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The Science & Art of Term Sheet Negotiation

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:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. 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.
9. 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. 
10. 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.
11. 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).
12. 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.

More On Convertible Debt

My previous post on why convertible debt sucks shouldn't be construed as advising to never use it, but rather to explore your alternatives and avoid it if you can.  For example, Andrew commented that this might be his only option.  Others have pointed out another scenario in the case where there is a major milestone in the near future and you're confident a little cash can get you there.  Okay.  Just remember, it's "easy" to get into, but harder to get out of than straight equity and it creates some screwy incentives.

Also, here are some additional resources with more detail on the mechanics of convertible debt and opinion and analysis from other entrepreneurs, angel investors and VCs:

• Startup Company Lawyer: details on a lot of the legal terms.
• VentureHacks: gives some rules of thumb.
• Bill Payne: an interesting analysis from the angel investor's point of view.
• Redeye VC: from a VC's perspective.

5 Reasons Convertible Debt Sucks

There are two scenarios where convertible debt is typically used: bridge financing and angel financing.  I've raised convertible debt a few times and I have to say that in most angel funding scenarios it sucks as a way to finance a startup (I think it's okay for bridge funding, but I'd avoid that too if possible).  Why?

1. It's complicated.  Many founders think part of the attraction of doing convertible debt is that you get to "punt" on a lot of the key financing decisions until "professional" investors do the real work and put a "real" value on the company.  Unfortunately, doing convertible debt requires making a bunch of decisions that in total are about the same complexity as preferred equity.  For example, you have to write a loan agreement that includes things like default clauses, collateral, interest rates and more.  If the loan is secured (e.g. against the IP) then you have to create a separate lien.  Also, it's typical to include a discount for the lenders in the form of a warrant, however the warrant is on an equity instrument that does not yet exist (e.g. on the Series A Preferred) but you still need to decide the term of the warrant and the strike price.  Also, most founders don't raise all their convertible debt at the same time so they end up with lenders with different warrant coverage (big Excel spreadsheet).  Then, when it comes time to close your Series A, you can have a problem where the cap table changes on a daily basis because the interest that accrues on the principal converts as well and that changes daily.  [By the way, if you do use convertible debt, I recommend you agree to pay the interest in cash after closing Series A to avoid this last problem.]  All of these issues add up and it makes it more complicated to take convertible debt as opposed to equity.
2. It sets a bad precedent (or at least fails to set a good precedent).  Valuation is just one of the key terms of an investment.  I wrote previously on how to evaluate the various terms of an investment.  By punting on negotiating the full suite of terms in a round of preferred equity, you are basically leaving it to the Series A investors to negotiate these.  And some of them make a big difference (like dividends, preferences, etc.).  Most of the time, you're in a much better situation to negotiate favorable (or reasonable) terms with friendly angel investors than you will be with professional VCs  My recommendation is to use the opportunity to negotiate favorable terms with angel investors and these will likely become precedent for future rounds.
3. It doesn't make a big difference in the upside scenario.  If you run a few scenarios (I have), the potential gain for founders is 3-5% ownership after the Series A round and about half that at a successful exit. If you're lucky enough to get a successful exit of, say $75MM, after raising $15MM of VC and you have 2 founders, you're talking about +/- $500K potential gain each.  Now that's a ton of money, but the point here is that in the upside scenario you're looking at a six-figure benefit against which you have to measure and compare the risks.
4. It makes a big difference in the downside scenario.  In a wind-up scenario, the priority of various parties is, from highest to lowest, employees, A/R, secured lenders, preferred equity and common.  Yes, founders are at the back of the line, but the secured lenders are slightly ahead of preferred equity.
5. It creates a perverse incentive.  The biggest problem with convertible debt is that it aligns the interest of your angel investors with future VC investors and against you!  Because the debt converts into equity at a price equal to or slightly discounted from what the VCs pay, the lower the price the more the angel investors will own.  And often times, the angel investors will have the relationships and connections to VCs (and hence know them better than you do) so it is in your interest to get your angels on your side of the table. 

Bottom line: convertible debt when there is a high likelihood of an equity round happening very soon (i.e. you're bridging a few month gap), but if you are raising angel money and want to use convertible debt to avoid setting a valuation, don't.  Raise equity instead.

Know Your Competition

There's a good post over at VentureBlog on knowing your competition.  The post is worth reading, but if you don't have the time, here's the conclusion:

My advice to any entrepreneur -- learn as much as possible about the competition. Not just because you'll do a better job of pitching your company, but because you'll do a better job of running your company. And, in the end, that is what ultimately matters the most.

I would add to the post that, for many startups, the competition is not another company, but rather a product (like MSFT Excel) or a process (like going to a physical store).  Be prepared in any pitch to describe the alternative to buying your product or service and don't be coy.  The better you know this the better your pitch will be and the more successful your business.

Lastly, don't trash your competition...you just might make the mistake of drinking your own coolaid!

Information Asymmetry In Fundraising

One of the challenges entrepreneurs face in raising money is that they typically do it once every couple of years.  The rub is that you're usually raising money from some folks who have done several deals in the last quarter.  TheFunded has been slowly arbitraging this information asymmetry. 

First they did it by creating a list of VC investors (before TheFunded you were forced to pay for expensive lists or limited to the handful of firms you knew personally).  The list by itself was quite useful.  Second, they started letting entrepreneurs comment on and rate funds/partners.  That bit was a little less useful, but still provided some useful feedback.  And most recently they launched a section on the site where entrepreneurs can share specific deal terms from term sheets they have received.  So far there are only 60 term sheets uploaded and you have to contribute one to see the others.  They claim to be getting about 3 per day.  This is a potentially catastrophic event for investors and a potential boon to entrepreneurs as it could lift the veil on the "deal spread." 

There is no doubt that the more deals get published, the more leverage will accrue to entrepreneurs.  That said, I wonder how long before some VC sues TheFunded (every term sheet has a clause that says you can't share the contents).  I suppose if you don't sign the term sheet there's no violation, but if you raised money on the term sheet (i.e. you signed it) then that could be an issue.  It will be interesting to see if any fund goes to bat on this.  In the meantime, I can hear the deal spread tightening!

How Much Of Your Business Do You Want To Own?

I hear from both entrepreneurs and VCs that one of the most commonly cited reasons for not investing is because the "business won't be big enough."  Usually that is delivered by the uninterested investor in the negative as, "we don't think the market is big enough," or "we think the market is going to take a long time to materialize."  Steve, one of the Softbank partners I work with, has a great saying that puts a positive spin on this and really gets at the heart of the issue (actually Steve has a lot of these Steve-isms, but that's a post for another day).  Anyway, what Steve often says is, "that's a business that would be great to own 100% of, but I'm not sure if I'd want to own 20%."

First, a little background.  Early stage VCs like to own about 20% of a company.  It took me a while to get my head around what seemed on the surface a random number.  But, there are a lot of reasons for 20% including that they typically like to invest between $5MM and $10MM in a company over time, that they like to have a co-investor or two with roughly the same interest and that software companies usually take $15-25MM-ish to achieve an exit of $100MM-ish based on revenue of about $25MM.  Add to that the need for an option pool and make room for founders and it basically works out to a rule of thumb of 20%.  That's the "typical" deal.

Now, if your business doesn't have a real shot at $25MM+ in revenue with a healthy growth rate or have a need for $15MM+ in investment, but instead has a very solid chance of achieving a few million in revenue, take a few hundred grand to launch and has the potential to throw off $50-100K per month in free cash, then that's a business that would be great to own 100% of!  Frankly, I see a lot of the latter companies pitching VCs for money, getting turned down and being frustrated when in reality they're in a great spot of potentially owning all of a valuable asset and not having to answer to nagging investors!