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AskAVC #12 - How to negotiate a term sheet - YouTube
Channel: Ask A VC
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hey everybody welcome back to my video
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series ask a VC my name is Ryan Floyd
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I'm a managing director at storm
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ventures we're an early-stage venture
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firm focused on enterprise and b2b SAS
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today I'm going to talk a little bit
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about how to think about a term sheet
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from an investor perspective there's a
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ton of resources available out on the
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web to help you understand and decipher
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a term sheet a bit more but I really
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want to give you a sense of where I see
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most of the issues that come up with the
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term sheet as we get into negotiations
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with entrepreneurs that we want to back
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the first thing that you really ought to
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think about with the term sheet is that
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it's a non-binding agreement and you
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might think well well why am I even
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getting into this then and the reason is
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because you really want to summarize the
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principle terms in a term sheet so that
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when you get an illegal agreement you
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don't have any major economic terms or
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governance terms that you have yet to
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really resolve there's lots of details
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to work out but you want to make sure
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you cover the big issues first so it's
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important as an entrepreneur if there
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are big issues for you that you make
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sure that they're outlined in a term
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sheet or that an investor is aware of
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them because I can assure you an
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investor will make sure that they put
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any big issues for them likely into a
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term sheet as well there's really only
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two provisions in a term sheet that are
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binding that is exclusivity so you sort
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of agree that you're not going to go
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talk to other investors about the
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opportunity once you sign it and the
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second one is confidentiality outside of
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those to understand that it's not an
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agreement to invest but it's a
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understanding about terms the first
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thing to really think about in terms of
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broad categories of the term sheet is
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valuation it's probably the most
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critical and so let's spend a few
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minutes talking about valuation and what
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it means you probably hear people talk
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about it all the time oh this company
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raised an X million dollar valuation and
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it's pretty simple but there are some
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nuances within understanding what that
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valuation means that it's important to
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really understand it as an entrepreneur
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so let's talk with well let's first
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define a couple of terms so let's start
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with post-money valuation what
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post-money valuation me
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is it's whatever the pre-money which
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I'll come to in a second plus whatever
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new money is coming into the business so
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let's say for a second that pre-money
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valuation was eight million dollars and
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you raised two million dollars your
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post-money valuation would be ten now
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that seems pretty simple right eight
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plus two ten post money's ten Ryan
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what's up it seems there's not much here
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true but it does get a little more
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complicated starting with an option pool
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every company that we invest in we want
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to have some option pool available to
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issue to new employees so you have
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options to give out to all those new
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hires and people that you're going to
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bring in and the way an option pool is
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typically expressed is a percentage of
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the post money so if I was to tell you
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I'd like to invest at 8 million pre just
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like the example I just gave and I'd
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like to have a 10% post money option
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pool and with my two million dollar
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investment your effective pre-money
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valuation is actually seven million so
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hopefully you just followed me on that
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so 10% of the 10 million post is a
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million dollars so seven million pre
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plus one is 8 which is kind of the put
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the pre-money plus the 2 million
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investment gets you the 10 the reason
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I'm pointing this out is if you're not
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thinking about what the option pool is
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and in addition to that if you have
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notes that are converting maybe they're
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converting in a discount maybe there's
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some warrants that were issued for some
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reason all of that collapses into that
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pre money calculation so for you as an
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entrepreneur it's really important to
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understand not only the post the option
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pool all the things contribute to
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actually what that effective pre-money
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valuation really is for you and it's
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important understand because you don't
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wanna be surprised by at the end of the
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day I make one other comment I get a lot
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of people pushback on an option pooling
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they say oh we don't need 10% option
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pool we only need 5 because this is how
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many people were gonna hire over the
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course of a year which I can appreciate
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that and you can go back and forth and
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argue at what size option Pelini and so
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forth but I would just simplify it for
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you
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option pool really is just a valuation
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discussion because it all comes in and
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factors into what that effective
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pre-money is so if you think about it in
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that sense I think it just simplifies
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everything and so the bigger the option
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pool the lower the effective pre-money
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the lower the option pool D a higher
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pre-money and so that's worse for
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investors better for entrepreneurs and
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vice versa the other way okay so the
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second big category that I think's worth
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talking about is the security and the
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type of security that people invest in
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it's a little unusual and that in the
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u.s. it's it's common to invest in
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preferred and I say unusual only in that
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it's not common stock it's not what
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you'd buy if you were buying most stocks
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that are publicly traded the reason that
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investors get preferred stock is that
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there's certain rights and privileges
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that are associated with that stock that
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are different than the common one of
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those rights is pro rata which means
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that investors can continue to invest
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against new rounds that are raised in
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the future to maintain their ownership
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and that's a really precious right to
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venture investors that want to continue
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to support their businesses going
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forward another attribute of preferred
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is that it has a liquidation preference
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and what a liquidation preference means
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is that if the company was to liquidate
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the preferred investors will get their
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money back before proceeds would be to
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distributed to commen it's typical today
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that it's only a one acts liquidation
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preference and it's what's called
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non-participating which means that me as
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an investor I have to choose either I
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get my liquidation preference back or I
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get to participate as though I was a
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common shareholder on a converted basis
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I can't have it both ways
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there are certain stock like redeemable
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preferred participating for there's a
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lot of different flavors in which some
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cases you can get both your liquidation
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preference back and then continue to
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participate but they're fairly unusual
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today in Silicon Valley unless there's
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some strange situation or need for that
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type of security so look for somebody
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that's non-participating preferred stock
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and that's a pretty typical
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all the rest of the rights that are that
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come with the preferred really shouldn't
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really concern you with really one one
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exception which is governance on
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governance is kind of the next the third
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area I think to really you know think
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about from a term sheet standpoint is
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how is governance going to be
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implemented in your business so the
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preferred likely will want to have some
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say at a board level in terms of how the
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you know company is you know running and
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and managed and that board structure is
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very important for you as an
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entrepreneur to think about because the
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board not only is it critical I think
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positively in terms of how it's going to
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make you a stronger entrepreneur it's
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gonna build for a stronger business it's
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also important because the board has the
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right to hire and fire the CEO as well
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so for you as a founder CEO that board
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composition is pretty critical in terms
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of how you may perceive your role and
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the business going forward I'll tell you
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that eventually in just about every
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single company founders don't maintain
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control of the board indefinitely so at
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some point it's likely that you're not
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going to control the board and that you
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know there is a risk that maybe you know
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you wouldn't be CEO going forward
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however early on I think it's very
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reasonable that the board ought to
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reflect the ownership in the business if
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preferred investors for example are only
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buying 20% of the company it'd be
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unreasonable that they controlled 7080
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percent of the board seats in a company
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because it just wouldn't match to to
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ownership so these issues come up much
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later in the business and it's usually
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after a lot of stock four founders have
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vested as well and everyone's kind of
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gotten comfortable with one another but
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it is important to think about early on
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because if you bring on an investor who
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controls the board realize that that is
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a real risk then that you can
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potentially run where you know there may
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be a challenge without investor going
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forward that may be very hard to resolve
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given their control of the board I'll
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make one last small note on cost often
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it comes up you know in a term sheet
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there's a term that usually has the
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company your company paying for investor
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counsel and a lot of entrepreneurs look
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at this and understandably say well
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that's crazy wait a second so this
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investment group is going to put money
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into my company and then I've got to pay
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for their legal expenses that doesn't
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seem fair and reasonable there is a
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there's a lot of reasons for that that
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are beyond the scope of the video in
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terms of how investors work but it's
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very standard that companies pay for
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investor counsel it's also reasonable
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that those costs me capped so I would
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wherever you are ask what's customary to
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pay for investor counsel and then just
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move on in the term sheet it's not we're
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spending a lot of time negotiating this
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so to pull it back up to a big picture
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their term sheet it's not a binding
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agreement it's really agreement on
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principle terms and from my standpoint
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as an investor the most important things
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really to be thinking about is valuation
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the most critical and there's some
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nuances and how that's calculated
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particularly around option pool the
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second is really on on governance and
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then the third is on the type of type of
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security and I think those are the big
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constructs to really be thinking about
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there's obviously a lot more terms and
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as I mentioned there's a lot of
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resources on the web that can help with
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particular issues but as an investor
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those are the really the big ones that I
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think you ought to be thoughtful about
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when it comes to looking at a term see
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that comes from an investor I'd also
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tell you at a high level realize that
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whatever terms get put into this term
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sheet they're likely going to be terms
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that persist throughout the existence of
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the business you're kind of setting up a
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framework at the very beginning that is
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going to follow you and the company
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going forward and so be thoughtful about
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that going forward how many directors
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there are in that initial round if you
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have 15 directors in your a round to
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exaggerate its gonna make it really hard
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to continue to build that board going
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forward so try to be thoughtful about
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that at the very beginning because
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you're really setting this up for for
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the future and the final thing I tell
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you as an entrepreneur is that for me as
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an investor my worst nightmare is if I
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was to invest in a company where the
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founder CEO left
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after you know some short amount of time
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whether voluntary or involuntary the
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reason is when I invest early it's
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really backing a team if that doesn't
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work out it's a very bad situation for
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me almost certainly that investment is
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in trouble at that point so founders
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have a tremendous amount of leverage
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that is sometimes difficult to capture
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in a legal term sheet that contemplates
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all these kind of crazy outlying
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scenarios but realize that you do have a
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lot of control just inherently because
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that investor likely is coming in to
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back you so thank you thank you for
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watching the video I'd love to hear
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anybody else's comments about what they
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see is major issues in a term sheet if
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you have questions specific questions on
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a term sheet please leave them in the
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comments section I'd be happy to answer
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them and give you my thoughts about what
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I value what I don't value and how I
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think about it and until next time
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please subscribe share with your friends
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and look forward to talking to you then
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Thanks
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