Altgate

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.

Startup Failure: 7 Deadly Sins

Blogger, investor and entrepreneur Roger Ehrenberg has written one of the best post mortems of a startup failure that I have ever read.  He's able to do this partly because he's a stand-up guy, because he is an excellent communicator and because he has done well enough in life that he can give the straight story instead of the politically correct story.

Roger was co-founder of Monitor110. He helped raise $20MM in VC over 4 years before concluding the return just wasn't there.  In his after action report on the demise of M110, he identifies and expounds upon 7 deadly sins that doomed the company:

1. The lack of a single, "the buck stops here" leader until too late in the game
2. No separation between the technology organization and the product organization
3. Too much PR, too early
4. Too much money
5. Not close enough to the customer
6. Slow to adapt to market reality
7. Disagreement on strategy both within the Company and with the Board

Ever first-time entrepreneur should read Roger's post...it's like that video they used to show in high school of the aftermath of car accidents.  Roger, thanks for the wisdom!

FriendFeed As FoeFeed

Here's a practical tip on how to use the new web service called FriendFeed to solve a real business problem: opposition research.  Every startup "tracks" news from or about their competitors, usually in the form of an email sent to a few folks within the company with the subject, "Did you see this?" 

Well FriendFeed allows a single person or a group of people to aggregate information and share it with each other (publicly or privately).  It's more than just copy-paste, FriendFeed allows users to permanently track specific feeds (like a competitor's blog) as well as one-off stories (like a TechCrunch review).  FriendFeed allows users to track all kinds of media (blog, video, pictures, etc.) from scores of sources (Flickr, Typepad, Youtube, etc.) and usability is superb.  Users can view the feed as a web page or RSS feed and multiple "rooms" (feeds) are easily configurable.

So do yourself a favor and fire your $10K per month PR firm that provides you with daily news snippets and build your own FoeFeed.

Ethics Test

Opinion Polls & Market Research

Here's a hypothetical situation.  You've been working with a VC for a while.  You've gotten through a lot of business diligence and there's one last pitch to the partnership before you get a thumbs up/down on getting a term sheet.  The CEO and head of sales are able to attend in person, but you (founder) have a scheduling conflict so you are participating by phone. The pitch goes off okay.  You can hear the meeting winding up with your team mates leaving the conference room when all of the sudden, the VC partners immediately jump into a vigorous discussion of the merits of the presentation, team, company and whether they should offer to invest.  It's clear that they do not realize you are still on the line and they have no real way of finding out if you are or are not. What do you do?

DROOM - Don't Run Out Of Money

John Nesheim has a great blog post on how to manage the process of running out of money.  Great post...and I totally agree.  As CEO, when you're company is burning cash, you should know the details.  Here's the bottom line:

Plan on running out of cash. Then execute your plan. Get going. Worrying is not going to make things better. Gather your core team. Build your recovery plan. Be wise about what you say to employees and investors. Get the entire company involved. More help is better than you alone. Do not try to do a miracle single handed and in secret.You need all the help you can get, even including spiritual assistance. When you can manage running out of cash, you will have added one of the most powerful skills to your tool chest. Use it to build your unfair competitive advantage.

All-Hands Team Meetings

The all-hands team meeting is unique to startups.  I think it's one of the great reasons to work at (or start) a company.  As an employee you get to interact with the CEO and management team in a way not possible at larger companies.  As CEO, you get to work with folks who actually do work as opposed to just manage others.  All around, it's really fund and refreshing.  Anyway, I recently saw a Youtube clip of an all-hands meeting and wanted to share it along with a list of tips on how to run a good all-hands meeting. 

Now this all-hands meeting is not your typical startup...it's actually Barack Obama speaking to his Chicago headquarters staff.  That said, if you're a startup CEO, you'll see a lot in common with what you do in this video.  Bear in mind that the HQ staff is probably a couple hundred people none of whom worked for the campaign 17 months ago.  The clip is a bit long (about 15 minutes), but worth watching.  So here are a few things to pay attention to (in roughly chronological order, as opposed to importance):

1. Entry.  There are different types of all-hands meetings, but this one was clearly used to deliver a message.  Part of setting that up is to bring the team together (note a key lieutenant was coordinating and actually "introduced" Obama).  It's an interesting bit of stage management, but you'll notice that Obama enters the meeting after everyone is assembled.  It definitely sets the tone of, "pay attention to this message."
2. Continuity.  I like how he starts by talking about the last all-hands meeting (which happened to be about 9 months previous which should be familiar to any CEO who's just gone through a crunch period).   If every meeting has a different message and there is no continuity, it makes it harder for the team to follow (and believe).
3. Honesty. You hired smart people and if you try to spin something, they're going to see right through it.  When recounting the message from the last all-hands meeting (I would love to see that video clip), Obama recounts that he said, "I wasn't sure if I would be the best candidate..."  At another point, he says, "it would have been nice to have a couple weeks off, but..."  That kind of candor will motivate your team much more than a hyperbole or hope. 
4. Humor.  Don't do comedy if that's not your thing, but people always enjoy an inside joke.  A good example is when he joked about the "fist bump" getting so much play in the press because that was one of the few chances they had to "celebrate."
5. Thanks for job well done.  Obama spent a lot of the meeting delivering heartfelt thanks to the team.  He said, "you have created the best political organization we've seen in the last 30-40 years" and continued, "it's not because of the candidate, it's because of you."  It's easy to revert to the "I," particularly after achieving some success, but this is a good example of how to deliver a meaningful thank you.
6. There is no plan B.  Sometimes the message you want to deliver is, "look, we've done a lot of work and we have a backup plan," but other times (like when you don't) you need to tell it straight.  Obama talks about the "enormous sense of obligation" they (the team) now have.  He says,"if I had lost Iowa..." there would have been a plan B (as in Hillary or Edwards or some other candidate), but continues "because we won, we now have no choice.  We have to win."  That was a great Cortes moment!  I could imagine saying something similar after raising an A-round...
7. Call to arms.  A salary gets people to show up, but real greatness requires inspiration and that can only be achieved by calling your team to achieve the greater good.  When telling the team they will have to work harder, longer than ever before he says, "I know that's a heavy weight.  But also, what an awesome opportunity.  You are 5 months from...changing the world!"
8. Finish up.  Notice how he doesn't linger around.  Doing so would dilute the power of the message.  Better to leave the chit chat for another time. 

All-hands team meets are important...take time to prepare and make them effective.  I'd be curious to hear comments from readers on what works/doesn't work for you.

Random Tips

Most of the posts on this blog have been about fund raising, so these tips are a bit off topic. Nonetheless, I wish someone had shared these with me so here goes:

1. How to test browser compatibility. Anyone who's developed a website knows that it is a pain in the butt to make sure the site plays well with various browsers.  There is a great tool at Browsershots that rocks.  You just type in the URL of the page you want to test and then select as many as 50 browser/OS combinations (that includes multiple versions of the same browser) and in a few minutes you get a screen shot of the page as well as a file you can download.  And it's free to boot.
   
   

   

2. How to do screenshots the easy way. I hate the fact that sending someone a screenshot requires that I first capture the page and then open another program, paste the shot and send an email.  Well, if you have Windows Vista, there's a crazy cool utility called "Snipping Tool" which allows you to grab the whole page, a rectangle or a random shape and then to copy it directly to a file.  To launch this program, click the Windows button and search for "Snipping Tool."
   
   

   

3. How to register many accounts with one email address.  A lot of sites (like the one I'm developing!) require an email address for each user account and that email can only be used once.  So if you're testing the site and want to have several users, how do you avoid creating a lot of email accounts?  Well, Gmail makes it easy.  Every Gmail account allows infinite aliases of the form: [email address]+[alias]@gmail.com.  All of these messages go to your existing Gmail account and most sites consider them an unique address.  For example, my Gmail account is fnazeeri@gmail.com and an alias that also goes to that account is fnazeeri+test100@gmail.com.   

Go Green @ Work

After several months in the oven, I am thrilled to announce the launch of my new venture, Viridus, a community for business professionals to discuss and advance corporate sustainability. 

Viridus is a practical "how to manual" for issues everyone faces at work.  Our belief is that everyone has a "green collar" job and it is how you do your job that actually makes it green or not.  An accounting department working on reducing paper billing, an engineering group designing for recyclability, a purchasing department seeking to reduce the ghg footprint of their supply chain, a facilities department looking to reduce energy or water consumption and especially those who work in corporate sustainability will all find value at Viridus.

Viridus is a members-only site with 100% user-generated-content.  We feel that an environment of business professionals who have responsibility for the sustainability of their organization is particularly valuable.  This way members don't have to worry about being solicited by vendors, press, regulators, NGOs, etc.

We are strongly committed to improving the sustainability of businesses everywhere and look forward to building the Viridus community.  We are currently in invite only private beta.  If you would like to request an invite, please sign up here.  In the meantime, please feel free to send us feedback, comments or questions.

And lastly, over the next few weeks I'll be posting more on my transition from EIR back to entrepreneur, so stay tuned!

It's Official

I'm a domain squatter! 

While poking around looking for domain names for my new company, I came across another (fellow?) squatter who owned iCapsule.com.  I liked the name and thought there would be some sort of tie-in with Apple's i-lines of business.  So I bought it. 

Since it was two "thieves" doing business, I decided to use Escrow.com.  It's a great service.  They charge about 6% of the transaction but essentially act as a trusted third party (e.g. I transfer the money to them, then seller transfers domain to me and then Escrow.com transfers money to seller).  Everything worked smootly and now I'm the proud owner!

If you or someone you know could use a great domain name, let me know! ;-)

Strategies for Two-Sided Markets

It seems almost every business I come across these days, particularly those of the Web 2.0 ilk, are essentially two sided markets.  Audience and advertisers, job seekers and hiring companies, dating sites, you name it.  My last company, Pivot, was literally a two-sided market (as in financial market).  When we started out, back in 2003/2004, there really was no roadmap for launching a business like that which is why I was thrilled when HBR published a paper on "strategies for two-sided markets" by Prof. Tom Eisenmann et al.  It's a couple of years old, but a must read for anyone starting a two-sided market business.

There are a lot of good points in the paper, but the main one is that every market has a side that is more valuable and it is important to get the pricing right (which often involves one side of the market subsidizing the more valuable side).  For example, it's free to join Monster as an employee but companies pay to post jobs (although TheLadders discovered that $100K+ employees are more valuable than companies).  It seems obvious...every mall charges rent to retailers but who ever heard of a mall that charged entrance fees?  But you would be surprised how many companies get this wrong.