Tag Archives: Term Sheet

Kryptonite Angel Round Terms

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:

5. Control

“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.

2. Non-Dilution

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.

How to Evaluate an Offer from a Startup Incubator

Great news — your startup just got accepted to an incubator! But before your startup signs up and cashes that $[XX,000] check, your startup’s co-founders should sit down and evaluate the incubator’s offer. The following are some issues to consider and actions to take before accepting an incubator’s offer:

(1) Calculate Valuation and Determine Value.

Pre-money valuations startups receive from incubators are typically low…really low. If an incubator offers your startup $25,000 in exchange for 6% equity, the pre-money valuation is a whopping $391,667.

As you can see, I don’t think any startup has joined an incubator based solely on the pre-money valuation. Thus your startup needs to determine the intangible value offered by the incubator (and yes, a $150,000 convertible note with no cap and no conversion discount qualifies as an intangible).

Rather than assign a monetary value to the intangibles, a startup should instead assign an equity percentage value to intangibles like mentorship. As equity in the company tends to be the currency of early stage startups, the startup should have a good foundation for assigning value in terms of equity.

This advice holds true for even if the incubator’s program provides tangible items free and such items have an assigned monetary value. For example, if your startup get $2,000 worth of massages during the program, don’t add the $2,000 in free services to the $25,000 investment amount. Determine how much of your startup’s equity you’d actually give up for those services if they weren’t provided free — it may be worth $2,000 retail but it can also be worth 0% of your startup.

Thus, if your startup is willing to give a couple points to a few advisory board members, determine how much the incubator’s mentorship (and introductions) equates to an advisory board and assign a percentage. Now subtract that amount (and any additional equity amounts you have assigned to other intangibles at the incubator) from the total equity the incubator is requesting.

Using the previous example, if your startup believes the mentorship is worth 2%, then re-calculate the incubator’s offer of $25,000 for 6% to $25,000 for 4%. The “revised for the cash investment only” pre-money valuation is $600,000.

(2) Scrutinize the Investment Structure.

Incubators aren’t non-profits, therefore in addition to asking for a low pre-money valuation, they may structure their investment in a way that helps to ensure a higher return across their portfolio. Most incubators take common stock and sit “side-by-side” with the founders, but some may want some (weak) preferred stock and/or dilution protection.

Other incubators may want to set up an option pool. If so, the startup’s founders need to know this option pool lowers your pre-money valuation. Using the previous example, if an incubator wants your startup to set up a 15% option pool as part of the $25,000 for 6% of the company, the pre-money valuation gets effectively reduced to $329,167.

Like any issuance of stock or investment, one of the main things a startup should be concerned with is: Is this going to fuck up a future financing? (Technically, your startup should be asking this question for any contemplated transaction.)

If the terms won’t hinder a future financing, then your startup is good to go. If the terms will, then the question becomes: is the incubator going to waive these terms when a VC makes the request — without asking for anything in return for the waiver?

(3) Research the Mentors.

I wrote in a previous post, startups value mentorship over money when it comes to incubators. Research the mentors so you can accurately assign the amount of intangible value (in equity percentage terms as discussed in point 1 above) and justify the shitty pre-money valuation.

Analyze the mentors not just in what those mentors currently do or did when you were in middle school — but also how they fit with your team and your startup’s product. Do they know your space? Will you get to select your mentor or mentor group? How often will mentors drop in or otherwise be available?

(4) Inspect the Office Space.

Some incubators offer free office space. If so, check out the lay of the land to determine if your startup can be productive in the office space. Does your startup get a private office or will it share space coworking-style? How is the conference room and how hard is it to schedule time in the conference room? Can you break away for a confidential call from your girlfriend or potential VC investor? Do the chairs make your butt hurt after sitting in them for more than one hour? How is the technology?

(5) Figure Out Your Incubator’s Class End Date.

When does the mentorship and other benefits end? Can you continue to work out of the incubator’s office after your class ends? While most incubators’ class end dates fall around the respective incubator’s demo day, what type of support will you receive post-demo day from the incubator and/or the mentors? The best incubators are going to have no true “end date” and will be a forever-resource with respect to mentorship…although the incubator can likely only offer office space until the next class of companies move in.

(6) Search For the Incubator’s PR and Marketing Efforts.

If the incubator doesn’t take its class “stealth,” take a look at what the incubator does to market itself and its incubated startups. Take a look at pictures and videos from previous demo days, if any, and see if they’ll help get your startup’s name out there. It’s not really a demo day if only friends and family show up. Of course, joining some incubators give startups an instant “I’m Awesome, Fund Me Now” virtual-badge. Nonetheless, if an incubator can’t promote itself, how is it going to help promote your startup or the crucial demo day event?

(7) Reach Out To Prior Incubated Companies.

If you contact a startup that was part of an incubator’s past class know that you are accepted to and contemplating the same incubator, you should not have a difficult time getting a few minutes from one or more of that startup’s co-founders. Ask them about points 1-6 above but go further — ask them which mentors they perceived as being the most helpful or even which office to snag if you move in to the incubator’s office space. If a startup doesn’t get back to you, then that may tell you something, but don’t automatically assume that startup had a bad experience with the incubator.

(8) Determine the Opportunity Costs.

A startup that is accepted by an incubator may have an alternative funding offer from an angel investor. This can add complexity to a startup’s decision, because maybe the angel doesn’t want your startup to join the incubator. If the angel investor is offering an investment amount (greater than the incubator) that would “guarantee” your startup will reach a certain goal, it may difficult to accept the incubator’s offer. Regardless if your startup has an angel investor lined up, your startup will need to have a tangible goal in accepting the incubator’s offer that can be realized by completion of the program (or shortly thereafter). If not, the incubator is just a bridge financing to potentially nowhere for your startup.

Conclusion

Getting into an incubator is an exciting experience for any startup, but before signing up take a look at the incubator and how (much) it will help your startup. With the explosion of startup incubators, I hope the list above is helpful in determining whether your startup should accept such an offer. The more intangible value you can assign to the incubator, the more appealing the incubator’s offer will appear.

Term Sheet Purgatory

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.

Convertible Note Term Sheets

Just like the preferred equity financing process, the convertible debt financing process can start with a term sheet, rather than a full set of financing documents.

A convertible note term sheet is beneficial because it postpones a lawyer from cranking out a full set of docs until consensus is reached regarding the convertible debt offering’s material terms. It also makes any potential back-and-forth negotiation on such terms easier to manage.

On the other hand, if you are dealing strictly with friends and family on a convertible note transaction, adding this extra step in the process could be somewhat cumbersome. Thus, it’s usually prudent to go straight to the convertible note deal docs with friends and family.

Here are terms that are typically found in a convertible note term sheet:

Amount of the Offering: How much capital can the startup raise via the convertible debt offering?

Closing: Is there a specific date that the convertible debt financing will close, or will there be an open round of seed investment?

Interest Rate: What is the rate of interest on the convertible debt? Is the interest payable upon maturity or monthly/quarterly/yearly?

Term: When is the maturity date of the convertible notes?

Prepayment: Can the startup prepay the convertible notes without the consent of the convertible note holders?

Convertibility: What amount of equity financing is required to trigger automatic conversion of the convertible notes to equity (i.e., the determination of qualified financing)? What is the discount received by the convertible note holders relative to the price paid by the qualified financing investors? Is there a convertible note discount price cap? Do the convertible notes convert to equity on the maturity date, and if so, at what valuation">pre-money valuation?

Liquidity Event Payment: How much (e.g., 2X/3X, etc.) do the convertible debt holders receive if the startup gets acquired before a qualified financing and the maturity date? What is the definition of “Liquidity Event”?

Warrant Coverage: Do the convertible debt holders receive warrants to purchase “Series A” shares, and if so, how much percent coverage?

Security Interest: Will the convertible notes be secured by any or all assets of the startup?

Amendment: What is the manner how the convertible notes can be amended? Majority of the principal amount of the notes?

Legal Fees: Does each party pay for its own legal fees?

Is a Term Sheet Binding?

A term sheet is an outline of the deal terms that helps frame the contemplated transaction for both parties. Term Sheets for financings and acquisitions are usually not binding. However, it is quite common to see various sections of the term sheet binding, including:

-No Shop or Go Shop Clauses: Can a party shop the deal to 3rd parties or is it prohibited?
-Expenses: Determine which party pays for (legal) expenses and which party’s counsel drafts the transaction documents.
-Confidentilaity: Keep the existence of the term sheet and contents confidential.

If a term sheet is not binding, then why draft one?

It’s a good starting point to help all parties involved define the deal, in addition to providing some safeguards if the contemplated transaction falls through during negotiation. Finally, if you can’t agree to a term sheet, it’s probably not worth proceeding with due diligence investigations along with drafting the transaction documents.

What is a Liquidation Preference?

The liquidation preference is the amount that must be paid to the preferred stock holders before distributions may be made to common stock holders. The liquidation preference is payable on either a liquidation of the company, asset sale, merger, consolidation or any other reorganization resulting in the change of control of the startup.

It is usually expressed as a percentage of the original purchase price of the preferred, such as “2x.” Thus, if the purchase price of the preferred is $5 per share, a liquidation preference of 2x will be $10 per share.

Alternatively, the liquidation preference can expressed as a per share amount, as seen in this generic liquidation preference clause:

The holders of the Series A Preferred Stock shall be entitled to receive, prior and in preference to any distribution of any of the assets or surplus funds of the Corporation to the holders of the Common Stock by reason of their ownership thereof, the amount of $10 per share (as adjusted for any stock dividends, combinations or splits with respect to such shares) plus all declared or accumulated but unpaid dividends on such share for each share of Series A Preferred Stock then held by them.

Let’s take a simple scenario to see how the math works:

(1) Series A Price = $5 per share
(2) Series A Shares = 500,000
(3) Series A Equity Stake = 33% (i.e., they are investing at a $5MM pre-money valution)
(3) Series A Liquidation Preference = 2x (i.e., $10 per Series A share) = $5,000,000
(4) Startup Company is sold for $6,000,000

While the Series A investors paid $2,500,000 total for their shares for 33% of the startup company, the 2x liquidation preference will ensure that the Series A investors receive $5,000,000 of the $6,000,00 purchase price of the startup. Thus in this scenario, the 2x liquidation preference gives the Series A investors 83.3% of the total sales price of the startup (even though the Series A equity stake is 33%) and the common stock holders will receive the remaining 16.7% pro-rata in accordance with their common stock ownership.

(This example assumes that the Series A preferred shares do not participate with the common in the remaining 16.7%. I’m also leaving out the possibility of conversion-to-common to simplify this example.)

WSGR Launches Term Sheet Generator

I just found out from Altgate.com that Wilson Sonsini has launched a “Term Sheet Generator.” Here is WSGR’s description of the free tool:

This tool will generate a venture financing term sheet based on your responses to an online questionnaire. It also has an informational component, with basic tutorials and annotations on financing terms. This term sheet generator is a modified version of a tool that we use internally, which comprises one part of a suite of document automation tools that we use to generate start-up and venture financing-related documents.

Furqan Nazeeri at altgate.com seems to have the scoop on the evolution and future of the term sheet generator in his post here.

I’ve only had a few minutes to check out the term sheet generator, but like most other open sourced legal documents, I think it’s great.

I Got a Term Sheet, Now What?

Getting a term sheet from an investor is like getting an invitation to the Prom in January–you’ve got a long way to go before you dance.

When you get a term sheet from a VC or angel investor, you need to decide whether the economics of the deal feel right. And you also have to understand that there’s more to a term sheet than economic terms like pre-money valuation. There’s control, liquidity, and management terms to carefully consider.

Do some background research on your prospective investor. Have they published a list of their portfolio companies?

Finally, resist the temptation to use one submitted term sheet to obtain another term sheet with a better pre-money valuation. Even though you may not be prohibited from shopping the deal, remember that the investor community tends to be close-knit.

You can shop deals simultaneously, but don’t try to leverage one venture firm against another. Remember that some deals are financed by more than one firm. And even if your deal is a one-firm deal, the serial entrepreneur in you will likely have you back in front of venture firms in the years ahead.

Don’t Be Coy With a Letter of Intent

I recently worked on a deal where the prospective seller over-strategized the letter of intent. The seller wanted my client to sign a non-binding LOI that contained about half of what should have been included in the letter. It was extremely frustrating and ultimately was a waste of time, because rather than acquiesce to the seller’s demands, my client walked away from the deal.

While the LOI was “non-binding” in every way (and the seller kept repeating that), that wasn’t reason enough for my client to proceed. Basically, my client didn’t want to push forward without knowing more terms. And I can’t blame him. Why start the acquisition process without sufficient knowledge of basic terms?

I assume the seller was either not that serious about selling or is trying to gauge a potential buyer’s interest, but either way you run the risk of alienating potential buyers.