The Challenge of The Ideal First Round Term Sheet
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.