As I watched 24 last night, I kept thinking to myself “Why the fuck does Jack have his cell phone ringer on – hasn’t he ever heard of vibrate?” immediately after his cell phone rang but right before he got shot at because the bad guys now knew where he was. I had a parallel thought this morning – “Why do we make all this term sheet stuff so long, verbose, and tedious.” The answer – word processers. If we had to type all this crap on a typewriter (or write it out by hand) it’d be a lot shorter. In both cases, technology is working against us. But – then again, we wouldn’t have blogs (and I can hear a few of you (and I know who you are) saying “and that would be a bad thing because?”)
While there is a lot to negotiate in a term sheet (as you can see from the series of posts on term sheets that Jason and I have written), a term sheet is simply a step on the way to an actual deal. Term sheets are often either non-binding (or mostly non-binding), and most investors will load them up with conditions precedent to financing. Entrepreneurs glance over these – usually because they are in the back sections of the term sheet and are typically pretty innocuous, but they occasionally have additional “back door outs” for the investor that the entrepreneur should watch out for, if only to better understand the current mindset of the investor proposing the investment.
A typical conditions precedent to financing clause looks as follows:
“Conditions Precedent to Financing: Except for the provisions contained herein entitled “Legal Fees and Expenses”, “No Shop Agreement”, and “Governing Law” which are explicitly agreed by the Investors and the Company to be binding upon execution of this term sheet, this summary of terms is not intended as a legally binding commitment by the Investors, and any obligation on the part of the Investors is subject to the following conditions precedent: 1. Completion of legal documentation satisfactory to the prospective Investors; 2. Satisfactory completion of due diligence by the prospective Investors; 3. Delivery of a customary management rights letter to Investors; and 4. Submission of detailed budget for the following twelve months, acceptable to Investors.”
Notice that the investor will try to make a few things binding – specifically (a) that his legal fees get paid whether or not a deal happens, (b) that the company can’t shop the deal once the term sheet is signed, and (c) that the governing law be set to a specific domicile – while explicitly stating “there are a bunch things that still have to happen before this deal is done and I can back out for any reason.”
There are a few conditions to watch out for since they usually signal something non-obvious on the part of the investor. They are:
1. “Approval by Investors’ partnerships” – this is super secret VC code for “this deal has not been approved by the investors who issued this term sheet. Therefore, even if you love the terms of the deal, you still may not have a deal.
2. “Rights offering to be completed by Company” – this indicates that the investors want the company to offer all previous investors in the company the ability to participate in the currently contemplated financing. This is not necessarily a bad thing – in fact in most cases this serves to protect all parties from liability – but does add time and expense to the deal.
3. “Employment Agreements signed by founders as acceptable to investors” – beware what the full terms are before signing the agreement. As an entrepreneur, when faced with this, it’s probably wise to understand (and negotiate) the form of employment agreement early in the process. While you’ll want to try to do this before you sign a term sheet and accept a no-shop, most VCs will wave you off and say “don’t worry about it – we’ll come up with something that works for everyone.” Our suggestion – at the minimum, make sure you understand the key terms (such as compensation and what happens on termination).
There are plenty of other wacky conditionals – if you can dream it, it has probably been done. Just make sure to look carefully at this paragraph and remember that just because you’ve signed a term sheet, you don’t have a deal.
A the end of the year, I completed a financing that was much more difficult than it needed to be. As Jason Mendelson (our general counsel) and I were whining to each other we decided to do something about it. At the risk of giving away more super-top-secret VC magic tricks, we’ve decided to co-author a series of posts on Term Sheets.
We have chosen to address the most frequently discussed terms in a venture financing term sheet. The early posts in the series will be about terms that matter – as we go on, we’ll get into the more arcane and/or irrelevant stuff (which – ironically – some VCs dig in and hold on to as though the health of their children depended on them getting the terms “just right.”) The specific contract language that we refer to (usually in italics) will be from actual term sheets that are common in the industry. Ultimately, we might put this into a Wiki, but for now we’ll just write individual posts. Obviously, feel free to comment freely (and critically.)
In general, there are only two things that venture funds really care about when doing investments: economics and control. The term “economics” refers to the end of the day return the investor will get and the terms that have direct impact on such return. The term “control” refers to mechanisms which allow the investors to either affirmatively exercise control over the business or allow the investor to veto certain decisions the company can make. If you are negotiating a deal and an investor is digging his or her feet in on a provision that doesn’t affect the economics or control, they are probably blowing smoke, rather than elucidating substance.
Obviously the first term any entrepreneur is going to look at is the price. The pre-money and post-money terms are pretty easy to understand. The pre-money valuation is what the investor is valuing the company today, before investment, while the post-money valuation is simply the pre-money valuation plus the contemplated aggregate investment amount. There are two items to note within the valuation context: stock option pools and warrants.
Both the company and the investor will want to make sure the company has sufficiently reserved shares of equity to compensate and motivate its workforce. The bigger the pool the better, right? Not so fast. While a large option pool will make it less likely that the company runs out of available options, note that the size of the pool is taken into account in the valuation of the company, thereby effectively lowering the true pre-money valuation. If the investor believes that the option pool of the company should be increased, they will insist that such increase happen prior to the financing. Don’t bother to try to fight this, as nearly all VCs will operate this way. It is better to just negotiate a higher pre-money valuation if the actual value gives you heartburn. Standard language looks like this:
Amount of Financing: An aggregate of $ X million, representing a __% ownership position on a fully diluted basis, including shares reserved for any employee option pool. Prior to the Closing, the Company will reserve shares of its Common Stock so that __% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees and consultants.
Price: $______ per share (the Original Purchase Price). The Original Purchase Price represents a fully-diluted pre-money valuation of $ __ million and a fully-diluted post money valuation of $__ million. For purposes of the above calculation and any other reference to fully-diluted in this term sheet, fully-diluted assumes the conversion of all outstanding preferred stockof the Company, the exercise of all authorized and currently existing stock options and warrants of the Company, and the increase of the Companys existing option pool by [ ] shares prior to this financing.
Recently, another term that has gained popularity among investors is warrants associated with financings. As with the stock option allocation, this is another way to back door a lower valuation for the company. Warrants as part of a venture financing – especially in an early stage investment – tend to create a lot of unnecessary complexity and accounting headaches down the road. If the issue is simply one of price, we recommend the entrepreneur negotiate for a lower pre-money valuation to try to eliminate the warrants. Occassionally, this may be at cross-purposes with existing investors who – for some reason – want to artificially inflate the valuation since the warrant value is rarely calculated as part of the valuation (but definitely impacts the future allocation of proceeds in a liquidity event.) Note, that with bridge loan financings, warrants are commonplace as the bridge investor wants to get a lower price on the conversion of their bridge into the next round – it’s not worth fighting these warrants.
The best way for an entrepreneur to negotiate price is to have multiple VCs interested in investing in his company – (economics 101: If you have more demand (VCs interested) than supply (equity in your company to sell) then price will increase.) In early rounds, your new investors will likely be looking for the lowest possible price that still leaves enough equity in the founders and employees hands. In later rounds, your existing investors will often argue for the highest price for new investors in order to limit the existing investors dilution. If there are no new investors interested in investing in your company, your existing investors will often argue for an equal to (flat round) or lower than (down round) price then the previous round. Finally, new investors will always argue for the lowest price they think will enable them to get a financing done, given the appetite (or lack thereof) of the existing investors in putting more money into the company. As an entrepreneur, you are faced with all of these contradictory motivations in a financing, reinforcing the truism that it is incredibly important to pick your early investors wisely, as they can materially help or hurt this process.
Fred Wilson has a nice post up titled The Ideal First Round Term Sheet. In it he describes the process of closing a financing using a standard set of Series A terms from Gunderson that he agreed to as part of the term sheet. In this case, the VC (Fred’s firm – Union Square Ventures) isn’t using a law firm. Fred states:
“I’d like to see this practice become standard in our industry. We need to lower the time and cost of raising capital. We need to eliminate a lot of bad terms that have caused a lot of harm (tranched investments, mutiple liquidation preferences, super pro-ratas, etc, etc). We need to converge on a set of standard Series A terms that everyone uses.”
I couldn’t agree more. Chris Dixon wrote a post titled Ideal First Round Funding Terms that Fred points to. I agree with almost everything Chris says, and especially agree with his assertion that you should “only negotiate over 2 things – valuation and amount raised.”
When my partner Jason Mendelson and I wrote our Term Sheet series in 2005, we had a lot of people thank us for demystifying the term sheet. Some time last year, both TechStars and Y Combinator open sourced their financing documents – TechStars were done in conjunction with Cooley Godward and Y Combinator’s were done in conjunction with Wilson Sonsini. On top of all of this, the NVCA (National Venture Capital Association) has had a set of model legal documents up on the web for a while (Jason was on the team that put these together).
So – there’s now no shortage of term sheet data (and forms) available. Now the trick is to get everyone to start using the same stuff. It seems like first round deals is a great place to start.
Ironically, if you read through all the various sets of documents with a fine tooth comb, you’ll find an interesting phenomenon – they are all slightly different. So – a next step is to get Gunderson, Cooley, and WSGR to standardize on one set. If there was truly a set of “first round docs” (for angel rounds, seed rounds, and venture capital rounds – whatever you want to call them) – life would be a lot better for entrepreneurs, VCs, and probably even the law firms since most first round deals are money losers for them even though they generally cost way too much.
We’ve funded a company called Brightleaf that plans to help with the document production part of this problem. But we also need leadership from VCs and law firms to realize that there really should only be two terms being negotiated in most first round financings – valuation and the amount raised.
Suddenly the blogosphere is talking about the need for a standardized first round term sheet. The latest iteration of this seems to have blossomed when TheFunded Founder Institute released a “Plain Preferred Term Sheet” (developed with WSGR). According to the article in TechCrunch, the goal is to (a) protect founders and (b) reduce legal fees. Kudos for yet another shot at this – between all the blog posts that have been written about this over the past few years, term sheets are no longer a mysterious thing to an entrepreneur.
However, let me suggest that the problem is not “the idea first round term sheet.” We now have a bunch of these – the YCombinator one, the TechStars one, the NVCA model docs, and several from law firms (WSGR did the YCombinator one, Cooley did the TechStars one.)
I think the focus should be on standardizing the docs and having a handful of fill in the blank terms for a first round financing. I’ve done my share of financings with a set of bullet points in email (I just proposed one today) and I’ve stated that the only things people should care about in the first round financing is (a) valuation and (b) the amount raised. That said, there will always be a handful of other things to argue about in a first round investment – most notably vesting dynamics, change of control issues, and option pool size (which is really just valuation). However, you should be able to do this off of a one page checklist that everyone understands.
But let’s get back to the real issue – standardizing the docs. I read through the protective provisions in TheFunded Founder Institute (TFFI) term sheet and they are a version that leaves a few things out that are important to me. I like a tighter version.
First is the TFFI version:
“So long as 25% of the aggregate number of Preferred shares issues in the financing are outstanding, consent of at least 50% of the then-outstanding Preferred will be required to (i) alter the certificate of incorporation if it would adversely alter the rights of the Preferred; (ii) change the authorized number of Preferred Stock; (iii) authorize or issue any senior or pari passu security; (iv) approve a merger, asset sale or other corporate reorganization or acquisition; (v) repurchase Common Stock, other than upon termination of a consultant, director or employee; (vi) declare or pay any dividend or distribution on the Preferred Stock or Common Stock; or (vii) liquidate or dissolve.”
Following is the standard we use in all of our financings:
“For so long as any shares of Series A Preferred remain outstanding, consent of the holders of at least a majority of the Series A Preferred shall be required for any action, whether directly or through any merger, recapitalization or similar event, that (i) alters or changes the rights, preferences or privileges of the Series A Preferred, (ii) increases or decreases the authorized number of shares of Common or Preferred Stock, (iii) creates (by reclassification or otherwise) any new class or series of shares having rights, preferences or privileges senior to or on a parity with the Series A Preferred, (iv) results in the redemption or repurchase of any shares of Common Stock (other than pursuant to equity incentive agreements with service providers giving the Company the right to repurchase shares upon the termination of services), (v) results in any merger, other corporate reorganization, sale of control, or any transaction in which all or substantially all of the assets of the Company are sold, (vi) amends or waives any provision of the Company’s Certificate of Incorporation or Bylaws, (vii) increases or decreases the authorized size of the Company’s Board of Directors, (viii) results in the payment or declaration of any dividend on any shares of Common Preferred Stock, (ix) issues debt in excess of $100,000, (x) makes any voluntary petition for bankruptcy or assignment for the benefit of creditors, or (xi) enters into any exclusive license, lease, sale, distribution or other disposition of its products or intellectual property.”
Details, but important ones. The protective provisions in the TFFI term sheet include the word “adversely” in section (i) – this is simply “lawsuit bait” if it ever comes to pass as an issue. I also want a protective provision to disallow increases in Common Stock. And – given the board size, I want a protective provision that doesn’t allow the board to be increased without my consent. Finally, I want a protective provision against making an exclusive deal or license for the assets – this is another way of selling the company out from under the investor.
Now, I guess I’ll negotiate on these, but I can’t imagine why anyone would struggle with any of this. Except for the lawyers. Remember – we are still in the term sheet – just wait until the lawyers expand this into the actual financing documents. I’m sure the WSGR lawyers might have a different point of view, as might my lawyers, or any other lawyer that looks at this. Or, if the WSGR lawyer is on the other side of the deal (representing the VC) he might have an issue with the TFFI version.
Standardizing the deal documents would solve a huge part of this. Also, if the lawyers acknowledged that they aren’t adding much value at this level (e.g. it’s a simple negotiation and a straightforward thing to document), you could get to a place where lawyers should be able to do this for a low fixed price (say, $10,000). However, this has to be done at the legal level, or you don’t really solve the fundamental issue. Sure – you theoretically can streamline the process by starting with a better “form” that has been “pre-negotiated” (e.g. take it or leave it), but until you standardize the legal stuff behind the deal, you are always going to have lawyers armed with word processors redlining things.
I’m not unhappy about the effort to simplify this – quite the opposite – I’m delighted even more people like TheFunded are getting in the mix. However, I encourage everyone, especially the lawyers, to recognize the value in standardization of the underlying docs (with the appropriate “fill in the blank negotiated terms”). I’m not sure how to get this to a standard point, but it’s got to be easier than figuring out if universal healthcare is possible and – if so – solving for it.
Earlier this week I did a brief post on the “no shop agreement” that is a common feature in a term sheet. I compared signing a no shop to the construct of serial monogamy in a relationship. I had a couple of comments (one that was intellectual, one that was a little harsher and painted VCs as “duplicitous.”) I was mulling over my obviously (in hindsight to me) asymmetric view when Tom Evslin very clearly and coherently articulated why my analogy was really unilateral monogamy (e.g. the VC isn’t signing up for serial monogamy – only the entrepreneur is.)
Tom – and the comments I received – are correct (although I don’t agree with the generalization that “VCs are duplicitous.”) After reading Tom’s post, I thought about my own behavior (at least my perception of my own behavior) vs. the general case and realized I’ve mixed the two up. I’ve been on the giving and receiving side of unilateral no shops many times and – when on the receiving side – have usually been sensitive to why the other party wouldn’t sign a reciprocal no shop. In most cases, I simply don’t put a lot of weight behind the no shop due to the ability to bind it with time (30 – 45 days), plus whenever I’m on the receiving end, I’ve done my best to test commitment before signing up to do the deal.
In addition to Tom’s post, Rick Segal wrote up his thoughts in a post titled “The Handshake Clause” where he makes the point that his firm doesn’t sign a term sheet until they are committed to doing a deal. His explanation of how he approaches this is useful, but it is important to acknowledge that there is a wide range of behavior among VCs – the group that doesn’t put a term sheet down until they are committed are at one end of the spectrum; the group that puts down a term sheet to try to lock up a deal while they think about whether or not they want to do it is at the other. I’d like to think that we are at the “good” end of this spectrum (e.g. we won’t issue a term sheet unless we are ready to do a deal.) Obviously, your mileage will vary with the VCs you are dealing with – hence the value of doing your own due diligence on your potential future partners.
As I mulled this over, I came up with a couple of examples in the past 10 years where the no shop had any meaningful impact on a deal in which I was involved. I could come up with an edge case for each situation, but this was a small number vs. the number of deals I’ve been involved in. In addition, when I thought about the situations where I was a VC and was negatively impacted by not having a no shop (e.g. a company we had agreed with on a term sheet went and did something else) or where I was on the receiving end of a no shop and was negatively impacted by it (e.g. an acquirer tied me up but then ultimately didn’t close on the deal), I actually didn’t feel particularly bad about either of the situations since there was both logic associated with the outcome and grace exhibited by the participants. Following are two examples:
- We signed a term sheet to invest in company X. We didn’t include a no shop in the term sheet – I don’t think there was a particular reason why. We were working to close the investment (I think we were 15 days into a 30–ish day process) and had legal docs going back and forth. One of the founders called us and said that they had just received an offer to be acquired and they wanted to pursue it. We told them no problem – we’d still be there to do the deal if it didn’t come together. We were very open with them about the pros and cons of doing the deal from our perspective and – given the economics – encouraged them to pursue it (it was a great deal for them.) They ended up closing the deal and – as a token – gave us a small amount of equity in the company for our efforts (totally unexpected and unnecessary, but appreciated.)
- I was an existing investor in a company that was in the process of closing an outside led round at a significant step up in valuation. The company was under a no shop agreement with the new VC. Within a week of closing, we received an acquisition overture from one of the strategic investors in the company. We immediately told the new lead investor about it who graciously agreed to suspend the no shop and wait to see whether we wanted to move forward with the acquisition or the financing. We negotiated with the acquirer for several weeks, checking regularly with the new potential investor to make sure they were still interested in closing the round if we chose not to pursue the acquisition. They were incredibly supportive and patient. The company covered their legal fees up to that point (unprompted – although it was probably in the term sheet that we’d cover them – I can’t recall.) We ended up moving forward with the acquisition; the new investor was disappointed in the outcome but happy and supportive of what we did.
As I said earlier, these are edge cases – in almost all of my experiences the no shop ended up being irrelevant. But – as both of these example show – the quality and the character of the people involved made all the difference. Near the end of his post, Tom makes the point that it’s “good negotiating advice to make sure that every clause which can be mutual is mutual.” I completely agree.
When I wrote my first post on the structure and financial components of a typical venture capital investment – where I described Liquidation Preferences – I alluded to the concept of participating preferred as a maligned and typically hotly negotiated issue in many venture capital investments. In this post, I’m going to try to explain the notion of participating preferred (referred to hereafter as PP), how it works, and its financial and emotional impact on a deal. I’m not going to take sides, but rather try to give a broad perspective on it.
First – some history. I first encountered PP when several of the angel investments that I did in 1994 and 1995 matured to the point where they raised a round of institutional venture capital. Since I was living in Boston at the time, most of the VCs looking at my angel deals were east coast firms. In every single case, the initial term sheets each of these companies received included a PP feature – a “double dip” as my east coast lawyer called it. When we pushed back on the PP, we were told that all east coast term sheets had them (our lawyer told us it was negotiable, but that it was definitely an east coast standard request). The PP survived several of term sheet negotiations, but not all of them.
My east coast-centric world changed significantly after I moved to Colorado in 1996 and started doing venture capital. Because of geography and investment focus, I ended up working on more stuff on the west coast. There, I rarely saw a PP feature and was told flatly that PP was “an east coast term.” As the 1990’s marched on and the bubble started to build, I rarely saw a PP – even the east coast guys had dropped it from their standard term sheets.
After the bubble burst in 2001, PP was back – and this time on both coasts. Suddenly every term sheet I saw had a PP feature in it, regardless of the stage of the investment, type of business, or location of investor. It had once again become “a standard feature”, although it was now bi-coastal (or – more accurately – a red-blooded American term.)
So, with this as background, and before we dig into the actual mechanics of a PP, lets first recognize it for what it is – an economic feature in a venture investment. It’s not a standard term, nor is it something that is evil and should never be part of a deal. Unlike a liquidation preference which is rarely negotiable with a VC, a PP is almost always negotiable. There are even cases where it economically disadvantages an early stage investor who insists on it in the deal from the beginning. Importantly, there is not a consensus among investors on when a PP feature is appropriate in a deal and each firm approaches it from their own, unique perspective.
A PP is the right of an investor, as long as they hold preferred stock, to get their money back before anyone else (the “preference” part of PP), and then participate as though they owned common stock in the business (or, more technically, on an “as converted basis” – the “participation” part of PP). It takes a preferred investment, which acts as either debt or equity (where the investor has to make a choice of either getting their money back or converting their preferred shares to common), and turns it into something that acts both as debt and equity (where the investor both gets their money back and participates as if they had converted to common shares).
To illustrate, let’s take a simple case – a $5m Series A investment at $5m pre-money where the company is sold for $20m without any additional investments being made. In this case, the Series A investor owns 50% of the company. If they did not have a PP, they would get 50% of the return, or $10m. With the PP they get their $5m back and then get 50% of the remaining $15m ($7.5m), resulting in $12.5m to the Series A investor and $7.5m to everyone else. In this case, the Series A investor gets the equivalent of 62.5% of the return (rather than the 50% which is equivalent to their ownership stake). The PP results in a re-allocation of 12.5% of the exit value to the Series A investor.
Obviously, this can get much more complicated as you start to have multiple rounds of investments with a PP feature. A simple way to think about how the economics of a PP works is that the total dollar amount of the preference will come off the top of the exit value (and go to the investors); everyone will then convert into common stock and share the balance based on their ownership percentages. For example, assume a company raises $40m over 3 rounds where each round has a PP feature and the investors own 70% of the company. If this company is sold for $200m, the first $40m would go to the investors and the remaining $160m would be split 70% to investors / 30% to everyone else. In this case, the investors would get a total of $152m, ($40m + $112m, or 76% of the proceeds – 6% more then they would have gotten if there was no PP.)
If you sit and ponder the math, you’ll realize that a PP usually has material impact on the economics in low to medium return deals, but quickly becomes immaterial as the return increases (or – more specifically – as the ratio of the exit value to invested capital increases). For example, if a company is sold for $500m, a $10m PP re-allocates a small portion of the deal ($10m of the $500m) to the investors vs. the $40m of $200m or $5m of $20m in the other preceding examples. As a result, a PP usually only matters in a low to medium return situation. If a company is sold for less than paid in capital, the liquidation preference will apply and the participation feature will not come into play. If a company is sold for a huge amount of money, the PP won’t have much economic impact, as the preference feature of the PP becomes a small percentage of the deal total. In addition, in essentially every case, PP’s don’t apply in an IPO where preferred stock (of any flavor) is typically converted into common stock at the time of the offering.
As PP started showing up in more deals, some creative lawyer came out with a perversion on the preferred feature called a “cap on the participate” (also known as a “kick-out feature.”) In this case, the participation feature of the PP goes away once the investor holding the PP reaches a certain multiple return of capital. For example, assume a 3x cap on a PP in a $5m Series A investment. In this case, the investor would benefit from their PP until their proceeds from the deal reached $15m. Once they reached this level, their shares are no longer counted in the cap structure and the other shareholders share the remaining proceeds. Of course, the investor always has the option to convert their shares to common stock and give up their preferred return (but participate fully in the proceeds). Put another way, at a high enough valuation the investor is better off simply converting to common (in the current example at an exit value above $30m).
Participation caps, however, have a fundamental problem – they create a flat spot in most deal economics where the investor gets the same amount across a range of exit values. If we stay with the example above and assume a 50% ownership for the Series A, the PP would apply until the exit value reached $25m, at which point the investor receives $15m in proceeds. Between $25m and $30m, the investor would continue to receive this same $15m (this is the flat spot – it doesn’t matter whether the exit value is $26m or $29m, the investor would get $15m). At exit values above $30m, the investor would convert to common stock and take 50% of the proceeds (i.e., their as-converted share of the proceeds would exceed the $15m cap so they would be better off converting to common and taking this share of the exit value). This is an odd dynamic, since the common shareholders are clearly not indifferent to exit values in this flat spot, but the investor is (and consider a case where this flat spot was much larger than the one in the example above). Any way you cut it there is misalignment, at least for a range of outcomes, between the investor and the rest of the shareholders.
Another perversion is the “multiple participate”. In this case, the investor gets some multiple of his participate off the top of the transaction. For example, a 3x multiple participate on a $40m investment would mean the first $120m would go to the investor (and then the remaining proceeds would be distributed to the investor and the rest of the shareholders). This type of PP only appeared for a short while when investors were doing recapitalizations without actually going through the mechanics of recapitalizing the company (more about this in a future blog post).
Interestingly, there is a case to be made that PP in early financing rounds can actually end up disadvantaging early investors. The math on this gets complicated very quickly, but if you assume that every subsequent investment round has at least as favorable terms as the initial round (i.e., include a PP if the first round does) and that subsequent rounds include new investors there are many cases where the initial investor is actually disadvantaged by the existence of the PP (they would have been better off to have not put it in the initial round and because of that pushed for its exclusion from subsequent rounds). It’s counterintuitive, but it actually works out this way in a number of very common financing scenarios.
So – if PP simply relates to economics, why is it a term that brings out such emotion in entrepreneurs and investors alike? A close friend of mine who is an extremely successful entrepreneur recently told me “I’ve walked on every investment deal for any company that I’ve run that even smelled of multiple dips of participation – and spit back in the direction the term sheet came from!” We debated back and forth a while. For example, I asked him “would you take $5m for 33% of a company with no participate or 25% of a company with full participate?” He responded “I would go find a deal where I gave up 26.5% without a participate” which, while an emotional reaction, ironically reinforced my point that it was just economics. After pondering this term over the years, I’ve concluded that participating preferred is one of those terms that creates real tension between the entrepreneur and the investor – it forces the acknowledgement by the entrepreneur that a moderate return is not a success case for the investor and at the same time forces the investor to acknowledge that in those moderate cases they believe it is fair to receive a greater percentage of the proceeds at the expense of the entrepreneur.
My partner Jason Mendelson and I are psyched to announce that our book – Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist – has been published and is now available. We are also relaunching AskTheVC – the companion website to the book that we maintained for several years, went dormant for a while, but is alive with content once again.
The book originated in 2005 when Jason and I wrote a long series of posts on this blog about a typical Venture Capital term sheet. It took us a year or so to get all the way through it, but it was fun and generated an enormous amount of positive feedback from entrepreneurs (and would be entrepreneurs) who told us how helpful it was for them to understand how a VC term sheet actually worked.
People regularly suggested that we turn the blog series into an actual book. Until about a year ago we’d simply encourage people to PDF up the posts and do whatever they wanted with them. We got great feedback from students and entrepreneurs all over the world who said they were on the receiving end of the posts, that the posts had been used as the curriculum for a class, or that they had simply referred to them during a negotiation and they were “more helpful than their lawyer.”
After I wrote Do More Faster: TechStars Lessons to Accelerate Your Startup with David Cohen (the CEO of TechStars), Jason and I decided to write Venture Deals. We knew the term sheet series would only be a small part of the book and would have to be re-written, so we just got to work. Once again, it feels amazingly good to “ship the book” – it’s remarkably hard work to get from “an idea for a book” to an actual book.
For those who think this is just a reprint of the blog posts, they make up less than 20% of the book and have been completely rewritten. The table of contents gives you a feel for this.
- The Players
- How to Raise Money
- Overview of the Term Sheet
- Economic Terms of the Term Sheet
- Control Terms of the Term Sheet
- Other Terms of the Term Sheet
- The Capitalization Table
- How Venture Capital Funds Work
- Negotiation Tactics
- Raising Money the Right Way
- Issues at Different Financing States
- Letters of Intent – The Other Term Sheet
- Legal Things Every Entrepreneur Should Know
While it’s a chewy topic, we’ve tried to keep it light, fun, and enjoyable. But we’ve also tried to make it a must read for any entrepreneur, or would be entrepreneur, or student interested in entrepreneurship, or junior lawyer that is working on deals, and our parents. We’ve created a dynamic companion site at AskTheVC, are working on a teaching guide, and have a few entertaining surprises up our sleeve that will be launched in early September.
Since I’m a shameless book salesman, you’ll be hearing plenty more from me on this blog. But for now, go take a look at Fred Wilson’s wonderful review titled Be Smarter Than Your Lawyer and Venture Capitalist.
In 2005, Jason Mendelson (my partner and co-author of AsktheVC) wrote what has become an extremely popular series dissecting the “term sheet.” The feedback we got from it encouraged us to write several more series of blogs and ultimately led to us deciding to start writing AsktheVC to answer random questions from entrepreneurs.
Last Friday I pointed to a post from Dave Naffzinger (Judy’s Book) about Stock Options from an Entrepreneurs Point of View. I woke up today to two more great entrepreneur posts on term sheets. The first is from Dick Costolo (FeedBurner) titled Venture Terms – Liquidation Preferences and Participation. The second was titled Term Sheet Hacks was on a new blog titled Venture Hacks and written by Naval Ravikant (Vast.com) and Nivi (EIR at Atlas Ventures.)
When I started this blogging thing back in May of 2004, I stated that I was motivated by Fred Wilson’s post on Transparency. I love that smart entrepreneurs are adding to the body of knowledge out there around the funding process. I’ve always been befuddled that a financing (both angel and VC) and the “term sheet” are such as mysterious thing. It has been rewarding to get thousands of emails over the past two years thanking me / Jason for what we’ve written – and it is fun to see some smart entrepreneurs continuing to add to the demystification of the term sheet.
For some time Jason and I have felt that VC’s have had an unfair advantage when it comes to understanding term sheets. So a few years back we wrote a whole series of blog posts (the Term Sheet series) which became the basis for the book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. Our goal with all of this was to help put entrepreneurs on a more even footing in negotiating a deal with a VC.
In some ways, I’ve always seen writing (both books and this blog) as a form of personalized teaching. It let’s me efficiently share whatever knowledge I have. But a few months back while I was visiting TechStars NYC, I had the chance to meet the guys over at Veri and pretty quickly realized they have a really interesting format for teaching things like how a term sheet works in an even more personalized way.
The result is Veri’s Understanding Term Sheets. The experience works like it would if we were learning it together one on one, namely that I ask you a series of question to figure out what you do and don’t know. When you know the material you get to quickly prove you’re a champ. When you don’t know something, I help bring you to the exact snippet of information you need to know. In other words, we figure out what you know, and help you learn only what you don’t. And hopefully have some fun in the process.
Let me know you think about Understanding Term Sheets, especially if there are ways to improve it.
On the heels of all the noise around Groupon’s $100m financing at a $7.5b (billion) post valuation, I thought I’d put out a call for “old VC term sheets – prior to 1990.”
My partner Jason Mendelson and I are working on a book titled Venture Financings: How To Look Smarter Than Your Lawyer and VC. The final draft is due at the end of February (feel free to give us your sympathy if you happen to see us between now an then) and based on my previous experience with our publisher (Wiley) on Do More Faster, I expect it’ll be out by the end of Q211.
The basis for the book comes from the Term Sheet series that Jason and I wrote on this blog in 2005. We’ve updated the series for the current reality of 2010 (of which much is very similar to 2005, with some differences), talk about lots of different twists that have appeared, and tell plenty of stories to illustrate what the implications of various terms and financing configurations are.
As part of this, I’m looking for some early VC term sheets. I started by trying to hunt down the original Digital Equipment Corporation term sheet (or letter describing the investment) from AR&D to Ken Olson but came up dry. Today, as I was working on some stuff, I realized it would be interesting to look at some term sheets from the 1970’s and 1980’s in whatever form they are in.
If you happen to be in possession of an older VC term sheet – either for a company that was successful or one that was a failure – I’d love to see it. You can email it to me if easy, or drop me a note and I’ll tell you where to fax it. I’ll make sure I honor your request to keep it anonymous if you want me to (either you, the company, or both) but of course would love the ability to weave it into the book where appropriate.