Brian Garrett, co-founder of CrossCut Ventures (http://www.crosscutventures.com) talks about VC term sheets. He reviews the four most important aspects of the term sheet, and how to handle them.
- Percentage of ownership based on contributed capital
- Quantity of available stock for hiring employees
- Structure of the board & voting rights
- Aim for the market standard with participating preferred stock
- An advisory board should provide guidance & access to the industry
The term sheets are incredibly complex legal documents, and basically if you boil it down, in my opinion, there are really only 3 or 4 key terms that matter when you are in that negotiation with your venture syndicate.
The first one is pre-money value. It’s sort of their ratio versus your ratio of ownership. How much do they own for the money they put in? How much do you own being the pre-money value of the company? That’s first and foremost the most important topic, always has been. But, there are other variables like a dial that affect that, and so the second one is the size of the un-allocated option pool.
And what that is, is basically a pile of stock that is used to retain and hire great employees, and without them you don’t have a company. So how big is that pool also affects your venture ownership position in the company so those two things in combination sort of determine the ownership structure of the business, and they’re the most important things that you should negotiate when you are negotiating the term sheet.
After that, most of the other topics are what are called governance- related issues. It’s sort of who has what with rights to vote for what? Who can block certain things? And there are only a couple of those that really matters. So the third topic or term that is important to focus on is board structure and voting rights. How many board seats is the investor group taking and are they taking a majority of the seats which would then give them more control?
We tend to try to structure boards that are even and it’s usually two common people representing the founders of the business. Two preferred which are the investors that have written the check for the company, and one independent who is the neutral third-party jointly chosen by the common and the preferred. And so that board structure gives a balance to the governance of the company, and the voting rights and mechanisms that sit underneath that board structure are important to pay attention to. And what you are trying to focus on is nobody having more control to drive a particular outcome over the other entity. You want it to come to a balanced decision across the groups. And that comes from alignment with your investors, but it also comes for making sure that they are not getting particular rights that give them an advantage in driving a particular outcome.
And then the last piece is participating preferred. It’s a term within standard term sheets that talks about a preferred return for the preferred shared holders that often has participation after that. And it’s one of the most complex terms in venture, but the gist is that investors often have a way of generating extra returns in suboptimal outcomes. If you sell the company for a low dollar value, they can often get their original money out plus still participate in the pro rata ownership of what proceeds remain. And so you want to just be cognizant of not accepting terms that are owner is to you as the entrepreneur, and aim for what I call the market standard. And that market standard moves, but right now it tends to be a one X participating preferred with a cap. And that is sort of a common middle ground that investors and entrepreneurs seem to be accepting within term sheets.
So like I said, in the term sheets there’s only 3 or 4 key terms. Your ownership is determined by pre-money value, size of the unallocated option pool and then the other topics, board structure and participating preferred are more around governance and eventual returns generated based upon outcomes. Everything is else is illegal jargon, it’s mind numbing, it’s necessary, but it’s not going to significantly impact the outcome and ownership you have in the business.