Nuts and bolts #1 – 8 things about Term Sheets

Yes – fundraising and Term Sheets.

Something many founders have to deal with.

We often get asked about this.Handshake

And we find ourselves saying to founders more often than not to think big picture, to think long-term partners, and to not overly focus on one single thing like valuation.  We also find ourselves reminding founders to think of building a company as a multi-stage process or journey.

First, the other key terms in the Term Sheet are just as important as the valuation.  More on this later in this blog.

But a second reason to not overly focus on valuation is that there are clear risks to raising at a high valuation – it makes it difficult to raise the next round and puts a lot of pressure on you the entrepreneur.  A high valuation can be a “noose around your neck” because both you and your VC want to raise at an “up-round” next time and neither of you can be sure the milestones for that is hit or that the fundraising market stays good then.  A “down-round” is demoralizing and often creates conflicts.

In other words, we remind entrepreneurs that building and growing a company is a multi-year journey and it is valuable to think about each step in relation to how much it improves your chances of getting to the next step(s) and whether it creates unnecessary constraints for your next step(s).

In addition, the most important reason why you the entrepreneur is doing this is to grow and build a great company (and in many cases create a new industry or transform old ones).  Fundraising is only a step in the journey in getting you there; raising at the highest valuation possible creates the highest possible pressure on you (to deliver the highest performance, when markets are often uncertain) and leaves you with no buffer.

And so, when evaluating Term Sheets, we advise founders to understand these not just in terms of valuation but in terms of a number of dimensions.  Some of the questions you should be asking:

  1. Big-picture: alignment: Does the investor have an aligned vision with you?  Do they understand and support the broad direction of the company?
  2. Remember the purpose – get yourself properly funded: Do you have enough capital to last you until the next milestone in your business plan even if you have a 6 month slippage?  (Try not to raise only half of what you need – you are likely to have to be out there doing the same thing again in 6 months).  Further, we advise to always think about the next round.  See “some rule of thumbs” in the 2 resources in our “P.S.” below.
  3. Make a balanced and informed decision: Does the investor get his or her money back, and are the proceeds split reasonable?  Make sure you understand key terms such as liquidation preference and redemption rights.
  4. Decision-making going forward: What is the shareholder voting structure and the Board structure?
  5. What if something goes wrong: If the investors are unhappy, can they redeem their shares and at what price?  What is the provision for that?
  6. Find some market benchmarks: Do you need future rounds of money?  If so, make sure the current Term Sheet do not have unusual terms that make it difficult for you to raise the future rounds.
  7. Find a reasonable process: Has the investor completed his or her due diligence?  As there is usually a “no shop” clause, you need to understand how long you will be “locked up” for.
  8. A final, big picture point: of course it’s important that the founders retain a significant stake and do not have unnecessary dilution, all other things being equal.  But it is almost always better to have a smaller part of a large pie than a large part of a pie that is marked at zero.  So, always think of increasing the odds of success.

Of course, there is no right answer, only trade offs.  And so, it’s important to have a “balanced” outcome.  Smart VCs also know that over the long run extremely lopsided terms will eventually be a problem.

P.S. We wanted to share 2 great resources from 2 entrepreneur-turned-VCs: the first is from Reid Hoffman, LinkedIn’s founder, who refers to fundraising as “island hopping” as if the exercise is about finding bridges that connect the various financing rounds.  “An entrepreneur has to figure out what they need to do so they can raise the next round.  If you don’t that successfully, that’s how you die.”  The second is an experience-sharing at Stanford by the VC Marc Andreesen in conversation with the angel investor Ron Conway offering highly useful pointers on How to raise money.


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