How To: Manage Series A Termsheets
Russ Wilcox
Partner at Pillar VC
All of your hard work has paid off — you’ve received a term sheet!
After sending over a term sheet, the VC will likely want you to commit right away. Issuing a term sheet is a nerve-wracking moment for a VC because it only happens a few times per year, and each time, the whole firm is watching to see if that partner can convince you to sign. No VC wants to disappoint his or her partners, or get outcompeted by a rival firm. So they will pressure you persistently to sign, and that is pretty normal.
If you have not done your diligence yet, perhaps because the process moved faster than you expected, now is the time to ask the VCs to provide references. Pick 2 or 3 of their portfolio companies at random and ask to speak to those CEOs specifically, which will ensure you get a sampling of good and bad rather than just the good.
Make these calls
before you sign anything.
Most term sheets are 3-7 pages long and full of legalese. At Pillar, we keep our term sheet to one page. When you get a term sheet, immediately send it to your Board of Directors and your attorney and ask for comments and a markup. The attorney will compile a list of small or large issues. Your Board may suggest a counterproposal on pricing. You can send all that back to the VC, which will buy you another day or two to see if they will offer a better version.
What you do
with that time depends
on how much you like the
deal on the table.
If you would be willing to sign the deal but actually prefer a different investor already in diligence, then call that investor up and say “We just got a reasonable term sheet from a reputable firm, and now we would like to see a term sheet from you before we decide. Can you get to a decision in the next two days?” Most will say no, but if he or she says yes, then you can come back to the first firm, thank them for sending a term sheet, but then say that another firm is also deep in the process and you have decided to give them 48 hours to put an offer on the table or walk away.
The first VC may not like this, but has to respect that you are not going to pull the rug out from under an investor who has been in deep diligence, and 48 hours is generally a reasonable time to wait.
Now it’s time to evaluate your options
If the term sheet is something you cannot accept because the terms are complex and filled with hidden gotchas, and your attorney looks like she wants to jump off a bridge, then stop and rethink. It could be that the VC is diabolical and you should run away. It happens. But it may also be the case that the VC thinks you are the problem because you are demanding an unreasonable valuation, or because your cap table is complicated by past financings, so he or she has to create a tortured offer. Go back and test this by saying “This term sheet has undesirable non-standard features. What valuation would you offer if we wanted to work with a generic, simple, clean structure?”
If the term sheet is OK but you do not really like the partner who gave it to you, then you are really in a tough spot because it is so risky to let go of a bird in hand. Call up everyone you like better in your pipeline and say “we have at least one firm indicating strong interest, can you give me a sense of your process and time needed to reach a decision?” Then you can at least make an informed decision as to whether to keep working your pipeline, or to accept, or to abandon Series A and ask insiders for a seed extension instead.
Please take this hard-earned lesson to heart: your goal as a wise CEO is not to achieve the highest valuation for this one round. Your goal is to find a VC who is willing to invest enough money for your plan, on market terms, and is someone you will want to work with for many years to come.
Multiple Term Sheets
Occasionally a startup is lucky enough to receive term sheets from two strong firms. The question inevitably arises: should you expand the round and try to get both on board, perhaps at a higher valuation?
Start by asking VCs for their opinion.
If they are both enthusiastic and have invested together before, then it could be a positive for everyone to have extra pockets around the table, especially if they would each agree to own a bit less than their usual target percentages to keep the round from growing too dilutive.
If they do not know each other though, and neither appears eager to squeeze down, then be cautious of forcing them together. A larger round with a hodgepodge syndicate could go wrong in several ways:
- When you get into trouble, if no one VC has the biggest stake, no one VC feels responsible to help you out.
- As neither VC owns a full 20%, they are both hungry to buy more ownership and will keep pushing you to raise more, take more risks to aim higher.
- VC partners with different styles may disagree and start fighting.
- More money raised is more money you have to repay if you sell the company, and requires that you sell the company for a higher number before the stock options have any value. You start losing your optionality as a founder to sell the company for a small exit before you reach a big exit.
- The post-money valuation ends up quite large. Why is that dangerous? Well, it lets you brag to your friends in the short term and you have more money in the bank, but now the bar for the next round is that much higher. Remember that you are trying to at least double the valuation before you raise Series B. So if you raise $15M on $30M (post of $45M) instead of $10M on $20M (post of $30M), now you will need to raise the next round Series B at $90M pre-money instead of $60M pre-money. Are you confident you can justify $30M higher pre-money value in the next 12 months with only $5M of extra cash? That is a tall order.
- In general, the more bullish the current round, the harder it is to keep accelerating valuation into the next round. You may be setting yourself up for failure at Series B.
If you are lucky enough
to be in this circumstance,
you will hear VCs start grousing about "ownership percentages"
A key point to understand about VCs is that by and large they are middlemen. The cash they give you mostly comes from other people – wealthy people and funds called limited partners (LP). The LPs are billionaires, universities, successful entrepreneurs, family offices, and investment companies. The LPs have lots of choices about where to invest their millions, and just as you need to compete to earn an investment from a VC, the VCs have to compete to earn investments from LPs. Famous VCs who have shown an ability to back unicorns in the past are mobbed by LPs who want them to try again, while up-and-coming VCs have to pitch, just like you. Famous VCs therefore tend to have a lot of cash per partner and seek to pack as much as possible into each investment, while new VCs are leaner and scrappier and more willing to work hard for a smaller investment.
To help make sense of this, a key metric LPs use to assess VCs is “ownership percentage.” Most VC funds have a target ownership percentage that they promise they will achieve. For Series A tech funds who lead, this number is 18-20%. Onto that amount, add another 5-9% for your insiders. Why? Your seed investors who bought 25% of your company in the past will try to own 25% of the next round, e.g. 25% of 20-35% or 5-9%. And add onto those amounts any further dilution that would allow some smaller funds to join. Smaller funds don’t really have the firepower to lead a deal, but they will try to “follow” with a smaller check, and try to join the round on the basis of their relationships or expertise, aiming at 5-10% each.
You can therefore predict that if your round is about $12M for 33% (a $24M pre-money), there is room for one VC leading with $7.2M for 20%, participation from your seed insiders for $3M for 8%, and a follow-on fund for the remaining $1.8M at 5%.
If you have two large funds who want to co-lead, also called a “two-handed deal” then a model here might be $18M round for 36% (a $32M pre-money), with each lead investing $7.5M for a relatively disappointing (for them) 15%, and the insiders again investing $3M for the remaining 6%, and no room for others.
Bottom line,
the more VCs you squeeze together, the worse the deal feels for them.
If you are a good businessperson, you want everyone who works with you to get a fair shake, so you are better off just keeping the deal to 1 or 2 main VCs and a few extras, and that’s that.
Negotiating a Term Sheet
As soon as you receive a term sheet, send it to your attorney and your Board and determine if there are any terms that are unacceptable, and which terms are worth haggling about. Your corporate attorney is a crucial adviser on the term sheet, so make sure you work closely with an attorney who has completed many venture financings.
Your ability to negotiate is based on how badly you need the money, and how many other term sheets you have or expect to receive in the next 1 – 2 weeks.
Tailor your negotiations to your cash needs.
The amount you can negotiate a typical term sheet can vary from 0-5% better up to 20-30% better, depending on the intensity of interest in your round. If you only have 1 term sheet and you like the investor, your best bet is to keep your requests in the 0-5% range and move ahead.
the benefit of a legal review or without the agreement of your board of directors
Pillar Partner Jamie Goldstein wrote a series of Medium posts, Can I negotiate my VC Term Sheet? and identified specific trade-offs and opportunities to consider at the seed stage.
From this, we created a list of what we consider “clean” and “labored” terms. In other words, what are the differences between the friendliest terms, and the not-so-friendly. You can take a look at our list below:
Understand specific trade-offs and opportunities to consider at the seed stage.
Understand the difference between friendly and not-so-friendly terms.
Compare different term sheets, or determine if your term sheet is founder-aligned.
Your ability to negotiate is affected by matters you control (your company, how you run your process, how many term sheets you attract, how aggressive you try to be on price) and also by matters you do not (whether your company is in a hot sector, and whether the capital markets are loose or tight.)
If you have any choice between a lower valuation with a clean term sheet, or a higher valuation with a labored term sheet, then always take the clean term sheet. In the end, positioning the company for success in the long term is more important than dilution in the short term.
Now, go close your deal!
