Term Sheet Hacks: The Cheat Sheet March 22nd, 2007 We show you how to negotiate a great deal with VCs. Why? Your investors know more than you do. How? Term Sheet Hacks—look below. Want more? Read the blog. “A fantastic blog… I heartily suggest entrepreneurs thinking about taking venture money read it.” – James Hong, Hot or Not “Knowledge is Power.” – Sir Francis Bacon Introduction # 1. Get a great deal Read Term Sheet Hacks and learn how to negotiate a great deal with your Series A investors. Work with your lawyers to implement the hacks. We strongly recommend you read the full articles because the devil is really in the details. Negotiation # 1. Create a market for your shares You need strong alternatives to hack a term sheet. Create alternatives with focus: pitch and negotiate with all your prospective investors at the same time. Focus compounds the scarcity and social proof which close deals. It also yields a quick yes or no from investors—either way, you will soon get back to building your business. 2. Get first meetings. 3. Get partners meetings. 4. Get the first term sheet. 5. Sign a term sheet. 6. Close the deal. The Board of Directors # 1. Create a board that reflects the ownership of the company Create a board of directors that reflects the ownership of the company and don’t let your investors control the board through an independent board seat. 2. Make a new board seat for a new CEO Create a new board seat for a new CEO. Don’t give him one of the common seats. Valuation # 1. Beat the option pool shuffle and raise your valuation Don’t let your investors determine the size of the option pool for you. Use a hiring plan to justify a small option pool, increase your share price, and increase your effective valuation. 2. Focus on your share price, not your valuation Focus on your share price and the number of shares you own — metrics like valuation and percent ownership can fool you. 3. Build your own cap table A cap table shows you who owns what in your company. It calculates how the option pool shuffle and seed debt lower your Series A share price. This article includes a spreadsheet you can use to build your very own cap table. Vesting # 1. Get vested for time served Don’t agree to vest all of your shares just because it is supposedly “standard”. Get vested for time served building the business. 2. Accelerate your vesting upon termination You made a commitment to the company by agreeing to a vesting schedule — the company should reciprocate and commit to you by granting acceleration upon termination. 3. Accelerate your vesting upon a sale Negotiate some acceleration if you sell the company ahead of schedule — you don’t want to stay at the acquirer for an unreasonable period of time. Also negotiate 100% acceleration if the acquirer terminates you and deprives you of the ability to vest your stock. 4. Supersize your vesting with microhacks Reclaim a terminated co-founder’s unvested shares. Run screaming from the right to purchase vested stock. Accelerate your vesting upon hiring a new CEO. Keep vesting as a consultant or board member. Convertible Debt # 1. Understand the benefits of convertible debt in a seed round Convertible debt is often the best choice for a seed round. It is convenient, cheap, and quick. It lets you close the financing quickly and turn your focus back to your customers—that’s good for the company and its investors. 2. Compare the economics of debt vs. equity If you raise convertible debt for a seed round, you should negotiate simple and short documents, close quickly and cheaply, and maintain your options for the Series A. But first, determine if you should raise debt or equity—debt is better for small financings with small discounts. 3. Make your debt attractive to investors Seed investors often argue that debt doesn’t incent them to (1) help the business and (2) increase the share price of the eventual Series A. Actually, (1) debt does incent investors to help the business and (2) equity may also incent investors to decrease the Series A share price. That said, you can make your debt much more attractive to investors with a few concessions. 4. Keep your options open if you raise debt Raising convertible debt from venture capitalists can restrict your Series A options and lower your Series A valuation—whether or not your investors have a right of first refusal on the Series A. You can keep your options open by raising debt from angels exclusively or raising debt from more than one VC. 5. Supersize your debt with these microhacks Convert your debt into equity if you can’t pay it on time. Determine your lender’s return if you sell the company early. Reserve the right to raise more debt. Finally, reserve the right to amend the debt agreement. Protective Provisions # 1. Understand why investors want protective provisions Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. They protect the preferred, who are minority shareholders, from unfair actions by the common majority. However, the preferred shouldn’t use protective provisions to serve their other interests. Picking Investors # 1. Unbundle money and value-add Smart money is money plus the promise of help that’s worth paying for, dumb money is money plus hidden harm, and mostly money is mostly money. Weed out the dumb money with diligence. Evaluate supposedly smart money with the smart money test. Finally, assume your investors are mostly money: unbundle money and value-add to get money on the best terms possible and value-add on the best terms possible.