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David, it is about damn time that we did an episode on term sheets. I feel like this is like in the life cycle of every person who is a venture capitalist and also either has a blog or a podcast. You eventually, you do the episode or the blog post on term sheets. It's like writing a power ballad or something as a rock star. It's like everybody has to try it once. Oh, man.
It usually doesn't age well. Yeah, it's true. Well, listeners, we should mention we're super excited to be doing this episode because I think if we did 20 LP episodes on different things in the life cycle of starting a company, running a company, getting a company funded, and didn't touch on a high-level overview of term sheets, we would be doing a massive disservice to a hugely important thing to understand in the entrepreneurial journey.
And we should also say that if you are starting a company and are about to go through a fundraising process, I highly recommend, and I know David does as well, reading Brad Feld and Jason Mendelson's book, Venture Deals. It is a Bible on the subject. And I think today we will skim across the top of some of these things and talk about what a term sheet is and a lot of the more
practical nuances of it. But if you really want to dive into the very, very sophisticated nature of it, couldn't recommend that book more. We talked about this a little bit on Slack for those of you who are on Slack. I feel like Slack has been great lately, by the way. So much great conversations.
Thank you, everyone, for participating. So with the LP shows, I feel like things are going really well. And we realized it had been a little while since we've had so many great guests on for interviews. It had been a while since we'd done an LP show with just us around a company building topic. So that's what we're doing today. And we're going to try and settle into a cadence of about a third, a third, a third of shows like this that are Ben and I discussing a company building topic.
a third interviews with operators at startups and big tech companies, and a third interviews with investors and their perspective. So let us know if you are liking that mix and we'll keep going. Yeah. And we reserve the right to talk about non-company building topics too, because I think, David, we thought this was going to be a little bit more, I think we starting out, it's like, Hey, sometimes like we'll just record our phone calls and,
We haven't done as much of that, but I think we may do those from time to time, and we'll give you a heads up if it's going to be a little less structured like that. Yeah. Well, term sheets. Yeah. So we're going to structure this a little bit, at least the opener, in kind of a Q&A with me to David. My first question to you, David, is what is a term sheet?
And what's it for and when's it happen? So term sheets are sort of a mythical creature in the venture and startup world. Everybody talks about, you know, getting term sheets and it's a pivotal moment used to refer to lots of things. But a term sheet is specifically it is it is a non-
binding document. It is literally what the name says it is. It is a sheet with a set of terms for negotiation on it for a potential investment. And it is typically given by a venture capital firm or angel or a group of angels to a company. And those are the terms at which they are going to offer to invest in the company. And why it's such a big deal is that when
when a firm does that, when an investor does that, they are saying, yes, I have gotten over the hump. You have gone, you have flipped from no to yes, I want to invest in your company. And then a negotiation kicks off on what are the terms on which you invest. But just getting to that point is like,
probably 90%, 95% of the work in terms of raising money. Once you get your first term sheet, then that drives FOMO from other investors who are considering potential investing. They have to make a decision about whether they are also going to get you term sheets. And typically that is what the first one that comes in kind of cascades the process. So non-binding, you say? Ah, yes. Tell me about that. Non-binding. So mechanically, the...
term sheet is not legally binding, nor is it what is the actual governing documents of the investment that is made. It is literally just the set of terms for negotiation. So you have to have a vehicle to put out terms so that you can go back and forth and negotiate. And that's what happens over a period of a day or a week or so. And then you ship it off to the lawyers and you say, turn this term sheet, this set of terms into a set of binding legal documents.
And this is after it's been signed and countersigned by both the investor and the entrepreneur. Then you hand it off to the lawyers. Exactly, exactly. And then the lawyers draw up a set of documents, always including a stock purchase agreement, which is a much larger document that governs the terms of the purchase of stock by the investor, but also amending the company's certificate of incorporation. And usually there's an investor rights agreement and a few other ancillary docs.
There's like eight to 10 different docs that get generated here. Depends. I mean, I've seen it as few as like three, but it could be up to eight or 10. And all of this from the term sheet. So how on a single piece of paper could they possibly lay out all of the terms of investment that will then get translated into these dozens, if not hundreds of pieces of paper that serve as the quote unquote definitive documents?
It's amazing the alchemy that these lawyers can do. We love our lawyer friends, especially our great sponsors, Perkins Coie. They do a fantastic job turning term sheets into binding legal documents. Yes, it is amazing how these things expand.
And the one point I'm trying to drive home here is you will get a term sheet and it is very unlikely that that term sheet will be a sheet. It's probably about eight pages, somewhere in there. Well, that's changing as we'll go through. Actually, this is a good point. Before we dive into, so we're going to go through an actual term sheet, but before we do that, let's talk about the history of term sheets. So Ben and I were joking before the show, Brad references, Brad and Jason in the Venture Deals book, that the first...
technically term sheet it was a letter of an offer to invest right uh in uh in deck in digital equipment corporation yeah and throwback that would be a fun episode to do deck someday oh man granddaddy of them all uh but yes it was a uh it was a letter right i think that's right i think that's right the sheet the the term sheet had not been coined yet
And actually, we should say like term sheet is a thing that predates a lot of definitive agreements, not just for a financing, also for M&A events, also for a lot of other transactions. So we should note that we're zooming in on the notion of the term sheet that is used as the canonical moment in time when an investor indicates they want to invest in a company.
Yeah, I'm a venture capital investor. So yeah, from that very first term sheet, which wasn't even a term sheet, it was a letter to invest, what, $70,000 in deck for 78% of the company? Some enormous percent, yeah. Oh my God, wow. Times have changed. So from that, then term sheets kind of exploded. After that, I remember when I first joined Madrona, our standard term sheet was like,
been like you're referring to like eight pages and had tons of terms and docs in there to now it's been like way winnowed back down. And I feel like this is part of the pendulum swinging back in favor of startups and founders recently about being more founder friendly so that our standard term sheet wave is based off the standard series seed term sheet, which we will go through in a bit on the show. It is two pages and is very simple and straightforward.
These things ebb and flow. So I want to talk before diving into the terms about sort of the mechanics of and the timeline of how this all goes down. So, you know, you're going through your fundraising process. You get a term sheet. You may get multiple. Hopefully, knock on wood, you get multiple. So you get to sort of pick what investor that you want to go with. David, you were mentioning sort of within a day or a week, decide to sign it and the investor signs it as well. But, you know, just because you signed that doesn't mean the money's in the bank.
There's then a sort of two to four week period where the company's counsel and the investor's counsel are going back and forth, making sure that they are being true to the term sheet, but also representing the interests of both parties as they draft the definitive documents. And there's a little bit of back and forth there, but hopefully the term sheet lays out enough in specificity that
Nothing can really go wrong to blow up the deal in drafting the definitive documents. I would say occasionally people don't do a term sheet and they agree to something over email and they kick it over to lawyers. That might leave a little bit too much ambiguity, but if the parties know each other really well, then it's a nice way to not have to go through this. I've actually never seen that happen. Have you seen that happen? I have. I have.
I have. Wow. Yeah. Wow. Interesting. You know, the more you lay it out in the term sheet, the less squinting and guessing that the law firms have to do later. And one thing to also clarify here that I think wouldn't be obvious to people who haven't been through this, both the company hires lawyers
council hires lawyers and the investors, uh, the lead investor, usually representing all investors hire separate council as well versus just one council drafting everything because it's kind of, it's, it's just like buying a house. It's like a real estate transaction. You have like the seller's agent and the buyer's agent. If you only have one agent, then one party could get screwed. So you need an agent representing each, uh, the interests of each party. Yep.
It should also be noted, and when I was a first-time CEO, this was surprising to me. You get a term sheet. You negotiate it. You come to terms. You both sign. The thing I didn't realize was it was then on me, the entrepreneur, to call my lawyers and say, all right, can you turn this into some definitive documents? Here is, I'm adding the investor's counsel to this thread as well. I sort of assumed because the investor issued the term sheet that the investor would tell their counsel to start drafting definitive documents.
But no, actually, the company counsel then starts doing that and takes a first stab at it. Yep, that is how it goes. All right. Well, we could talk about the minutiae details around term sheets, surrounding term sheets all day. But should we actually dive in and
Talk about a term sheet. Just to put a total pin on it. After that, you know, two to four weeks, give or take some time goes by. The definitive documents come out. Everyone signs those. That is the day that the money is actually wired and the company gets funded, which is the time for everyone to both celebrate, get to work, pop the champagne, do whatever it is. But that is the, you know, you end up with sort of a month from all this term sheet nonsense to when the money is actually in the bank. All right.
Diving in. One more caveat before we dive in. We're talking about... I know, I know. I'm sorry. We're talking about equity term sheets here. So you may be familiar with SAFEs or convertible debt, although SAFEs are... Almost nobody uses convertible debt anymore. I think it's just SAFEs. Those are not equity investments, not legal agreements. They're debt. Those happen like right away. That's like a...
They were designed as a very simple, easy instrument. So you can sign and wire same day and all of the whole agreement is contained within the sheet that describes the safe. It's not like the term sheet that then goes to be used by the lawyers to create legal docs. Yes, this is for a equity purchase, otherwise known as a priced round.
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Okay. So listeners, if you want to follow along blow by blow here, we will put a link in the show notes, but we're going to use the standard series seed term sheet and go through that.
This was developed, I think, originally by Ted Wang, who was a partner at Fenwick and West, one of the great Silicon Valley law firms. He wanted to open source these term sheets because this was like proprietary knowledge. Like each firm had their own term sheet and they didn't share it with anyone. He wanted to open source. Yeah. Like why? And like entrepreneurs didn't know, you know, what was in there.
He wanted to standardize and open source these term sheets. So he created the series seed.com and maintained it. He then, I think in 2014, left Fenwick and joined the VC firm Cowboy Ventures as a partner. Since then, Cooley, which is another great Silicon Valley law firm, they've kind of taken over stewardship of the open source series seed documents. They forked, it's on GitHub. They forked the original repo and created the Cooley fork, which is the most kind of up-to-date
today. I will also talk about how we've adapted it for our term sheet at Wave, but we based ours off of the coolly stewarded current version of Series C. So we'll link to all this in the show notes.
So begins David and I trying to read a legal document on air and make for good radio. This is so exciting. Okay, well, so let's jump in. So the first under offering terms, the first term here is securities to issue and shares of a new series of preferred stock of the company, the quote unquote series seed.
pretty self-explanatory as just saying the type of stock that uh the investors will be buying is a new series of preferred stock to be called the series seed and it's preferred stock as opposed to common stock because it will have a set of preferences associated with it uh that common stock does not have david i didn't mean it literally mean like read like i we can we could do maybe like i'm just
But yes, the important bit to know here is that the preferred stock is a different class of stock than the employees hold. Founded employees. Yes, exactly. That has a preference. So it is sort of the first money out off the stack. Well, we'll get into more specifics. We'll get to it. It has a whole set of rights associated with it that common stock does not. All right. Aggregate proceeds. Okay. This is how much money you're raising.
an important detail. In the standard Series C term sheet, there's then a bunch of language about, in addition, some amount of convertible securities are converting. This is if you've raised safes or convertible debt before doing this price round, which a lot of companies do these days. This is where the investors would put in what happens to those. What rights do they get? Do they get all the rights that the new investors in the Series C get? Do they get some of the rights?
depends deal by deal okay purchasers this governs this is just saying who is buying so so far we've gotten uh when people say something like oh i'm raising a two on ten uh so far we have covered the two but not the on ten and the uh different things that that could mean
Yeah, which we are about to get into. So, okay, the most important, we're going to talk about all of the rights and preferences in this term sheet, but by far the most important piece is valuation. Well, it's how much you're raising at what valuation and thus how much dilution you're taking, what percentage of the company you're selling for that money. In the standard series seed
term sheet. This is captured here in this price per share term. We actually changed this in our version because we wanted to be much more clear about spelling out like what is the valuation that we're investing at and how much of the company are we buying. So we just structured ours a little differently there, but it's the
same thing. What this is saying, so in the standard term sheet here, it talks about a pre-money valuation. The price per share will be based on a pre-money valuation of some amount and including an available option pool of another amount. So, okay, what does this mean? You're laying out the pre-money valuation of the company. You then...
the money to get to a post money valuation. There are lots of other blog posts that talk about this math. The pre money plus the money. Plus the money. Anyway, it boils down to the percentage of the company you are selling is the amount of money you are raising divided by the post money valuation of the
So if, say, you're raising $2 million at a $10 million post-money valuation, you are selling 2 divided by 10, 20% of the company. We'll come back to option pool in a sec. And so, you know, when I was first dipping my toe into this whole thing, the notion that there was a pre-money and a post-money gap
why isn't there just one valuation? Like this thing makes no sense. And it's interesting because if you think about it, you know, I'm sitting here today on April 4th. I'm going to keep sticking with these same numbers here. My company's worth $10 million hypothetically. And tomorrow we get 2 million in cash. So tomorrow we've got the 10 million that's actually, uh,
the intrinsic value of the company, theoretically, plus now in our bank account, we have another $2 million, so we have to be worth $12 million. And it's one of these wild things that because the cash was added to the company, even though the intrinsic value didn't change, you now have the intrinsic value plus the cash.
Yeah. So, okay. I hate all of this. I think my view is that this whole concept is way over complicated and was originally dreamed up and explained by finance people, not by startup people. And forget all of it. Here's what you need to know. So we do our term sheet differently. We do post-money valuation. Pre-money valuation is like a myth. It's like, forget it. All that matters is the post-money valuation. Because that's how you think about your dilution.
Exactly. Exactly. So the post money valuation is the denominator in the equation about how much you're selling. And so what we say when we invest, our term sheet says the post money valuation is X, $10 million. Just to keep going with the same example, it would be 12 in that thing I was referencing before. Oh, yeah. In the thing you were referencing. But to keep the math easy, we'll say it's 10. Okay.
When I joined Madrona and back in the day, all of our term sheets were based on pre-money valuation. That's just how it was done in the industry. But the problem with that is if you change how much you're raising, which often happens through a series of the negotiations, you get term sheets from a bunch of people. You're like, I like you. You're going to be a lead, but I like some of these other people too. Maybe they'll come in and be smaller pieces. Maybe we'll increase the amount of money we're raising or whatever. As the amount you raise change, if you've fixed
set in stone the pre-money valuation and not the post-money, the percentage of the company that you're selling and the percentage of company that investors are buying is changing. And that's just stupid. So basically the whole industry over the last couple of years, I don't know why the series C documents hasn't made the shift too, has just moved to like
We negotiate the post-money valuation and we negotiate how much you're raising and that's it. It's fixed. So our term sheets are Wave will – like our typical term sheet, Wave will invest $2 million at a post-money valuation of $10 million. We are buying 20% of the company. If you then want to raise more money –
into the round, like have some angels in or whatever and raise more money. Totally fine. You can sell shares to them as well. We'll say up to a certain amount, but the post-money valuation stays the same. So you're saying like, I'm going to sell. So you sell another 500,000 to other folks. You're selling another 5% of the company to them. It just makes it like waste cleaner and simpler and easy. Like this is the valuation I'm selling.
the percentage of the company based on the dollars I'm raising. So David, how does that work mechanically? If, uh, let's talk about timeline and then we'll get back into moving through the term sheet here, but let's say, and let's readjust my previous example. So now we're talking about a two on 10 post or sort of if we were in pre landed B8, but we're going to fix the post at 10. So,
There's a term sheet. It says that the amount that I'm going to raise is two. The post money is going to be 10. How does it work with an entrepreneur talking with a venture capitalist about what that lead investor's allocation is going to be versus other people? Does that happen before the term sheet, after the term sheet? Does it get worked out well? Definitive docs are getting worked out. Where does that all happen?
Definitely before definitive docs, but somewhere between before during the courting process and then during and after the term sheet during the negotiation process. So typically a lead investor like us at Wave, we have an ownership that we want to lead. We want to be the majority investor in the round. We have an ownership target. We say we want to buy X percentage of the company, in this case, 20% for our $2 million. That's
that is what it is. And then we say, you know, if there are other people, other great people who we want involved in the company on the cap table as investors, let's bring those folks in. And you as an entrepreneur are welcome to do that. It's kind of up to you to sell how much of the company you want. I see. I see. And the term sheet doesn't include sort of strict guidelines around, you know, if I then go and say, okay, cool, I sold another 3 million to these
Yes. No, we do within guardrails. So typically in our term sheet, we will say, this is how much we're going to invest. And then we typically say, we will leave room for other investors up to a certain amount. So I'm looking at our template term sheet right now. It says Wave will invest $2 million and other investors can invest up to $250,000. We've done one investment where...
Now, the smallest any that other groups have done is 300,000. But anywhere from 300,000 to a million is typically what what we see. But again, this depends totally on who your lead is, what their strategy is. Some people have higher ownership targets, some people have less.
anywhere from, you know, zero to, in this case, in our toy example, 250,000, you could let other people in. So I'm hearing this between two and three and on a 10 post. We haven't talked about options pull yet. We will get there. So is it fair to say just from the dilution of capital that what's typical in these sorts of seed rounds is selling 20 to 30% of the company and taking 20 to 30% of dilution from the capital?
Yeah, I would say that's, that's what I mean. In some cases, you know, again, depending on how much you're raising from whom, what the company is like, could be slightly less than 20%. I would say average we see is right around 25% in total for the round. Typically, you know, in our case with a lead taking around 20%, but 25% is a good like, that's like middle of the road. And that's as we speak here in spring of 2019, these things also ebb and flow. It is worth noting, yes, that...
So option pool.
as you mentioned, Ben. Let's talk about that. Before you raise your first money, which presumably a seed round would be, unless you've raised convertible debt before or safes, you as a founding team and any employees you may already have own 100% of the equity in the company. You are then selling however much you just agree to, as we discussed, to investors, but investors all
also say part of raising this money, we're going to need to hire a bunch of people into the company. And those people were going to compensate them most likely with equity. We carve out an option pool for those future employees to be hired with. And
This is an artifact of history that this is done before investment, but that option pool is carved out before the capital comes in. So you're selling 20, 25% say to investors. You are also negotiating with investors about how much of that option pool for future employees you are creating with this round. Now, why is that done before investors invest?
In some ways, this is really just a valuation discussion. Like it could be like, oh, we do it afterwards. If you do it after, then the investors take the dilution. Whenever you create an option pool, the existing shareholders get diluted. Yeah, let's pause and say that slowly for a second because I think it's worth dissecting it.
Think about if you LPs were investing in the company and there was no option pool. So it's like, great, I'm going to put $2 million in and it's going to be 10 post. Oh, they want to bring on an employee? Ooh, my 20% just went down to 19%. Ooh, they want to bring out another play? Ooh, it's going down. And so this would continue to happen and happen and happen. And of course, it's going to happen later when more investors come in. But what you're basically doing here is you're saying for the next...
Until we raise the next round, 12 to 18 months, we are creating an amount of shares that's already set aside that happens before our 20% is created. So that as you hire people for the duration of the time that this option pool is around and you haven't given it all out, that we aren't getting diluted by these hires. And that is sort of the pretense upon which we are investing. It makes much more sense to do this versus...
versus the other way around because you can then have the negotiation up front around this of like, well, what is the right amount of equity for the next, you know, for this period, this seed stage of the company or the series A stage of the company. And then when we raise the next round of capital, you can think about equity compensation just like cash. You're raising this amount of cash to hire employees and build the company until you reach your next financing milestone. Same thing with equity. Yep.
And so, David, dive into why is it a valuation term? How could it be you can do the math such that your valuation is higher and your option pool is higher or your valuation could be lower and the option pool could be smaller, but ultimately your dilution is the same?
Well, so, okay, let's think about this from an investor perspective. Let's say you are lucky enough, both as an investor and a startup founder, that your company raises lots of money in the future, goes public, has a big exit someday.
you will need to hire a lot of employees along the way and issue a lot of options. As that happens in the future, every time a new option pool is created, that is dilution to the investors. So you could say...
all the existing shareholders. So as an investor coming into the company, you are doing the math in your head or in your fund models about like, okay, I'm going to take X amount of dilution. I'm assuming in the future in this company, some of that's going to be come from additional capital come coming in. But some of that is also just going to be coming from option pool refreshes over time.
So, you could say, well, when we invest up front here at the very seed stage or series A or whatever round you're talking about, we're going to create an artificially really high option pool so that we don't have to worry about that dilution from future employees for a long, long time. Okay, great. If we do that, well, I'm willing to give you a higher valuation because I know I'm going to be taking less dilution from the option pool side of things over time. Now,
That would be a really stupid way to negotiate and think about things. So I don't recommend it. What is standard? What is sort of like, what's market right now for, let's not say what the option pool size is necessarily, but what's standard for the amount of time that it should last you when you create an option pool? Two answers to this. The kind of standard quote unquote amount of time is 18 months-ish, like whatever the time is between when you're anticipating raising this round and raising your next round. But
But the right way to do this is in conjunction with a whole plan around like operational and financial milestones of like,
Like you exist today, you're raising the seed round today. You see it as an example. What do you need to look like to be able to raise a series A? How much time does that take? How much money does that take? How many employees does that take? And how much associated equity issuing to them does it take? I really like this exercise. We really like this at Wave. We do this with all of our companies because even though
generally as a rule of thumb, like valuations come out around 10 million and option pools come out around 10% and like all this stuff and runway comes out around 18 to 24 months. You want to actually build it from the bottom up as it applies to your business. If you just say like, oh, I'm going to do that because that's what everybody else does, then you have no plan. You know, it's much better. Exactly. As you said, Ben, apply it to your business. Mm hmm.
giving the entrepreneur perspective here, it helps you sleep easier at night. And it makes you feel like you have your hands on the controls of the business when you are able to sort of like, when you're building your fundraising materials, if you look at an operating model and say, okay, let's say I'm doing a B2B SaaS business. And 18 months after my seed round, I want to go raise a series A, which means I'd love to have like
$1.8 million in annual recurring revenue because I'm hearing that that is market for a Series A right now. Okay, great. So what do we have to do as a business to get there? How do we have to staff that? How many salespeople do I need? At what rate am I going to hire them? You can sort of build out this whole operating model. And of course, it's not going to be exactly right. It's hard to forecast what your revenue build is going to be over time. I mean, this
This model is way more accurate than your model of what does the business look like five years from now. Everyone knows that that's a little hand-wavy. But with this, it's really nice because then you have a spreadsheet that says who you need to hire when, how many customers you need to be landing each month.
And then you can really understand like, okay, great. Well, what's market rate to hire all those people? Okay. Market rate at this stage, that's going to be this on the cash side, this on the equity side. It, of course, doesn't actually work like this because the business has crazy ebbs and flows. But then you have like a spreadsheet that you can look at with you and your board member and your senior team and frankly, the whole company at this point and try and understand like,
okay, what do we just need to do each month to stay on plan? And then we'll get there. And we feel that we'll be sitting pretty to... It's not like the goal is raising money, but usually in these businesses, you do continue to need capital. So if you understand that I need to look like a great Series A fundable company a year and a half from now, we just got to execute the plan. The most important benefit of doing...
this whole exercise is it results in alignment. And I think I've talked about this on the LP show for sure, if not the main show too. Back when we were starting Wave, Greg McAdoo, who was a long time partner at Sequoia, the first board member at Airbnb, he gave us the very first piece of advice he gave us, he's an advisor to us now at Wave, was venture is all about alignment. And
And this is what creates this exercise is what creates alignment between a founding team and a company and a venture investor and a board member. What it is, is that like you create this plan and then you can see every every month, every board meeting. Are you on track or not?
if you are on track with the plan, great, you have a line on the plan, everybody should be happy. If you're unhappy, then it's like your own damn fault because you agreed to the plan. But if the company is not performing to plan, then you have a structured way to have a conversation around things are not going according to plan and it's not about you
you're an idiot or like, I'm an idiot. It's like, we agreed to the plan. The plan is not like, now we need to adjust. It's a fantastic exercise that you certainly can raise money. There are founders and investors who will go through and raise money without doing this exercise, but I really, really don't recommend it because even if you think you're aligned without getting down to brass tacks like this, you may not be.
Yeah. Yeah. It saves it saves any conversation in the future where someone says, oh, I didn't know that's what we were doing. It's like, no, no, no. It's all laid out right here. The plan is the plan until the plan changes. And I think that's some famous, famous aphorism. But like it gives you a grounding upon which to change the plan from. Yep. Totally.
Okay. So now listeners might be following along here and being like Ben and David, like guys, we've, we've been talking about this for 30 minutes and you have gotten through technically four terms in this term sheet. Like what's going on here? We have just gotten through 95% of the important stuff in a term sheet and negotiating a venture investment. Um,
All of these other terms are the 5%. And for a couple of reasons. One is because they're often technicalities. The other is these are market. We're about to talk about liquidation preference. If liquidation preference is anything but what David is about to tell me on a series C term sheet, run for the hills. Well, it just means somebody's trying to get a non-market deal on one side or the other. Okay. So we'll run through all the rest of these quickly.
liquidation preference the preference here is what gives rise to the term preferred stock took me a couple years to figure that one um so this is saying that investors uh by virtue of putting money in when there is a liquidation makes it sound like a bad thing but like liquid like there's a liquidity event an m&a transaction could be a shutdown but um any liquidity event
They're entitled to get the dollar amount that they put in back first off the top before the proceeds are then carved up according to percentage ownership in the cap table. And this is a option to get one or the other. So either you can get your money back or you can get your, you know, in this case, 20% ownership in the whole pie. So in a good outcome, you will, of course, say, yeah, I'm going to take 20% of
a billion dollars versus my $2 million I put in. You would quote unquote convert to common. Exactly. Exactly. Uh, in a bad outcome, uh, where say the company is only selling for like $3 million, you put $2 million in, but you own 20% of the company. You can say, Hey, instead of getting, uh, what is that? 300, no $600,000, which would be 20% of, of, uh, 3 million. I'm going to get my money back first. Um,
Um, this is a protective provision. It's, it's downside protection. It's, uh, if, if, if everything goes swimmingly well, that nobody pays any attention to this term. It's really only there in case, uh, you know, there's only a little bit of money there and people need to fight over who, uh, who should get it.
Yep. And that for sure happens. Now, it used to be this term has ebbed and flowed a little bit over the years. It used to be that like sometimes investors would get two times their money back or three times their money back before. But there'd be other ways of doing this. Now, this is super common. It's going to be 1X.
liquidation preference, not participating. Anything else is way off market. Yep. Um, and it's worth briefly touching on this sits on the quote unquote preference stack, sort of one level above the common stock every single round where you raise more money. Uh,
that as an additional, uh, uh, preference on top of the stack. And so for all those, uh, computer scientists listening, listening out there, you build up the stack and then you pop off the stack and it happens in that order. So it's a last money in first money out stack with, uh, the common and then all of the equity rounds. So it's common ABCD on and on and on, and then debt on top of that. Sometimes that's different, but yeah, that's normal. Okay. Conversion. This is just saying that
The mechanism by which you would go from having your preference and getting your money back to instead being like, no, give me my 20% of this great outcome is you convert from the preferred stock to common stock. This is just saying you can one for one convert your one preferred share into one common share. There's some technicalities in there, but not worth getting into. Um,
So voting rights. Yeah. Before diving in here, we should note, and this is a great thing that's pointed out in Brad Feld's venture deals. Every term that we have talked about so far has been an economic term. And this is the first time that we have a control term. And really everything in a term sheet falls into one or the other, where all the economic terms are about really sort of what am I owning in the business? And in what scenarios do I own what and get what money? And then the control terms are really about the board dynamics and what
really what control do I have over the company and what rights do I have as an investor.
So in the standard series seed term sheet, we have copied this word for word into our term sheet. The investors in the round get as control rights that approval of a majority of them is required to one, adversely change the rates of the preferred stock so that the rest of the company can't say like, hey, screw you guys, we're going to take away your rights. Two, change the authorized number of shares. This could be like
massively diluting them without their authorization. Three, this is essentially raising the next round of capital. So this is an important, you know, important thing to think about. It means whoever issued this term sheet is saying, hey, if you're going to go raise money again, you need to check with me first.
Exactly. And that makes sense because otherwise you could go the next day, turn around and go do a deal with somebody and say like, Hey, I want to cram down those people I just invested in. I'll let you invest at way better terms. And then you'll issue me as a founder, a lot more options to re-up my stake. And anyway, that would be like a really dark arts way of doing this. This is to protect that. Now, as an entrepreneur though, you
You need to realize you will give this right away. This is standard in the literally the standard series seed document. This means that the majority of the investors in your seed round or a they can veto your next round of financing.
So this is a little bit like a marriage contract. This is even more teeth than a marriage contract. You are getting married to these people and they have a lot of control over your company. So back to alignment and making sure your relationship is good. You better make sure you feel comfortable on both sides with this relationship. It's kind of crazy to think about because...
In all likelihood, this will not be the last time that your business needs a capital infusion that does not come from revenue. And so what you're basically saying is you're giving this investor the right to let your company die if...
You need to raise more capital and they don't want you to raise more capital on for whatever reason. Now, fortunately, they're very incentivized for you to stay alive as a business by the nature of their millions of dollars into the business. But, you know, they have the right to say, nope, you can't do that. You bring up a good point, Ben, that like, again, it comes back to alignment of incentives. Okay, next.
is redeem or repurchase shares. This is basically saying that you won't cash out other people before cashing out them. Declare or pay any dividend.
doing that via dividends. Which is super rare. Like let's for a moment say like there's some talk of dividends in here. That's not really a thing in startups. Okay, next change the number of directors so you can't like load up the board with, you know, all your cronies on either side. And then very important, this last one, seven, liquidate or dissolve including any change of control. This is saying that you need the approval of your majority of your investors to sell the company or shut down the company.
Again, super important. This actually very, very rarely would this kind of come to blows. But in the previous era of venture capital, it did all the time of like company wants to acquire the company for...
X amount of dollars, say $10 million. Investors are like, that doesn't move the needle for my fund. I'm going to block this sale. But the founders are like, but this would be life-changing money to me. And the angels are like, this is actually a good multiple. Yep, exactly. Again, you know, it's very rare these days. Like usually everybody's pretty aligned when you invest. But just another thing to keep in mind that you are giving investors this level of control over your company. Okay.
Okay, documentation, this is referring to what we were talking about half an hour ago, that this is a set of terms that will then be documented by the lawyers. And so this is saying the type of documentation that is going to be used here is standard documents, in this case, from the automated document generator at cooleygo.com, which is awesome. And actually, really, you know, great. The point here, the reason this was all done was to save money on legal costs, like,
use a document generator and have lawyers work off of that versus have lawyers literally draft up, reinvent the wheel every time. This is a really good time to talk about the costs incurred in doing this because one thing you're doing as you're building out your financial model for what are you going to do with the cash from this round, you should understand how much the financing itself is going to cost. Now, David, you're probably going to say this is high because I suspect
the way that, uh, that, that you do it and the way that it kind of happens among seed funds in the, in the Valley is probably a little bit different, uh, but maybe not. It's probably going to cost you about $25,000 on the company side and about $25,000 on the investor side. And it is, uh, uh,
up to the company to pay both of those out of pocket after the transaction closes. So if the deal falls through for any reason, then the investors eat it. But in all likelihood, the company is going to be paying for both. And it is a pretty significant bill.
I would say we usually see, yeah, about 25K sounds about right on the company side, 25 to 30K. We see 10 to 15 on the investor side, but it just depends on what law firms are willing to do it for. Yep. And it also depends how much standardization there is. I mean, if you're using a standard term sheet, or perhaps you've done a deal before with that investor under very similar terms, and you want to repurpose stocks or something like that, you can often get it done cheaper. Save a lot of...
Yeah, it comes down to how many hours both partners and associates at the respective law firms are going to spend on this. Okay, financial information. This is basically getting the rights going forward to have access to the quarterly or annual financials of the company. This is important for major investors like...
like I said, Wave, we own a large portion of the cap table of the companies. We need to know your quarterly financial results and we need to also have a function to make you as a company actually do your financials in accordance with GAAP every quarter because otherwise the SEC would be unhappy with all of us. Is it actually GAAP? Do the companies have to do GAAP financials?
Yeah, you can debate whether you should have them audited or not. Typically, what we do is unaudited quarterly financials and then audited annual financials. You can debate whether you actually need the audit in the early days annually. We often waive the audit for a year or two. But once you're operating for a while and you have significant revenue, it's important to get
audits regularly. And this is because at the worst case, fraud preventing that. But less than that is just inconsistencies, improper accounting. This leads to massive problems as you're setting up the company to ultimately have an exit, be it an acquisition or an IPO. These things are like,
That's going to get looked at in diligence. Yeah. Exactly. And starting sooner is better. So David, I noticed this little thing in here about major purchasers. So if you're going to put in 2 million and then this other firm is going to put in 250K, they asked me for a board observer seat and I said, no, I'd like to keep my board small and I just bring you on as the lead investor on my board.
Do they have financial information rights, even though they're not on the board? How does that work? And what does that have to do with major purchasers?
Well, that's where the concept of major purchasers comes in. Yeah, this is a negotiated term and typically goes exactly as you said, Ben. There's a smaller investor coming in. Does the lead investor and do the founders of the company think that that smaller investor deserves to have the right for financial information going forward, but also pro rata, right? Which we're going to get into in a sec. And, you know, that depends. I've seen...
I have set the threshold such that for being a major purchaser, such that only the lead has those rights. If it's mostly individuals coming in below that, I've set it so that pretty much everybody has those rights. It really just depends on the dynamics of the relationship. Cool.
Participation right.
in future financings to invest enough money in those financings to keep their percentage ownership in the company constant versus being diluted. This is super important as an institutional investor, like a venture firm, like Wave or anybody. We reserve capital to invest
beyond our initial investment in companies. And that's to keep our ownership. Otherwise, as companies raise a bunch of capital along the way, we'd get diluted and own less and less. And that's like half, right? Like of a fund. I mean, I think you reserve half or more of your capital for follow-ons.
It totally depends on the fund and the strategy, and it's evolving all the time. Some funds will... It is more than half. It's two-thirds or even 75% of the capital is reserved for later rounds versus the current round. Because we're pretty concentrated at Wave, we're about two-thirds up front and one-third reserved. So we're pretty far on the spectrum of the other end. In any case, a significant portion of the fund is going to be reserved for investing in future rounds of the company. And so this is important because...
It provides protection that your existing early investors won't get boxed out in later rounds by new investors coming in and saying, Hey, I want to take all of this round. Right. So think about this. Let's say that I'm investing as a venture firm, um,
a million of this 10 million post round. So I have 10% of the company. And in the next round, the company sells 20%, or let's say 25% and a 10% option pool. So there's 35% dilution happening. So all of a sudden, my 10% that I was super happy to own of this company, I'm now down to 6.5%.
And if I didn't have a pro rata right, like, holy crap, I just, you know, the way that I was looking at, boy, if this company hits a billion dollar valuation, my fund's sitting pretty to, whoa, that's a pretty big haircut. And if this is the one winner in my fund, gosh, it's not going to move the needle the way that I thought it was. And so pro rata rights are in there really to...
you know, help investors in the case that things are going well at the company to not take too much dilution in the subsequent round after they invest like right away in all likelihood. And David, I want to turn it back over to you. You're not going to have this right forever. Number one. And two, you're not going to have the capital forever.
Because if the company keeps growing and growing and growing, if you want to somehow preserve 35% of your investment and the company is raising at a $700 million valuation, you got to put a lot of capital to work because the share price just went way up. And so, David, if I have a pro rata right from the seed and I'm an investor, what tends to happen in the Series A and what tends to happen then in the Series B?
Well, it really depends. If the firm that led your seed is a large venture firm, a series A or multi-stage firm, then they're probably going to want to do it all the way. If you're a
dedicated seed fund like us that's a smaller we're a 55 million dollar fund we will look to do our full pro rata in the a or as much as close to it as we can afford depending on how much money you're raising and then drop off uh thereafter because we just won't have the capital to invest or or we may do uh have our have our do co-investments with our lps or it's really a case-by-case basis but the point is like the most important thing is sort of the next round for us
And that's really how you should think about it on a round by round basis. Now, to be clear on all of this, this is not saying your investors get to keep their same ownership in the next round for free. They have to put the money in. So you're still getting the capital. It's just that they have a right to do part of your next round rather than that next lead investor getting to take all of it.
yep exactly um okay board this is very straightforward this is just saying who is going to be on the board after the round closes typically not always but typically the lead investor in a given round will join the board we always do at wave let's see then expenses that's what we were talking about earlier about these legal expenses associated with the round um now there is you
you could say, wait a minute, why is the company paying for the investor's expenses? I did just breeze over that, didn't I? You did just breeze over that. This occasionally does change. But at the end of the day, the investor and the fund
is investing the money in the company. A cost of doing business is getting the round done. And so the investor is bringing the money. That money should pay for the legal fees of getting the round done is the justification. There's also a practical element to this too, which is that companies are set up as companies, obviously, and raise money. And that goes into operations of the company broadly and doesn't really affect...
the individual fortunes of any one person at the company, whereas funds are not set up as companies. Funds are pools of money. Oh, come on. This could be handled. Funds have not only the investable capital, but they also have fees and then there's fundraising expenses which gets carved out. You could see legal expenses getting carved out with fundraising expenses or something like that if people actually wanted to structure it that way.
You totally could. It's not typically common, though. So, yeah, this is all the justification. At the end of the day, it's just pretty standard right now. And again, these things ebb and flow.
Okay, future rates. Now, this is an interesting one. I've seen this stay in. I've seen this get struck or negotiated away. This is basically saying because this is a fairly light term sheet compared to when you raise larger rounds later in the company, there tend to be more control terms associated with them. This is saying essentially a most favored nations clause that your investors currently at the seed
any future rights that control rates you would give to investors, they are also going to get those could go either way. I mean, depends what those future rates are. At the end of the day, your existing investors also have a block on you being able to raise the next round. So if they really hate those rights, they have a, you know, a big red button on the negotiations that they can push anyway.
Okay. And then last meaningful term, key holder matters. It's a weird name for it. We call this founder vesting in our term sheets, which is what it is. This is setting or resetting the terms of vesting of your equity as a founder in the company. And then also what happens to your equity upon an acquisition. So this is like of all these kind of other ancillary terms,
Probably one of, if not the most important for you as a founder as you're negotiating term sheets. And often the toughest to swallow because I think, you know, David, one of the things that I like about us doing this episode is that I think it's nice to like signal to a lot of people before they begin a fundraise process like what this could look like. Because I think a lot of people hear one or two economic terms and then that's sort of in their head of, okay, cool, this is all that's going to be in that document.
And then they see this here that says, oh, I know you've been working on this business for three years and I know you put yourself on a four-year vest, but we're going to reset it back to basically that you've only vested for one year, even though you've been working on it for three and you still have three more years to go. And that is a gnarly thing to stomach if you didn't think about it beforehand. And so I think I'd love to open up a little discussion here of sort of why that happens, how common that is, you know,
Yeah. What have you seen? Yeah, totally. Well, one at the seed stage, this is typically not that controversial because typically the company has recently been started or just been started. And so whatever vesting you've put in place is typically acceptable, you know, to us a wave also, like we're usually investing, right? As companies are getting started. And as a founder, I
Unless you are a solo founder, if you have co-founders, you definitely want to have vesting on your and your co-founder's stock. Because should one of you just decide to leave at some point before vesting, then you would walk away with a huge portion of the equity in the company and not be working on the company anymore without earning it over vesting, just like an employee would in the option pool.
Now, where exactly, Ben, as you were saying, where this gets controversial is in later rounds, investors...
may and often do want to reset your vesting as a founder. And they could incentivize you by issuing more shares, which is what you tend to see as these re-ups in the series B, C, D. But often in the series A, it's taken a long time to find product market fit and you could be 75, 80% of the way through your vested shares. And it would be hugely dilutive to the whole cap table to issue you enough to incentivize you for the amount of work still ahead. So...
So instead, they reset your vesting so that you have to stick around for X number of years to re-earn, re-vest shares that you may have already vested. And that can indeed be a tough pill to swallow.
From an investor standpoint, though, you know, if you're going to be fully vested in six months, they're investing in you. They want to make sure you stick around. You know, it's a negotiation. Yeah, it's funny. I'll give a quick anecdote. I was talking to a friend who did a YC company, was backed by Sequoia in the Series A. It was exactly the scenario. It was three years into a four-year vest, got wound back to a...
basically counting all that as one year of vesting. And he later sold the company for... Which is what often happens. Yeah, yeah. For hundreds of millions of dollars. We were having lunch and I remember him saying like, as much as I was pissed at the time and thought those were like, you know, those guys were total jerks. We had...
way more than half the work still in front of us. And to the extent that the vesting represents sort of the value that you need to have the business create and the value you need to contribute to the business, you put the company in kind of a tough position if a dramatic amount of the work is still ahead, but you've vested a dramatic amount. This is always something I try and keep in mind, I think, when looking at my vesting in anything is always like, well, I should be intellectually honest with myself, even though the
you know, the, the amount of value creation is really the ultimate truth. And sometimes things need to change in order to, uh, facilitate that value creation. And so there's an intellectual honesty that should sort of always happen where you're, it's like your vesting sort of doesn't matter as much as if you don't feel that the business is most of the way there, you shouldn't emotionally feel like your vesting is most of the way there. Now, also,
This is back to the relationship and alignment of incentives. This should never like this can be a negotiation sticking point sometimes in rounds getting done. But this should never be an issue because incentives should be aligned around value maximization in the company. And so if you're a founder, a significant portion of your net worth presumably is tied up in the company.
And if you're thinking about leaving, presumably that would be pretty bad for the company. Maybe if it's good for the company, then your investors might be happy about you leaving. And then you should re-examine in your life. But assuming that's not the case, even if you are fully invested...
Like today when the Jeff and Mackenzie Bezos divorce settlement was announced is an interesting day to talk about this. But Jeff Bezos is fully vested in Amazon. He's also very incentivized to stick around and continue creating value for his investment in the company. Right. And, you know, I should we should go back to that other point of like there are ways to continue to incentivize people beyond taking away things that are already vested, like issuing new shares. But the shares kind of have to already be worth a lot in order to make that material.
Yep, totally. Oh, one more, I forgot, related to founder vesting, acceleration. So what does acceleration mean? This means that should the company be acquired, what happens to the portion of your stock that is not yet vested? Does it get
accelerated, do you get it all immediately or do you have to wait even until post-acquisition and stay at the acquirer while you continue to vest into that value? David, we had a great Perkins Coie explanation of this a couple episodes ago. Oh, that's right. That's right. We did. Well, I can refer everybody back to that. The real quick single trigger means that
There is one trigger which triggers full acceleration, which is an acquisition happening. Double trigger means two things have to happen. You have to get acquired and then you have to be fired by that company terminated without cause. So essentially made redundant. They say, hey, goodbye. The reality is people get all bent around the axle around whether you have acceleration or single or double trigger acceleration. The reality is
it doesn't matter that much what you have in the documents because an M&A acquirer is going to renegotiate everything at the time of acquisition anyway.
Full disclosure, which should be all over this episode, I am not a lawyer and neither is David. I don't think they can actually renegotiate what it says in your employment agreement or in the definitive documents. But what they can do is change things like earnouts and the amount of stock that you get in the company that's acquiring you and that sort of thing. And the terms of your employment with the acquiring company?
There are ways around all of... Whatever is in your current docs, there are ways for acquirers to...
rewrite whatever rules they want. But an interest at an interesting point, though, is whatever ends in your docs is the starting point for negotiations with the acquirer. So the more friendly it is to you, the better the starting point for you. This is where I'm glad this is like only an LP episode. And I think a lot of this is stuff that like we're not going to go talk about this to tens of thousands of people on the Internet, but super happy to do it with LPs.
The thing that ends up mattering the most for venture firms is really the relationship with the founders and being there through thick and thin. Because a lot of the times during an acquisition, companies will try and pull the craziest stuff. The founders ultimately get to be the single point of advocacy for everyone, for employees, for existing investors. And it's really about the relationship between
that you have and trusting that the founder is going to represent the interests of everyone as part of the deal. And there are ways for that not to happen. And I think that specifically, companies can say, well, we're going to buy you for a low amount, but we're going to incentivize you, you, and you with these big bonuses. And I think it comes down to relationships and it comes down to empowering the founder to be the advocate for everybody on the cap table. This is a great point.
place to wrap all this up because it really brings it back to one of our previous LP episodes and my wonderful and fantastic partner, Sarah Adler here at Wave. You know, she was head of M&A at Dropbox for many years. She was first at Facebook and then head of M&A at Dropbox and Airbnb. And she had such a fantastic reputation in Silicon Valley, even being on the
the acquirer side at companies, which typically is an adversarial negotiating position here, because she realized she was long-term greedy, not short-term greedy. And really, whether it's any kind of negotiation or deal, whether it's an acquisition or whether it's a term sheet and a venture round, there are two ways to approach it. You can be long-term greedy or you can be short-term greedy. And
Silicon Valley runs on relationships and relationships are built when both sides are mutually long-term greedy. And that's really, you know, the biggest piece of advice I think I certainly would give Ben, you can agree or disagree about for any side in a venture deal is, is
Be long-term greedy and make sure your partner on the other side of the table is too and be aligned with them around that. And whatever terms are in the term sheet are meaningless if you don't have that relationship-driven alignment. Well,
There is one more thing that says binding terms. No. That's right. We're leaving out the last term. This is the only binding term in the agreement that you sign, the term sheet, which just basically says the period of which you will have exclusive negotiations in good faith to try and clarify
close the round around these terms typically 30 days from when you sign but I have never once seen this be actually referred to or thought of again after the term sheet is signed well David do you want to do some quick follow-up from our our lift episode before winding this one down yeah great let's do it um
We had a couple little tidbits that didn't quite make it into the episode that we wanted to share with LPs. Yeah, listen, one thing that's fun about the LP show is David and I always have these gigantic piles of notes and we sort of
Yeah, totally. First...
One of my favorites. This was just complete oversight during the episode that we didn't get this in. About a year after Lyft, after the pivot to Lyft within Zimride, I believe it was July 2013, the company reincorporated from Zimride, reincorporated as Lyft, and they sold the assets of Zimride. No employees went with this. So no negotiation of single or double trigger acceleration. They sold the Zimride assets to Enterprise Rent-A-Car. Right.
total fun aside, which I believe had also acquired Zipcar at that point. Uh, I thought it wasn't that Avis. I could be wrong. No, you're right. It was Avis. Okay. I can't keep these rental car companies straight.
Yeah. Okay. So that's one. I have two points here that came in the series. I can't remember what it was. H. It was the round last year led by capital G. There were two investors of note that I think when looking into the S1 is interesting to peel back a little bit further. So
One was a person named Louis Gonda, who put in $500,000 along with that investment. And then another $2.5 million from Lexington Ventures, which is his venture fund. That is Logan Green's father-in-law. And keeping it all in the family. Yeah, a nice little $3 million investment for a nice IPO with a pop that hopefully continues to go up just a year later.
So that was one. That was the first thing I found. I texted it to David and was like, whoa, did you see this?
So the more fun thing is when you keep digging in a little further, there is a group called Oasis Investment Partners that as a part of that round put in $25 million. And I was like, what is Oasis Investment Partners? So you can go on the SEC and you look in their Edgar thing. They filed, I think it's a Form D for when they raised that fund. The entire size of that vehicle was $25 million. And you're like, okay, well, what happened there? It looks like that fund was raised exclusively to invest.
you know, it's like, I guess a special purpose vehicle. It has two partners. The first of which is the COO of Lyft, John McNeil. And the other is Phil Deutsch, the famed energy investor and the former president of social capital, which is a whole other, uh, uh,
a whole other story. I don't have a lot of comment there that I think in the, the other thing to note in the SEC document is that there were 20 people who had already committed by the time they had filed the form D, but interesting to see that, that SPV be raised there and invest the whole thing right before, or sort of in that last round before the IPO. Yeah. Super interesting. Other real quick piece of followup is news came out today that acquired Swarovski
super villain, Carl Aiken. We really, I really want to have Carl on the show. If anybody, if you work with Carl, uh, or you know, Carl, if you're listening, like please hit us up, acquired FM. I think, I think I would know if Carl became an LP. We're monitoring David and I send out a personal welcome. I, unless Carl had a very secretive, he may use an alias. Yeah, he could use an alias. That's very true. Um,
Anyway, we would love to have you on the show. But turns out that he sold his position in Lyft before the IPO to George Soros, of all people. So he still probably made a lot of money. Probably.
We don't know the price at which he sold. Listeners, that was our best attempt to try and do term sheets in an hour. And hopefully you either feel more armed to go and understand this world before having to go through it. Or maybe you had some things clarified that you always sort of wondered about. Or maybe you were like, why on earth did I make it this far in an episode of these two guys who aren't lawyers reading a legal document? But either way, David, I had fun. So.
Yeah, me too. As always. Yep. All right. Well, LPs, if you're enjoying it, feel free to shout it from the hilltops and invite others to become an LP too. The, the continued growth has been super fun for us. And please know you are really enabling us to, to grow the show and to make acquired bigger and better than ever. And, and,
bring on awesome guests and get to be with them in person. I think a lot of you saw the, the, the tweet that we put out, but the, the lift episode was by far our biggest ever. And I think we're in a really great place. And, uh, uh, David and I just booked some flights for a really sweet guest later on in season four. So thank you for helping us to keep growing the show and, and, uh, we love doing it. Yeah. Can't wait for the next one. Yep. All right. See you later, David. Later.
