Here’s a list of the top 5 deal terms that cause harm to startups at the seed financing stage and therefore should be avoided:
“Control” of a startup can manifest itself in various forms such as equal (or investor-favorable) representation on the board of directors or a requirement of obtaining seed investor approval for new hires and/or budget matters. Whatever the form of control, seed investment is way too early to be even thinking about losing any amount of control of your startup. You need to figure out why your potential angel investor wants to control your startup.
4. Dividend (that pays out)
By paying your investor a dividend (rather than having dividends accrue and be paid out at acquisition or other typical payable events), you are simply paying back the investor with his own money. What a deal — for the investor. This is something you might see in a late stage private equity financing with a company that has a history of generating revenue. It does not belong in any early stage deal. If your potential angel investor insists on getting dividends paid out quarterly, the angel investor should invest in dividend aristocrats or MLPs, rather than your startup.
3. Tranched Investment
Don’t agree to a tranched seed investment based on milestones. I don’t like tranched investments for 3 reasons. First, the benchmarks are typically difficult to come up with and negotiate and are often imperfect indicators of performance. Second, startups will tend to focus towards hitting these (imperfect) milestones and possibly ignore other projects or natural off-shoots that may pan out huge. Third, some angel investors like to make the additional investment at their option once your startup hits the milestone. Therefore, if you do agree on tranched investments, make sure they are at least automatic — if you hit, they wire. But even better for the startup would be to negotiate a tranched investment that was at the startup’s option upon hitting the milestone.
The investor wants non-dilution rights because they are either really greedy or they don’t trust you to issue additional equity. The angel investor’s best protection against “wasted dilution” is the fact that the founders are being diluted pro rata along with the angel investor — you have to get the angel investor to wrap their brain around this. Unfortunately, for some angel investors having the co-founders sit “side by side” with them is not enough protection.
1. Personal Guaranty
If the shit hits the fan and the company has to shut down, co-founders should only be out time…not additional cash to their investors. If your co-founders didn’t already have ulcers from taking the startup leap, they will soon after signing the personal guaranty.
There’s a lot of advice about (1) how to attract VCs, and (2) how to negotiate a venture capital term sheet. Both sets of advice tend to ignore the gap between an investor’s expression of investment interest and your startup’s receipt of the term sheet. I refer to this waiting period as “term sheet purgatory.”
Term sheet purgatory
can seem like is an eternity for a startup, although it may last from one week to over one month. Usually, the investor is just prepping the field to make the investment. While progressive discussions with an investor about the investment are fine and most revolve around pre-diligence matters, sometimes these discussions shift towards the pre-money valuation and investment amount. And this has potential negative consequences for the startup.
It can be a mistake to arrive at a consensus with your investor on pre-money valuation & investment amount before receiving the full term sheet. Terms like the option pool, liquidation preference, and board composition are just a few other investment terms that have a meaningful impact on your startup. You’ll feel real solid about that $6,000,000 pre-money until you receive the term sheet and it specifies a 25% option pool, 1X participating liquidation preference, and an investor-favorable board.
Of course, you can re-negotiate the pre-money and/or investment amount, but it still makes for potentially awkward conversations and/or feelings of mistrust. Neither is a good way to kick off your relationship with your future investor. (Even worse, a startup may feel like they can’t re-negotiate because they’ve already “agreed” to those numbers.)
Thus, if your potential investor continues to verbally discuss investment terms with you, consider asking for the term sheet.
Even if you are comfortable negotiating verbally on one facet of your startup’s capital raise and blindly on the rest — what’s the point of talking about the color of your corsage if you haven’t received a (non-binding) invitation to the dance?
Request that all key terms of the investment are laid out in front of you in the form of a term sheet. This may be the quickest way to get you out of term sheet purgatory and avoid negative consequences along the way.
Selecting the optimal structure when raising capital for your startup can be a challenging task. When clients ask me for my recommendation, I find myself recommending the convertible debt financing route more often than traditional equity financing (i.e., I’ll give you $100k for 20% of your company’s stock).
So what is convertible debt?
Convertible debt financing is basically an investor loan to your startup that has a future conversion-to-equity feature. That is, your startup’s investor gives your startup a loan like a bank would, but the outstanding balance of this loan will convert to shares in your corporation at a future date.
When does convertible debt convert to equity?
Convertible debt typically converts to equity the next time your startup raises capital (think venture capital or similar large investor). Technically, this large raise is called a “qualified financing” per the convertible debt agreements (note and note purchase agreement).
How does convertible debt convert to equity?
Convertible debt converts to equity based on the valuation your startup receives from the venture capital firm in the “qualified financing.” For example, if your venture capital investor ends up paying $1 per share for your startup’s preferred stock and you have $800,000 of convertible debt, the investor will receive 800,000 shares of preferred stock. The loan will then be cancelled. (Note: Convertible debt often converts to preferred stock at a discount than what the venture capital investor pays for the preferred shares.)
So why do I recommend convertible debt so much?
Simple: It delays the valuation discussion. I see many founders struggle with their investors over a valuation to do a straight up cash-for-shares equity investment. And this struggle can last for months and eat up development time.
Recently I have been asked a lot of questions regarding nondisclosure agreements (NDAs) and investors, either angel or venture capital. I previously wrote my thoughts on trying to drop NDAs on venture capital firms in “Why a VC Will Take a Lighter to Your NDA.”
And yesterday, Guy Kawasaki echoed my NDA-VC sentiments in “The No-Bull-Shiitake Investor Wishlist,” Guy’s latest post on the Open Forum by American Express. In his post, he gives some candid advice to those of you debating whether to hand over your nondisclosure agreement to a venture capital firm for a signature:
[D]on’t ask any potential investor to sign a nondisclosure agreement (NDA), because asking them to do so will make you look clueless. Venture capitalists and angel investors are often looking at three or four similar deals, so if they sign an NDA from one company and then fund another, they expose themselves to legal action. If you find an investor who is willing to sign an just to hear your idea, you probably don’t want his or her money.
I’ve never heard of a venture capitalist or angel investor ripping off an idea—frankly, few ideas are worth stealing. Even if your idea is worth stealing, the hard part is implementing the idea, not coming up with it. Finally, continuing the dating analogy, you probably won’t get very many dates if the first thing out of your mouth is “Will you sign a prenuptial?”
Guy’s advice about NDAs is just the tip of the iceberg in his post, as he also lays out the characteristics of an “attractive and fundable date” for a venture capitalist or investor. I strongly suggest reading the full post here.
Y Combinator and Wilson Sonsini Goodrich & Rosati are happy to announce the Series AA Equity Financing Documents.
The Y Combinator documents are back up again–grab them while you can.
At first glance, it looks like they added a term sheet. And now each document comes with a fancy new header:
This [document] and all of the Series AA financing documents on this website have been prepared by Wilson Sonsini Goodrich & Rosati for informational purposes only and do not constitute advertising, a solicitation, or legal advice. Transmission of such materials and information contained herein is not intended to create, and receipt thereof does not constitute formation of, an attorney-client relationship. Internet subscribers and online readers should not rely upon this information for any purpose without seeking legal advice from a licensed attorney in the reader’s state. The information contained in this website is provided only as general information and may or may not reflect the most current legal developments; accordingly, information on this website is not promised or guaranteed to be correct or complete. Wilson Sonsini Goodrich & Rosati expressly disclaims all liability in respect to actions taken or not taken based on any or all the contents of this website. Further, Wilson Sonsini Goodrich & Rosati does not necessarily endorse, and is not responsible for, any third-party content that may be accessed through this website.
So don’t forget to delete the headers when you customize your legal documents…