Monday, September 11, 2017

VC Negotiation Tricks: Simplified Term Sheets & Post-Money Valuations

Every 5 years, the VC community comes up with new negotiation tactics that work well against first time entrepreneurs. Two such recent approaches in the VC community are (i) simplified term sheets that lack some of the details needed to assess all terms being offered and (ii) an emphasis on post-money valuations.

(i) Simplified Term Sheets
A few years ago, venture firms would send entrepreneurs a 3 to 5-page terms sheet that would spell out the explicit details of their offer. These term sheets would contain the main highlights entrepreneurs tend to focus on (mainly board and valuation), but also got into the details on terms that are key such as protective provisions (special rights for investors). This meant that signing a term sheet came with an explicit view of all the major items that are part of the round.

More recently, venture firms have been sending 1-page term sheets which have simplified out a number of important details. One term sheet I helped a founder with recently contained only 200 words (this is 10-20% the length of term sheets just a few years ago)! This means the founder was being asked to sign a term sheet without knowing a subset of key terms that would impact future financings, potential company product directions, the ability to exit or sell the company, and limits or rights on employee option pools etc[1].

Once you sign a term sheet as a founder, you lose most of the leverage in a fundraise with a VC. You are typically locked into a 30 day exclusivity period where you can not entertain other VC offers. Founder etiquette at this point is to tell the other funds you have been talking to that you have chosen your financing partner.

Before signing a term sheet, you should have your lawyer fill out the following items in a simplified term sheet:
1. Board structure.
How many common and preferred board seats are there? Is there a CEO-specific seat or would a new CEO seat get created if the founder/CEO steps down or is fired?

One common VC trick is to write the common stock (i.e. founder) board seats as
"The holders of Common Stock shall elect two directors, one of whom will be the then-serving Chief Executive Officer." While the later part of this sentence seems innocuous, it gets interpreted by overzealous lawyers to mean that if a founder ceases to be CEO they lose their board seat which goes to a new CEO (i.e. it is a "CEO" seat, rather then a founder/common board seat. If the board hires in a new external CEO, the founders may immediately lose control of the company.

2. Protective provisions.
Protective provisions are the set of special rights investors in a financing get to protect their minority investment. Protective provisions include[2]:

Future financings. Often VCs ask for the right to block any future preferred stock sales by the company. If you agree to this block, only have it apply to preferred financings with terms worse then the round you just did. In other words, if you get terms equal to, or better, then your current round you should be able to close future financings without approval.

M&A. Most investors ask to be able to block future exits by the company. If you agree to such a term, it should be voted on collectively by all future rounds of stock. I.e. the series A, B, C etc. should all vote together, in a manner representative of shareholdings in the company, on such rounds. Otherwise you can have multiple different VCs, each with their own incentive, block exits.

Company product lines. Some VCs insert language that they can block changes in major lines of business for a company. While this may make sense for a private equity buy out, it does not make sense for an early stage company and should be taken out.

Board. A commonly asked for provision is the ability to change the size or composition of the board. Talk to advisors or angels to get advice on this in the context of your own startup.

Any protective provisions that one round of investors gets (e.g. your Series A) will often carry over into future rounds (series B, C, D, etc.). Be careful in the precedents you set.

3. Liquidation Preference.
1X non-participating preferred is the most typical structure for a series A or B financing. If a VC asks for anything more complex it usually implies something weird about your company (strange re-cap?), your valuation (is it super high prematurely?) or your investors (are they taking advantage of you?).

Ask your lawyer for more details[3].

4. Option pool.
You should shoot for an option pool that allows you to hire the team needed to get you to the next fundraise or major company milestone. It is good to add a little padding to this. To see how option pool may chance effective valuation, see this venture hacks post.

(ii) Valuation: Pre-money versus post-money.
Both pre- and post-money negotiations have been around for decades. While there is not a single right way to do it, many first time entrepreneurs tend to be less savvy in their understanding of a post-money valuation negotiation.

Setting a company valuation by negotiating its pre-money first means that you and the VC agree on a price for the company before the financing occurs. You then add in SAFE and convertible note dilution and new money in, and end up with a total valuation for the company. Negotiating valuation based on post-money means that no matter how many SAFEs or convertible notes are outstanding, or even the total new money raised, the company ends up with the same post-money valuation[4].

A pre-money valuation negotiation tends to be more transparent to a first time entrepreneur. Your company is worth a certain amount before you raise money. Once the money comes in it should be worth more in a manner that scales with capital. E.g. a company that has raised $15M should be worth $5M more than an identical company that raise $10M. Negotiating valuations around post-money tend to distort these economics.

VCs will negotiate the round valuation around the post-money valuation in some cases as it leads to significant additional dilution (and a much lower pre-money) then most first time founders realize:

A. More money in the round can be incredibly dilutive.
B. SAFE Conversion can jack down your pre-money significantly.

Lets take a simple example for (A) above. Suppose you are raising $5M. If you set your post-money at $25M (for a $20M valuation before the round is funded) then you take 20% dilution for the $5M. Say that a few weeks after you sign the term sheet another investor wants to come in for an additional $5M. In a post-money situation, your valuation before the round drops to $15M and you just sold 40% of the company ($10M/$25M).

In contrast, in a pre-money situation the company itself is deemed worth $20M before any money comes in. If you raise $5M, you similarly dilute by 20% and end up with a $25M post. However, when the incremental $5M comes in, you still start off with a $20M pre-money valuation, and end up with a $30M post. In other words, you dilute by 33% instead of 40%. This 7% incremental dilution makes a huge different in ownership.

SAFE notes effectively act the same way the incremental new money coming in above does. They can jack down your effective valuation if you negotiate the valuation on a post-money basis. If you raise $5M in SAFE notes and they convert at a 20% discount, you may have just dropped your pre-money by $6M ($5M + 20% of $5M). Caveat emptor!

Post-money valuation based negotiations have become more common in the last ~2 years and I think is a way for VCs to take benefit from entrepreneurial ignorance around SAFE conversion mechanics and how financing rounds work. As an entrepreneur, you should understand these mechanics and understand the details of your prior financing docs.

Notes
[1] A good lawyer should spot and put these terms back in.
[2] There are a number of other protective provisions that I don't mention - e.g. the ability to issue new stock is often blocked by investors to prevent unlimited dilution etc.
[3] I can also understand that VCs probably simplified term sheets to make negotiation faster/simpler with founders and to emphasize the terms first time founders care the most about.
[4] There have always been pre-money and post-money driven term sheets. However, the market has largely been shifting to post-money term sheets more recently. I am guessing this is due to SAFEs. There is nothing "wrong" with a post-money term sheet a priori - although it does create inflexibility in adding money to the round over time and sets a cap on potential fundraise size. Worst case you can always amend your financing docs.

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