I recently got some comments on a blog post I did a while ago from Yoichiro "Yokum" Taku, a partner at Wilson Sonsini Goodrich & Rosati and the blogger behind Startup Company Lawyer, on my post about evaluating one or more term sheets. By the way, SCL is a great blog and I highly recommend it as a resource. If you're looking for a quick education on startup legal issues so you can have an efficient conversation with your own attorney, this is the place to go.
Yokum gave me the following feedback:
At first glance, my
initial feedback is that you have overvalued the RORFR/Co-sale and
(non-cumulative) dividend rights. All deals have a ROFR/Co-sale and they
are rarely invoked as a practical matter. West coast deals have
non-cumulative dividends, which makes a dividend preference meaningless.
Also, I think that the relative weighting of liquidation preference and
anti-dilution is a bit off. I think that liquidation preference is
significantly more important than anti-dilution.
This got me thinking that I should repost my original treatise and see what folks think. So have a read of the below post. What do you think?
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By the time I was in the 9th grade, I had been playing chess for a
few years (as in I knew the rules) but I didn't play seriously and more
often than not I lost. Then one day at the library (remember,
pre-internet) I happened to find a book on chess. So I read the book
and almost 
overnight
I became one of the chess "stars" in high school. In one of the
funnier incidents, I started playing chess during lunch hour and was
"hustling" money which on one occasion resulted in a kid pulling a
knife on me after I relieved him of a few bucks. True story.
What was it in that book that allowed me to take advantage of the
situation? Well, there was a lot of basic stuff, some general rules
and even some strategy, however, the most useful bit of information,
initially, was a table on the relative value of pieces. You know, a
pawn is worth 1, a knight/bishop 3, rook 5, a queen 9 and the king
"infinite" unless it's the endgame then it's more like a 4.
Experienced players have a "feel" for this from many games played and
they can also break the "rules" by, for example, sacrificing a queen
for a rook to get better position. But these are all things learned
from experience and best not tried by a novice. If you are new to the
game, you have no idea. When you are starting out, having some rules
of thumb can make all the difference between winning and getting
hustled.
What does this have to do with negotiating term sheets? Well, I
think a lot of newbies get hustled when negotiating term sheets because
they don't know the relative importance of the various terms. Have you
heard the joke about the VC who says, "I'll let you pick the pre money
valuation if I get to pick the terms?" My goal here is to provide a
framework that gives relative value of various terms on a term sheet
and allows you to compare them on two dimensions: economics and control
(or as my friend Noam Wasserman likes to say, "rich" versus "king").
In the same way that a chess grand master doesn't need rules of thumb
from someone else, if you're a seasoned negotiator of term sheets then
this is probably equally useless. And no, this is not based on any
academic or scientific study. It's based on my own experience and,
more importantly, that of a few other experts like Dave Kimelberg
(Softbank's GC).
In my view there are 12 important terms on a typical Series A / B
term sheet. Yes there are other terms and yes sometimes they are
important, but if you go with the thesis of keep it simple, then 12 is
the magic number. In terms of rating, the rich/king differentiation is
important as different people are after different things so depending
upon your motivation you may be inclined to pay more attention to one
column than the other. So without further adieu, below is a table
showing them as well as the relative importance:
Term |
Rich |
King |
1. Investment / price |
10 |
- |
2. Board of directors |
- |
8 |
3. Option pool refresh |
10 |
- |
4. Preemptive rights |
1 |
3 |
5. Andi-dilution protection |
5 |
- |
6. Registration rights |
1 |
1 |
7. Drag along rights |
1 |
5 |
8. Right of first refusal / co-sale |
5 |
- |
9. Dividend right |
5 |
- |
10. Liquidation preference |
7 |
- |
11. Protective provisions |
- |
8 |
12. Redemption |
1 |
- |
Here a 10 means it is really important to get as favorable a result
as possible on this term, a 1 means it is not so important and a "-"
means it doesn't apply (i.e. a zero). The cool thing about having
something like this is you can use it as a tool to compare term sheets
(provided you can determine how favorable or unfavorable each
individual term is...more on that below).
The next part of this post is to provide a range of typical results
for each term which will give you a means to rank each term in each
term sheet with a "1,3 or 5" where 1 is "unfavorable", 3 is "fair" and
5 is "favorable." If you aren't already familiar with the terms in a
term sheet, you should check out the model term sheet (basically
a template) put together by the National Venture Capital Association.
They have other model agreements too, but you will see with the term
sheet that they include various options, some discussed here. Below is
a scale for each of the 12 key terms across the two dimensions:
- Investment/price. I think
there are two ways you can rank price. One is to rate it relative to
your expectation and another is to rate it relative to similar
companies (in terms of stage, geography, sector, etc.). If you don't
have comparables, you can fairly easily get them, for example Dow Jones
puts out a quarterly survey of VC deal terms which includes pre-money
valuation (send me an email if you
want a copy). If you're less than 80% of your benchmark, that's
probably unfavorable, if you are within +/- 20% than that's fair and if
you're over 120%, then it's favorable.
- Board of directors. This term
comes down to simple math. If you give up and don't have control of
the board, that's unfavorable, if it's tied, call it fair and if you
control it, that is quite favorable. BTW, the reason I didn't rate the
board control a "10" on the "king" scale is because even when you give
up control, your board members are bound by fiduciary obligations to
the firm, i.e. they can't do whatever they want.
- Option pool refresh. Often
time this will show up as a separate term in the term sheet, however it
is actually just another bite at the apple in terms of price.
Traditionally there is a refresh pre-deal so that after the round the
company can execute on its hiring plan without needing to expand the
pool for 12-18 months. You will have to develop your hiring budget if
you haven't already. Given that benchmark and your hiring equity
budget, I'd say less than 12 months is favorable, 12-18 months is fair
and more than 18 months is unfavorable.
- Preemptive rights. As you
know, preemptive rights give your investor the right to invest in
future rounds. This is of moderate economic value, however you are
giving up some control of future financings. There is remarkably
little variation in how this term gets negotiated, probably because of
its relatively low importance in the grand scheme. I'm told the only
area that gets negotiated is whether the investor has an "overallotment
right" whereby they can take a portion or all of the pro rata of
another investor in the same series who didn't participate. That said,
unless something unusual is in your term sheet, it's probably a 1 for
rich and 3 for king.
- Anti-dilution protection.
Anti-dilution is a pretty important economic term. In terms of the
range of possibilities, no anti-dilution would be a 5, broad-based
weighted average would be a 3 and full-ratchet would be a 1. I think
the vast majority of deals end up as broad-based weighted average.
Very few deals avoid it altogether, but it can be done, particularly in
later stage or very hot deals.
- Registration rights. Reg
rights have some economic value and in theory you do give up some
control, but in reality they're close to worthless. You can push on
these and most investors will give in when pressed. You can negotiate
when the right kicks in and cutbacks. But bear in mind that investors
will love it if you waste time negotiating this because it is not an
important term. Unless something unusual is going on, I'd rate this a
1 on both dimensions.
- Drag along rights. Most deals
include drag along rights and like many of the other terms, the key is
in the voting thresholds. I rated this a 1/5 on the rich/king scale.
In terms of economics the issue is with regard to a sale of the company
where the preferred stock, because of special rights, is indifferent to
a deal that would be better for Common. However, the bigger issue is
on the control side of the equation where you could get dragged into a
sale that you don't want to do. So in terms of rating both the
economic and control sides, I would say that if the thresholds are such
that a single investor can unilateral drag along, that's a 1, if it
takes 2 or more investors that's a 3 and if it takes investors plus
either a neutral party or Common (you) then it's a 5.
- Right of first refusal / co-sale.
I rated this a 5 because this is essentially a "lock-up" on the
founders stock which seriously affects liquidity and thus value. It
doesn't really affect control issues. If you read the actual section
of the stock purchase agreement that describes this term it's several
pages of bureaucratic procedures for a sale that in the real world you
can't imagine ever occurring (which they don't). As a result, the only
real counter party for selling common stock is the other investors or
the company with the investors approval and they're all quite likely to
low ball. Unfortunately, I've never heard of avoiding this term
completely, so in terms of how to rate it, I'd say that if you can
negotiate a right to sell some portion (say 20% on an annual basis)
you're at a 5 otherwise if it's a standard lockup then you're at 3.
- Dividend right. I rate this a
5 on the economic scale. In terms of the range, there is no dividend
which is a 5, then there is a simple interest dividend which I'd say is
a 3 and a 1 would be a compounding dividend. For some reason, the
dividend rate has been 8% ever since I've seen term sheets. You can
negotiate the rate, but the bigger battle is whether you pay a dividend
and how the rate compounds.
- Liquidation preference. This
is a very important economic term that doesn't have any importance in
terms of control. The issue here is during a sale, how do investors
get paid out. I'd say about 1/3 of deals have a preference at 1X but
no participation, another 1/3 have a preference with a cap and
participation and the balance a preference with no cap plus
participation and that's pretty much how I'd rate it, i.e. 5 for 1X
preference/no participation, 3 if with a cap in the 2-4X range and 1 if
with no cap and participation.
- Protective provisions. This is
very important from a control perspective but not so economically.
While there are a ton of these protective provisions, the key ones
relate to sale/merger of the company and future rounds of financing.
As with other control rights, the key is in the voting thresholds so
I'd assess this the same as 7 (drag along rights).
- Redemption. Finally, we get to
number twelve, redemption rights. This is an almost worthless economic
right. I've never seen or heard of this being exercised and most
investors will acquiesce if you push on this. Unless you see something
unusual, I'd rate this a 3.
Ultimately the individual rating combined with the overall
importance of each term will allow you to create a weighted average
total for each term sheet on both the rich and king dimensions. While
you wouldn't want to make a decision to take an investment on this
alone, it will give you a basic idea of where the strengths and
weaknesses of particular term sheets lie. It also gives some tips for
negotiating. For example, you don't want to waste your time
negotiating redemption rights and attorney's fees and instead, you want
to go to the core of what's important to you on the rich/king scale.
Finally, I'd love to hear feedback from folks. How would you change
the ratings? Are their other key terms? Feel free to comment on this
post or send me email.
I saw this picture in an 
Here's a practical tip on how to use the new web service called 
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