I’m often asked by entrepreneurs if I can recommend a good resource for understanding term sheets. One of the best resources I can think of and one I often consult myself, is a book by Alex Wilmerding called Term Sheets & Valuations – An Inside Look at the Intricacies of Term Sheets & Valuations. It’s an easy read, 100 pages, and organized by term sheet line item.
Wilmerding explains the differences between company favorable, investor favorable and middle of the road terms, providing actual language typically used in a venture capital term sheet. I find this to be a very helpful guide for startups that I meet with and provides a context for negotiations.
Although no term sheet ends up being “plain vanilla” or “middle of the road”, understanding such things as liquidation preferences, voting rights, anti-dilution and how a Board gets composed should be carefully understood and negotiated.
Most prominent law firms will have a standard set of transaction documents tied to what they consider a middle of the road term sheet and often you can start with that when doing your first investment round, keeping your costs down by doing so.
In the past few months, I’ve also noticed expectations around terms have changed significantly within both the investment and entrepreneur communities as we all navigate the challenges of the current economy.
I recently attended a briefing by Tom Cervantez, an attorney at Davis Wright Tremaine in San Francisco, who described some of the changes he was seeing in term sheets. Tom is also very involved in the entrepreneurial world, heading up the Golden Gate and Harvard Angel networks.
Tom had these observations to share:
- Several angel groups in Silicon Valley are no longer allowing any entrepreneurs to present if they are proposing a convertible note structure (convertible notes are less favorable as they are essentially a bridge to a venture round, offered at a discount or with additional warrant coverage, whereby the investor advances their capital and takes risks and most often does not earn a return commensurate with the risk taken…when things work out, the new round is priced much higher and they don’t benefit from the value they helped create)
- Founders are having to re-vest their shares over 4 years with 15-20% granted up front; all other key employees get 4 year vesting with a 1 year cliff
- Double trigger accelerated vesting is rare now (double trigger means your shares vest 100% upon an acquisition of the company AND a loss or reduction in position)
- $2M pre-money valuations fairly typical for a first round startup with no revenues. This of course varies greatly with where you are with traction, experience of the team, market potential etc.
- If a convertible note structure is used, 10-50% warrant coverage is typical, even 100% occasionally, whereas it was more like 20-30% before. In addition, time limits are being set for the notes whereby if a venture round is not raised within say 6 months, a term sheet is attached and valuation pre-set for automatic conversion of the notes
- Liquidation preferences are more like 2x “participating”, versus 1x “non participating” before. Participating means that after 1x or 2x is returned, the investors continue to share in the divided up profits with common holders, as opposed to non participating where they only get their 1x or 2x back.
- Antidilution is trending more to full ratchet, as it did in the years after the dot-com bust. Full ratchet means if there is a round priced at a lower share price than the last round, all preferred shares are adjusted as if the last round were priced the same, having a significant dilutive impact on the founders/team. Middle of the road anti-dilution is “broad based weighted average” which is a less dilutive formula.
- Board seats allocated as 1 for common, 1 for preferred and 1 objective outsider mutually decided in advance.
Another good resource to get a barometer for terms is Fenwick & West, who publish a quarterly survey of trends in venture financings in Silicon Valley.
