1. Guiding terms and valuation (pre-term sheet)
When an investor begins leaning in to your investment they’ll often start to ask you buying questions like these:
“What kind of deal were you thinking here?
What are your expectations on valuation?”
One of the most hotly debated fundraising questions is whether you should be upfront and definitive with VCs on your preferred terms and expected company valuation, or avoid the topic entirely. Here are the pros and cons to each of the two schools of thought:
1.1. Leave the valuation process completely open and let the investor come up with their own price and terms.
If you’re going down this route, say something like “we’re going to let the market speak to our valuation in this round.”
The main benefit of this approach is that it maximizes your chances of receiving term sheets. It doesn’t deter investors who like your business but may be more conservative on price. It invites them to submit a term sheet regardless, signaling that you’re open to at least considering every deal that comes in.
A CEO with a term sheet in-hand, regardless of the strength of that term sheet, is in a much stronger negotiating position than a CEO without one. Everyone around the table suddenly views you, your business, and the process in a completely different light. And if you’ve secured a term sheet from a tier 1 investor, your negotiating position is amplified even further.
It’s also worth noting that the amount of capital you’re raising is an unspoken signal of your valuation expectations anyway. At Series A for example, the rule of thumb is that the you can expect to take 20-25% dilution. That means if you’re raising $10MM, the implied valuation is $30-$40 MM pre-money/ $40-$50MM post-money. So even without verbalizing it, you’ve already soft-signaled your expectation by stating how much cash you are raising.
1.2. Be upfront and definitive with investors on your preferred terms and expected company valuation.
If you’re going down this route, you could say something like, “our competitors raised at a $[X]MM valuation last quarter and we have more ARR and are growing faster. So we’d like to see at least a 20% premium to their valuation.” Or something like, “we are raising $[X]MM but we probably won’t take a deal if the dilution is going to be more than [Y]%, or if the term sheet isn’t clean.”
CEOs will typically do this if they are coming from a position of strength (or trying to position themselves as coming from a position of strength) for one of the following reasons:
- They don’t actually need the capital with any urgency;
- Market conditions are particularly favorable; or
- They have exceptionally strong growth and metrics.
If you take this approach, be ready with as much support for your proposal possible. Using EBITDA or revenue multiples, comps from recently priced rounds, and providing a rationale and logical justification will go a long way versus just saying you think you deserve X. Ultimately, while competition will drive the round dynamics, investors need to justify the price and write memos supporting their decision-making.
Our recommended approach
Unless you are positive you have a winning hand and multiple terms sheets are a sure thing, we prefer letting investors drive the conversation on price and terms. Getting your first term sheet in the door is the hardest step and it’s also the biggest single catalyst that can drive the rest of your process. Once investors know you have a term sheet and someone has built enough confidence to make you that offer, they are forced to move towards a decision one way or another.
That said, every situation is different and details matter. Seek input and weigh the pros and cons of both strategies for your specific situation before you raise.
2. So you got a term sheet… now what?
Do: Immediately tell every other interested investor about the term sheet. And immediately tell every one of your existing investors, who can help spread the word even to net-new investors that it might spark to jump into the process. Once you receive the term sheet, the clock is ticking, so blast those emails out immediately!
Don’t: Do not share every detail on your term sheet and never share who it’s from. It violates the confidentiality clause in your term sheet and can shatter trust, destroying your relationship with the investor that sent it to you. Be wary of other investors that pry to see if you’ll give up the name of the participating investor. Just don’t do it, no matter how pushy they are.
Instead of using a specific name, say something like “a tier 1 investor” or “a brand name investor”, if that’s true, or use another generalization that speaks to the class/quality of your first term sheet to pump it up as much as possible and add excitement to your still prospective investors.
On terms, broadly describe what terms they have to beat or just stay silent. One example on how to successfully sidestep prying question but still get your point across is with a statement like this: “we’d love to see another term sheet at X valuation, and if we did we’d be likely to take it.”
3. Negotiating with a term sheet in-hand
Having multiple term sheets in-hand gives you more leverage through the negotiation process than having just one, but ultimately your goal for a successful fundraise should remain the same regardless — get as much as you can on the most important terms only and be ready to compromise on everything else. Don’t expect to get everything on your wish list.
It’s also a worthwhile reminder to recognize that you, the CEO, are at a disadvantage going into your negotiation with a VC. Whether you’ve raised capital one or more times successfully, chances are the VC you’re negotiating with has done it at least 10x that number of times already. It makes educating yourself on key terms and variations of those terms all that much more important.
You’ve probably already had people tell you that valuation isn’t the most important part of a term sheet. And you’ve probably rolled your eyes at those comments, the same way we did at one point before. However, we now strongly endorse the idea that there are much more important terms than valuation to be mindful of.
Instead of just continuing to repeat that point, we’ve listed out below the most important non-valuation terms you should deeply consider. In our view, these things can cost you much more than a 10% swing on price.
3.1. Board Seats
It’s almost always the case that Series A and Series B lead investors expect board seats. If you’re not comfortable with that, consider whether it’s because this isn’t really the right investor to lead your round or whether there’s another reason you’re weary of taking on a new investor board member.
If you’re at the seed-stage, expect less standardization. Many lead investors require board seats and many never take them. That said, be weary of seed investors that do not lead your round or who are not professional VCs that want a board seat. Think through what value they’re really going to add and whether more realistically they’ll become a challenging counterparty to deal with down the road.
In addition, new investors often view rigid board structures as a headache to overcome and deal with — they don’t want to have uncomfortable conversations with their peers (the other VCs already on your board) about who’s a better board member) — so it can become another point that adds friction to closing on your new round if you don’t handle it appropriately.
Best argument in favor of a balanced board
“I want to make sure the board accurately reflects the stage of the company at each step along the way to ensure optimal governance.”
3.2. Liquidation Preference
1X preference is the goal here and that’s typically what you’ll see in most markets. However, during more challenging markets, 2-3X is not unheard of. Understand how liquidation preference works for your capital stack because it’s many times more impactful to you and all your equity holders than 10% +/- swings on your headline valuation.
Best argument in favor of 1X preference
“I’m uncomfortable with our incentives being misaligned. I want to be long-term partners with you and be in lock-step at every point along the way.”
3.3. Founder Vesting
Most priced term sheets at Series A and before, will ask for the founder to re-vest some, or all, of their equity. This ensures that the founder can’t quit the month after a fundraise and leave the investor (and the company) high and dry. Push for as short of a vest as possible not because you’re already looking to quit, but because the sooner your equity is re-vested, the stronger the argument you have to propose top-up grants for yourself and any co-founders.
Best argument to shorten up founder vesting schedule:
“I’ve poured my heart and soul into this company and I have zero plans of ever doing anything else until we have accomplished the mission here, but something to me doesn’t feel right about putting me on a full vest like I’m a rank and file employee.” (The only real argument here is an emotional one.)
3.4. Negative control provisions
VCs typically require negative control rights (i.e. an investor veto) on major company decisions, including future financing events, a sale of the company and mergers. While this is standard, the language sometimes can extend to include operational decisions like hiring/firing executives, investing in new business lines, approving your annual budget. When the trains are running on time and everyone is in sync, these items are non-controversial. But when things are not going so well, they can become major headaches.
Best argument to eliminate operational vetoes
“You have said that you are betting on me with this investment. These control rights don’t communicate that same thought. I’m sure we will agree on the direction of the company but including these terms sets a precedent for all future investors to get the same rights, which both you and I may not align with down the road. Let’s remove that and keep a clean term sheet to protect both of us.”
3.5. What does a “good” (aka founder-friendly) term sheet look like?
Below is a sample, founder-friendly Series A term sheet. Here are the primary reasons we consider this a founder-friendly term sheet:
- Founder controlled board - The investor is taking one preferred seat while the founder(s) (”appointed by the majority common”) has two seats.
- Negative control provisions limited to financing actions - The investor cannot veto operational decisions (i.e. backdoor control of the company) but instead can only veto fundraising and company sales (in addition to standard board changes and stock changes).
- 1x liquidation preference - It’s not participating preferred, doesn’t have more than 1X preference, and doesn’t include warrants or any additional structure.
- Dividends are noncumulative - Cumulative dividends are a back-door way to increase the stated 1X preference considerably over time.
Company: | [__________], a Delaware corporation. |
Securities: | Series A Preferred Stock of the Company (“Series A”). |
Investment Amounts: | $[_] million from [__________] (“Lead Investor”)
$[_] million from other investors
Convertible notes and safes (“Convertibles”) convert on their terms into shadow series of preferred stock (together with the Series A, the “Preferred Stock”). |
Valuation: | $[_] million post-money valuation, including an available option pool equal to [__]% of the post-Closing fully-diluted capitalization. |
Liquidation Preference: | 1x non-participating preference. A sale of all or substantially all of the Company’s assets, or a merger (collectively, a “Company Sale”), will be treated as a liquidation. |
Dividends: | 6% noncumulative, payable if and when declared by the Board of Directors. |
Conversion to Common Stock: | At holder’s option and automatically on (i) IPO or (ii) approval of a majority of Preferred Stock (on an as-converted basis) (the “Preferred Majority”). Conversion ratio initially 1-to-1, subject to standard adjustments. |
Voting Rights: | Approval of the Preferred Majority required to (i) change rights, preferences or privileges of the Preferred Stock; (ii) change the authorized number of shares; (iii) create securities senior or pari passu to the existing Preferred Stock; (iv) redeem or repurchase any shares (except for purchases at cost upon termination of services or exercises of contractual rights of first refusal); (v) declare or pay any dividend; (vi) change the authorized number of directors; or (vii) liquidate or dissolve, including a Company Sale. Otherwise votes with Common Stock on an as‑converted basis. |
Drag-Along: | Founders, investors and 1% stockholders required to vote for a Company Sale approved by (i) the Board, (ii) the Preferred Majority and (iii) a majority of Common Stock [(excluding shares of Common Stock issuable or issued upon conversion of the Preferred Stock)] (the “Common Majority”), subject to standard exceptions. |
Other Rights & Matters: | The Preferred Stock will have standard broad-based weighted average anti-dilution rights, first refusal and co-sale rights over founder stock transfers, registration rights, pro rata rights and information rights. Company counsel drafts documents. Company pays Lead Investor’s legal fees, capped at $30,000. |
Board: | [Lead Investor designates 1 director. Common Majority designates 2 directors.] |
Founder and Employee Vesting: | Founders: [_______________].
Employees: 4-year monthly vesting with 1-year cliff. |
No Shop: | For 30 days, the Company will not solicit, encourage or accept any offers for the acquisition of Company capital stock (other than equity compensation for service providers), or of all or any substantial portion of Company assets. |
Note: This is not legal advice. Consult your corporate counsel before making any decisions.
4. Founder dilution
Here are specific resources we find extremely useful:
- Andy Areitio, GP at TheVentureCity, does a great job explaining the typical evolution of a startup CEO's ownership stake.
- Index Ventures has a great calculator that gives you an idea of the projected dilution/ownership based on assumptions you can easily personalize.
- Finerva published the results of a study of 8,000 funding rounds to understand how much dilution founders should expect by stage.
References
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