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How Term Sheets Build Community

Wednesday, June 13, 2018 7:17
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One of the things that is tricky with entrepreneurship is the term sheet.  A ton has been written about term sheets and all the terms that go into them.  What I want to explore is why it is beneficial for a seed stage VC to make sure they offer term sheets that are good for everyone.  When they do it that way, successful companies will go on to seed the ecosystem.

I don’t know if you have read the book Venture Deals, but you should if you are an entrepreneur or an early stage VC.  They cover term sheets extensively in the book.  We encourage every entrepreneur that we speak with the read it if they haven’t read it.

Seed deals should not cost a lot of money when it comes to legal.  I am disappointed that more rounds are not priced at seed.  Two of the largest reasons are legal costs or that the entrepreneur doesn’t have a lead.  If an entrepreneur reads the book, they could actually “price” the round themselves and just tell potential investors that this is the price.  Not a lot different than telling me what the cap on a note is.

Priced rounds are better for founders, and better for investors.

In our discussions with entrepreneurs over terms, valuation and how much money they need to raise, we are very transparent.  We are deliberate at why we are doing what we are doing and what it means for them. We tell them why we want a 1x liquidation preference.  We work really hard with them to get the amount of capital they are raising right.   We talk about and through valuation and other issues because we believe strongly in priced rounds.

Raising capital is sort of like Goldilocks and the Three Bears.  If you don’t raise enough, it’s too cold.  Raise too much, too hot.  You need to raise where it’s just right.

Too cold doesn’t give you enough fuel to get to the next round.  Too hot means you raised at too high a valuation, and your business won’t support that valuation going into the next round so you and your investors will be faced with a down round.

To be frank, just right is just right for the VC, the entrepreneur, the employees and the future employees.  You have to speak for the company when you are doing that initial term sheet.  If things go well, we are charting a course not just for one VC and a couple of founders.  We are really charting a course for an entire company, the future employees of that company and the ecosystem it exists in.  That’s why term sheets build community.

You need to think hard about option pools and what they mean.  It allows you to distribute equity to key employees.  Rule of thumb option pools are not a good idea.  Tailor your option pool to what you think you will need to get to the next round.  VCs will always want a large option pool.  10% is rule of thumb at seed, but if you can get by with just a little less you can do it.  The key is that equity gets distributed across the organization.  That’s good for the company and good for the community.

Corporate finance is a strategy that is not any different from marketing or dev ops.

I like to tell founders that when we do a deal, I want to buy a Porsche that fits my 6’5″ frame and I want them to buy an island.   At exit, founders are going to own 5%-20% of their company depending on how much they exit for and how the financing rounds go.  If they raise too much capital early, there won’t be enough capital in the business for them to have an incentive to build a blow out company.

Conversely, if I am a VC and I offer up a $1MM raise at a $2MM valuation I am doing a disservice to the entire community.  If that company is successful, it will sell at $10MM-$20MM and I might do well but none of the employees will make much money so they won’t have an incentive to go out and do it again or seed the ecosystem.

Lawyers that larder on all kinds of fees in a seed or Series A transaction are doing a disservice as well.  In Chicago the lawyers that understand venture really well have not done this but it wasn’t always like that.  If the service community wants to see an ecosystem bloom where they have the potential to build a bigger practice, they cannot tax it with all kinds of fees early in its life.

If a VC offers terms like a 2X liquidation preference or other very adverse terms in their term sheet, they are doing a disservice to entrepreneurs and the ecosystem.  If you are an entrepreneur, turn them down. Fortunately, in more mature ecosystems we don’t see that happening as much but in emerging ecosystems where knowledge is less and capital is scarce it is a more regular occurrence.

If you want to build an ecosystem, it’s really up for VC’s to get on board.  While entrepreneurs actually build the ecosystem, VC’s can do a great service by making sure that the money gets spread across it and not just into a few hands.  They can do that by creating simple but solid term sheets.


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