Negotiating your Seed round++

How to be smarter than your VC/Lawyer

I spent 2 hours today thrashing out a term sheet with 4 other panelists at StartupBootcamp Singapore’s Term Sheet Battle with Michelle Katics from PortfolioQuest, Rosalind Tan from Adatos, Jasmine Liew from 500 Startups, and Chris Wilson from Simmonds Stewart. It was a great session, probably one of my favorite panels ever. To be precise it was not really a panel, but a “Battle” where two investors role-played with two founders and a lawyer to negotiate an example term sheet. We spent a fair bit of time negotiating the less-talked about terms rather than the valuation and the ownership. This is good, because I think most founders understand how valuations and dilution works, but don’t really understand how some of the intricate terms in the term sheet work. I’ll cover a few of these sticky points that came up during the conversation and share my thoughts on each of them.

These are some of the basic terms presented in the example term sheet:

$1M round size
$3M pre-money valuation
$4M post-money valuation
15% fully diluted Option Poll
4 year founder vesting with 1 year cliff of 20%
2x Participating Liquidation Preference(!)
Full Ratchet Anti-dilution(!)
4 Board Members (2 Investors, 2 founders)

The cap table pre and post-investment looked like this —

The founders started the conversation outlining their issues with the term sheet and we ended up discussing almost all of them:

2x Participating Liquidation Preference

Yes the term sheet had this! So somehow Jasmine and I had to wiggle our way around this and convince the founders that there was a justifiable reason for putting in a 2x Participating Preference. We secretly wanted to push for 1x Non-participating but the founders ended up settling for 1.5x Partcipating, which is quite bad for them. From the Investors’ point of view, the reason for putting this in was that in case of a low return scenario they should be protected. Case in point, the deal was being done at $4M valuation. If there was an exit to happen at $10M valuation then the founders could have walked away with $6M and the VCs would get only $2.5M or 2.5x their initial investment. As you might know venture capital business is about getting returns more in line of 10x or above, and hence this term protects the investor somewhat in a low return scenario.

Argued this way, it becomes difficult for the founders to push back on this term. So how should a founder get out of this mess? Chris Wilson, the lawyer on the table rightly explained that the best way to convince an investor is to explain to them that putting in participating preference is not good for them in the long run. If the next round investors also end up getting the same terms then the Seed investors will lose in the long run. Many investors don’t really understand how this works and founders even more so, so I have tried to explain it here.

Let’s assume that the company ends up raising 2 more rounds of $5M and $20M after the current round and then exits at a $100M valuation. Let’s assume all the investors have same preference terms in each case. This is quite common in the venture community. If the Seed round investor got a 2x Participating, the Series A round investor wants it also and so on. The left part of the table indicates how the ownership changes with each round. The right half of the table explains what each of the investor will get in a Non Participating, 1x Participating, and a 2x Participating preference scenario. As you can see the Seed Investor earn-out is the lowest in the 2x Participating case whereas a Series A investor is quite agnostic on what preference to take. So essentially it’s just the Series B round investor who “wins” in this case if you put in a participating term in your Seed round. Also good to note that the founders’ ownership can be 42% post dilution, but once the preferences kick in, the value of that ownership is actually quite less.

Board Seats and Control

The next big discussion was around Board Seats and Control. The founders brought an interesting point out that they would not like to see a lot of “Control” over them by putting in a big board of 4 people and would prefer a simple 2 founder board as had existed. Obviously a founder-only board was a no-go from an investor’s perspective so both Jasmine and I pushed on getting a 3 member board (2 founders, 1 investor). In real life, usually my thumb rule is to roughly keep the board composition similar to your equity ownership. So in this case, the ideal board structure in my opinion would be 2 founders, 1 investor, and 1 independent director.

I just want to add a note here, that despite what founders might think, boards are good for companies. Obviously the board is super helpful in navigating through tough times. But even in good times, it helps to keep everyone accountable and responsible on the table. And this applies not just to the founders, but also to the investors. We have had an investment where no board was formed (thanks to the ever loved convertible notes), and no investor was accountable for the company. Thus no one really spent time guiding the company on next milestones and targets to achieve. This hampered the company from reaching its full potential in my opinion. Simply put, don’t be a control freak. Investors are there to help you, let them help, and don’t be worried they’ll snatch away your business from you. It’s not in their best interest to do that.

Founder Vesting

This is an interesting topic. Michelle and Rosalind (the founders) came back saying they would like full vesting upfront. This was not acceptable to the investors, both in the role play and in real-life as well. Institutional investors always like to see founders’ shares vested over time so that they can’t walk out with all their shares the moment they get demotivated. Usually we put in a cliff if the company is very young but 3 to 4 years of vesting is very commonly seen. The easiest way to convince the founders to undergo this is by asking them what would be their strategy if only one of the founders decides to walk out. So if Rosalind, for whatever reason, decides to stop running the company and walk away, will Michelle like to see part of Rosalind’s shares coming back into the company both for being fair and for being able to attract new top management with significant equity ownership?

One more interesting thing that came up from the audience at this point of time was whether there is a difference from an investor’s point of view on how to treat vesting vs reverse vesting. I think simple vesting is always the best option, but reverse vesting is more easily executable given the fact that the equity already exists under the shareholders’ name. I believe there should be some tax implications for each way, and I’d suggest you to look into them.

Full Ratchet Anti Dilution

This was obviously a big no-no and even though we did not get time to negotiate this, both Jasmine and I wanted to go to a Broad-based weighted average anti-dilution clause.

Other points

Veto rights

This came up from one of the audience member where he said that it’s a bad idea to give any investor a veto right and it just puts complete control in the investors’ hands. I think this is false. There is always a Reserved Matters/Veto section in any investor document, because somethings an investor will always like to have a say on such as next round, acquisition, incurring debt, etc.

Legal Fees

The same audience member argued that founders should ask investors to pay for the legal fee. This was almost a joke, because investors usually don’t have the management fee to support $10–20k legal fee per financing. They expect you (the company) to use the investment amount raised to cover the legal fees.

Personal Peeve: Convertible Notes Suck!

This came up from Jasmine’s recommendation of notes being great, fast, and easy, and I understand why, given that she is from 500 Startups and they have their standard KISS notes to follow. But SAFEs, KISSes, and even your self-drafted notes are not always great (founder friendly), easy (to negotiate), and fast (to finance). And they come with a hidden full-ratchet clause which founders don’t realise. I have written at length about this, there is a huge debate in the US as well about this. In the end, notes serve the purposes of angels and microVCs and this is why they are being pushed so actively around. If you want to understand why I am against notes, read my detailed post on the topic.

Tips

So this was most of what we covered over the two hours. But before I leave you, just some tips here on how to go about negotiating your round.

1. Hire a good lawyer
2. Know what each term in the term sheet really means. Nothing is «Standard».
3. Read VentureDeals by Brad Feld and Jason Mendelson. Seriously.
4. Find and work with investors who ALIGN with your vision and LOVE your business
5. Don’t overnegotiate the term sheet. Know what you can and cannot accept.