side.

Related Reading:

Suddenly, everyone who just shows up to school gets a participation trophy, every lawyer with small clients is a ‘startup lawyer,’ and everyone who can pull a few strings is a startup ‘advisor’ or ‘mentor.’ While there are truly great advisors/mentors out there, I see founders constantly wasting time, equity, and in some cases money on people who have very little substantive value to deliver to an early-stage technology company.

While the above-linked post gets more in-depth into the source of the problem, this one is about one specific type of ‘advisor’ that every single founder team should have: other experienced founders; specifically founders who have gone through a successful fundraising process, dealt with the nuances of founder-investor relations (preferably with the same/similar types of investors), and either achieved an exit, failed (you can get great advice from people who failed), or are still going strong.

Cut Through the PR

Given how easy it is to orchestrate personal branding and online PR that obscures the truth, every founder team needs people to talk to, privately and confidentially, to get direct, relevant, unvarnished advice; the kind that doesn’t make it onto twitter or blog posts. And there’s no better place to find that advice than experienced founders. 

Want to know what it’s actually like to work with a lawyer? You don’t ask other lawyers, or google, or other people in the market who know her; you ask her clients. Want to know what it’s actually like to work with a specific VC? You don’t ask twitter, or angel investors, or people who run accelerators. You ask their portfolio companies. And more specifically, within those companies you don’t ask the CEO put in place at the first large round and who managed to negotiate the ‘founder’ title for himself; you ask the original founder team that took the first check.

I can’t tell you how often founders will ask the wrong people about a lawyer, a VC, an accelerator, or some other service provider, and then get a complete 180 degree, unvarnished perspective when they ask, off the record, the direct ‘users’ of those people. That’s how you find out that the X lawyer who is ‘extremely well respected and well-known’ happens to take a week to respond to founder e-mails; or that Y ‘well-connected’ VC uses shady tactics to coerce founders into accepting unfair terms. You won’t get it from twitter. And you won’t get it from people who didn’t sit directly in the founder chair. 

There is a world of difference between talking to people who know about the challenges of being a founder v. those who lived them.

Finding Experienced Founders

Don’t expect seasoned founders to be running around town doing free office hours for random founder teams with an idea and hope. They’re not mother teresa. They’re sought-after, extremely busy people, and expect to have their time respected just like anyone else. So hustle to connect with them just like how you hustle to connect with other important people. Meetups, LinkedIn, Twitter, Accelerator Alumni Networks, etc. While I have serious reservations about lawyers connecting clients directly to investors, I think great VC lawyers are excellent connectors to experienced founder teams, as long as the ‘intro request’ makes sense.

But you can know that most excellent founder CEOs I know, even the ‘tougher’ ones, have a special, soft place in their heart for other founder CEOs fighting the same fight. Despite the fact that their advice is probably some of the most valuable you’ll ever find, they’re often the last people to ask for ‘advisor equity’ in exchange for their advice. Although that doesn’t mean you shouldn’t voluntarily offer it to them.

In short, very very few founder teams can make it very far purely on their own judgment. They need independent advisors to consult with on relevant issues. But most advisors don’t have first-hand knowledge of the core challenges of being a founder, and therefore aren’t qualified to advise on those issues. That knowledge lies with experienced founders. Find them.

The Best Seed Round Structure Is the One that Closes

Nutshell: People with strong opinions can argue endlessly about whether founders should be structuring their seed rounds as convertible notes/SAFEs or equity. The problem is that the optimal structure for any type of financing is highly contextual, so anyone offering absolutes on the subject should just “Put that Coffee Down” in the Glengarry sense, before they hurt someone.  The X round that closes is better than the Y round that doesn’t.

Complete standardization of startup financing structures has been a pipe dream for over a decade. Every once in a while someone will produce a new type of security, or flavor of an existing security, and proclaim its superiority. The problem, of course, is very much like the problem faced by any product whose founders hopelessly believe that it will achieve market dominance on technical superiority alone: distribution channels, inertia, and human idiosyncrasies.  In the end, a financing is the act of convincing someone, somewhere, to give you money in exchange for certain rights that they value enough to close the deal.  Values are pesky, subjective things that don’t do well with uniformity.

Outside of Silicon Valley and a very small number of other markets, the people writing the early checks are usually not all rich techies in jeans and t-shirts debating the latest startup/angel investing trends on twitter. Even in Austin they aren’t. They’re successful individuals with their own backgrounds, culture, and values, and very often won’t give a rat’s ass about a blog post saying they should suddenly stop using X security and use Y instead.

So let’s start with the core principle of this post: The Best Seed Round Structure Is the One that Closes. That means priority #1, 2, and 3 for a group of founders is to get the money in the bank. Only from there can you work backward into what seed structure is optimal.

SAFEs are better than Notes? Many non-SV investors don’t care.

This was the same reasoning in a prior post of mine: Should Texas Founders Use SAFEs? To summarize my answer: unless a TX founder is absolutely certain that every investor they want in the round will be comfortable with a SAFE, it’s usually not worth the hassle, and they can get 99% of the same deal by just tweaking a convertible note. Yes, a SAFE is technically better for the Company than a convertible note, and YC has done a great thing by pushing their use. But the differences are (frankly) immaterial if they pose any risk of slowing down or disrupting your seed raise. Here’s what a conversation will often sound like between a founder (not in SV or NYC) and their angel investor:

Angel: Why do we need to use this SAFE thing instead of a familiar convertible note? I read the main parts and seems pretty similar.

Founder: Well, it doesn’t have a maturity date, in case we don’t hit our QF threshold.

Angel: So you’re that worried about failing to hit your milestones and hitting maturity?

:: long pause::

Put. That Coffee. Down.

Debt v. Equity? Do you really have a choice?

There are so many blog posts outlining the pluses and minuses of convertible notes/SAFEs v. equity that I’m going to stay extremely high-level here. The core fact to drive home on the subject is that the two structures are optimized for very different things, and that’s why people debate them so much. Your opinion depends on which thing you value, and that will depend on context.

Convertible Notes/SAFEs are built for maximal speed and flexibility/control up-front. Cost: Dilution, Uncertainty. You defer virtually all real negotiations to the future, save for 2-3 numbers, and note holders often have minimal rights. You can also change your valuation quickly over time, at minimal upfront cost, as milestones are hit. The price for that speed is you’ll usually end up with more dilution (because notes have a kind of anti-dilution built into them) and possibly more liquidation preference. See: The Problem in Everyone’s Capped Convertible Notes.  You’ll also pay a harsher penalty if your valuation goes south before a set of Notes/SAFEs convert than if you’d done equity from the start.

Equity rounds are built for providing certainty on rights and dilution. Cost: Legal Fees, Control, Complexity. An equity round is more inflexible, and slower than debt/SAFEs, but the key benefit is that at closing, you know exactly what rights/ownership everyone got for the money.  Those rights are generally much more extensive than what note/SAFEholders get. If the business goes south, or the fundraising environment worsens significantly, you’ll pay a lower penalty than if you’d done a note/SAFE. But for that certainty, you’ll pay 10x+ the legal fees of a note round (if you do a full VC-style equity round), and have 10x the documentation. That’s why you rarely see a full equity round smaller than $1MM.

Raising only $250K at X valuation and planning to raise another $500-750K at a higher valuation soon, before your A round, because you’re super optimistic about the next 6-12 months? Note/SAFE probably. Raising a full $1.5MM round all at once that will last you 12-18 months, with a true lead? Probably equity.

Seed Equity is a nice middle ground, but if your investors won’t do it, it’s just theoretical. Series Seed, Series AA, Plain Preferred, etc. Seed Equity docs are highly simplified versions of the full VC-style equity docs used in a Series A. They are still about 2-3x the cost of a convertible note round to close in terms of legal fees, but dramatically faster and cheaper than a full equity set. They are a valuable middle ground for greater certainty, but minimal complexity and cost.

But after pondering the nice theoretical benefits of seed equity, we’re back to reality: will your seed investors actually close a seed equity deal? I can’t tell you the answer without asking them, but I can tell you that I know a lot of seed investors in TX and other parts of the country, including professional institutionals, who would never sign seed equity docs.

There is an obvious tradeoff in the convertible note/SAFE structure that has become culturally acceptable for both sides of the deal. Founders get more control and speed up-front, and investors get more downside protection and reassurance that in the future they will get strong investor rights negotiated by a strong lead.

With seed equity, investors are (like with Notes) being asked to put in their money quickly with minimal fuss, but without the downside protection of a note/SAFE, and with significantly simpler investor rights. Many seed investors see that as an imbalanced tradeoff. Whether or not they are right isn’t a question that lends itself to a single answer. It’s subjective, which means the Golden Rule: whoever has the gold makes the rules.  Can they beef up those protections in the next large round? Sure, but many don’t see it that way, and good luck ‘enlightening’ them when every delay brings more reasons for why the round may never close.

I think seed equity is great, and am happy to see founders use it as an alternative to Notes or SAFEs for their seed raise. But that doesn’t change the fact that for every 10-15 seed deals I see, maybe 1 is true, simplified seed equity. And those usually look far more like Friends and Family rounds – where the investors are so friendly that they don’t care about the structure – instead of a true seed with professional seed money.

When it comes down to getting non-SV seed money in the bank, most founders only really have 2 choices for their seed structure: convertible notes or a full equity round. If you’re lucky enough to get a SAFE or seed equity, fantastic. Go for it. But don’t let the advice of people outside of your market, with minimal knowledge of your own investor base, cloud your judgment with theories. When a team debates what type of product to build, the starting point isn’t which one is technically superior, but which one their specific users will actually pay for. Seed round structuring (like coffee) is for closers.