When we launched in 2016, we took the unusual approach of saying we’d buy common stock in startups. We believed then, and still do, that alignment with founders was more important than covering our downside in investments that didn’t work as planned. Said differently, we wanted to enhance our upside through alignment, rather than maximizing our downside through terms.
The world has changed a lot since that time. While we are actively making investments, and still buying common stock, we know that many entrepreneurs may be trying to raise money now — and it is very hard.
Fred Destin wrote a great piece about the ugly terms that can creep into term sheets during difficult times. If you have a choice between a good term sheet and a bad one, of course, you’ll take the good one. But what if you have no choice? And how can you compare term sheets in the first place?
To this end, we developed the term-sheet grader, a simple way to compare different term sheets or help characterize whether a term sheet is good or evil.
Let me first point out that none of this has anything to do with the valuation of the round (share price), the amount of capital, the likelihood of reaching a closing, the quality of the firm or the trust you have with the individual leading the investment, all absolutely critical pieces of the puzzle. Here, we are just looking at the terms and conditions, the legal structure of the investment.
We’ve listed nine key terms below — five that have to do with economics and four that relate to control and decision-making:
- Each key term can earn +1 for being friendly and -1 for being tough.
- There are a few really friendly terms that have a score of +2 each.
- Likewise, there are a few really tough ones that earn a -2.
- The best a term sheet could score is a +11, the worst is a -11.
- The “Industry Standard” deal scores a 0.
FWIW, the Pillar common stock standard deal earns a +8 (shown below).
Image Credits: Jamie Pillar
So, what to do if your term sheet has too many tough terms, and which are the ones to focus on?
Ask for “clean terms”
VCs know what this means — it means “give me a version of the term sheet that has the industry-standard terms, ones that would score a “0” using our scorecard above.” This term sheet will undoubtedly come back with a lower valuation than the version with the bells and whistles, so be prepared. While it may feel painful to take money at a lower price, and your ownership on the spreadsheet now looks much lower than you’d hoped, you are likely better off than having an investor who is completely misaligned with your interests (as many of these terms do — see below). Remember, the number on that spreadsheet reflects what proportion of the proceeds you’d get if things work out well. If they don’t, you’ll get far less.
If you get clean terms, congratulations. Take the money and live on to fight another day. A few tips on negotiating the finer points can be found here.
Terms to avoid if at all possible
There are two economic terms and one control term that can matter a lot. I say “can” because if everything works out well, these terms won’t hurt you. But in the downside case, they can really sting.
Full ratchet. This is the draconian version of anti-dilution. It basically means that if money is raised in the future at a lower price than is being paid now, the investment being made now will be repriced to that lower number in the future. It means that your investment is much more like a loan with a cap than a priced round. Why is this so bad? You may think you sold 25% of your company for $2.5 million, but it turns out that you really sold much more if the next round happens at a lower price.
[Note: This is why I find it curious that entrepreneurs have been so drawn to convertible loans with caps over the last decade. It might look appealing when everything appears to be moving up and to the right — but when things turn, it is really just an investment with a full ratchet. Yuck!]
Participating preferred. This means the investor gets their money back and their pro-rata share of what is left. This creates huge misalignment because they can make money in low outcomes, whereas you may not. In really bad term sheets they can get more than 1X off the top (2X, 3X) and still get their pro-rata of what is left (if any).
Trust is paramount
Voting controls are part of the industry-standard term sheet — they say that the preferred investors (usually a majority) need to approve any future round of investment, any borrowing or the sale of the company. If you are working with good people whom you trust, this is not an issue. They will likely want to do the same thing you do. But if you don’t trust the investor, these could be a huge problem. We have seen many examples where an existing investor didn’t want to allow a new investor to participate, putting the company in a weak position — then taking advantage of it later.
As my colleague Rich, used to say, “the process is the diligence.” You’ll learn a lot about what your new partner is going to be like to work with as you work through this negotiation. Do they seem to want to work with you on solving these issues? Can you find a compromise? Do you believe they actually want you and the company to succeed, or is it just a vehicle for them to make money?
There are many factors to consider in choosing an investment partner — who it is, the numbers and the terms. The alignment scorecard can help you evaluate the terms — they have important economic and legal implications and may reveal the true motivations of your new partner.
Final notes
This is not an exact science and we have greatly simplified our scoring system.
1) No doubt, there are scenarios where the relative cost or benefit of these features change — for example, the cost of a dividend relative to a preference is a function of interest rate and time to exit. The importance of vesting or re-vesting shares depends on time to exit and the likelihood that a founder leaves the business.
2) A founder may interpret our system to say that having a VC on your board is a bad thing. On the contrary, having a great VC on your board is likely the best thing for you. The point is that it is the founder’s choice rather than the investor’s mandate.