Emerging Enterprise Center Blog - Commentary and Analysis For Entrepreneurs and Startups

This was going to be one post, but it reached 5000 words, so I broke it into two.

If Vinod Khosla is standing there ready to write you a check for $10 million, perhaps you should take the money (and not worry about the 1x preference with full participation and 8% dividend) before he changes his mind. These days, clients are having a hard time finding any financing. So, almost always, you take what you can get.

However, let’s engage in the willing suspension of disbelief. A name brand VC has handed you a term sheet with everything slanted her way. You are feeling feisty, and you are ready to negotiate. What should you care about and what should you let go?

I am not going to discuss valuation, except to say that it is a black art (not a science). One piece of evidence to support this observation is that way too many deals are done on what looks like a formulaic basis. The five on five valuation happens way too often to be random. Obviously, negotiate the best deal you can get, but I am going to leave valuation to another post. 

I am also not going to discuss full ratchet antidilution. (It has its place is some (very few) deals, but it is not a typical Series A term.) If Vinod presents you with a term sheet that has a full ratchet provision, tell him you will save him from investing in a founder stupid enough to sign up to that.

Finally for this post, I am going to take the words of the various provisions I comment on from the NVCA form term sheet. I strongly recommend that you familiarize yourself with that form (and the related deal docs). They are a gold mine of useful information about all the legal stuff in the investment docs.

Here is my list of six terms you should negotiate over:

(1)          Dividends. Hate them dividends. According to us (see, EEC Perspectives), 70% of series A venture deals in New England in Q4 of ’09 had a dividend provision. Dividends ran from 3% to 8% per annum. Let’s assume, for purposes of this post, that the term sheet has this in the dividend provision:

The Series A Preferred will accrue dividends at the rate of 8% per annum, payable only when and if declared by the Board or upon a liquidation or redemption. For any other dividends or distributions, participation with Common Stock on an as-converted basis.

A couple of things to note here (assume per below that the term sheet also provides for a 1x participating preferred): This provision (taken with the provision for a participation) means that, when you sell your company to Google for a princely sum, your investor will get her investment back plus accrued interest at the rate of 8% per annum before you get one penny. BTW, this is also the amount that you would have to pay upon redemption (should that provision ever come into play).

I have reason to believe, based on research, that the average number of years from inception to exit is about 10 years. I also know, based on anecdotal evidence, that the average number of years from initial investment to exit for portfolio companies of top tier venture funds is about 8 years. (Years to exit depends upon so many factors that it is hard to make sense of.)

According to the rule of 72, at 8% in 9 years the amount of the investment will double. So, if the initial investment is $10 million and you exit in 9 years, your investor will get $20 million before you get one penny. In low to mid valuation exits, this can be painful. It also gives the investment a debt like feel rather than an equity feel. Finally, it creates a set of outcomes in which the investor may want to exit and you may not.

So, knowing that in the last quarter 30% of deals didn’t have dividends, I would push back. Argue that it misaligns the interests of the investors and founders. When your investor says that they always get dividends, don’t believe them.   (Our firm keeps a database of deals that tracks who the investors are and what the terms are. As a result, we can tell you, on an investor by investor basis (for the years since we have been keeping the data), whether, and how often, they get dividends.) Try to get no dividends or low dividends. It could be real money to you, and you want everyone’s interests aligned.

(2)            Participating Preferred. Sometimes referred to (when there are no VCs around) as “pig preferred”. So here is the hypothetical participation provision in your yummy term sheet:

First pay one times the Original Purchase Price plus accrued dividends on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.

It should be clear from point number 1 what this means, but just in case, when you sell the business (not in an IPO situation) even in a good scenario, the investor gets its bait back plus the 8% interest (which after 9 years means twice its bait) before you get anything. Then, you and the investor share pro rata on an as converted to common stock basis.

            We know, and we have published for all the world to see, that in the last quarter of 2009, 32 % of Series A deals in New England had a 1x participating preferred without a cap on the participation, 9% had a capped participation and 54% had no participation. (The remaining 5% had greater than a 1x preference and are outliers.)

            When coupled with a dividend provision, it makes the venture investment work like a note with a warrant – giving the investment a debt-like feel. (BTW, VCs also get board representation – sometimes a majority on the board. I have sometimes wondered why they have not been sued on a lender liability theory, but that is a topic for another post.)

            So, the problem with participating preferred is that in low and mid-value exits, the common holders take it on the chin. You do the math. If you raise $30 million and six years in you sell the business for $60 million, what is left for the common. Remember, the founders will not be the only holders of common. You could end up with a meager payday. Maybe that is just and fair, but it certainly misaligns the founders and the investors. Keep in mind that investors have a ten year life on their funds. If they make an investment in year four and then wait six years, they are under pressure to liquidate. You may think you are on the cusp of greatness, and a single may be looking pretty good to your VC. (Also, remember what the numbers say about years to exit.)

            Fight this one. Ask for no participation and, perhaps, settle for a capped participation. Just to be clear, in the capped participation scenario, the investor gets the greater of (a) 1x plus dividends plus participation up to an agreed number perhaps 2x the investment or (b) what they get upon a simple conversion to common (i.e. without any participation or preference).

(3)            Founder Representations. A great war has raged over this point between east coast and west coast. For many years, east coast VCs demanded and got founder reps on Series A deals. On the west coast, the view seems to have been that the practice was something close to diabolical. Fortunately for entrepreneurs, the west coast VCs are very close to beating their east coast brethren into submission on the point.

            Here is what your term sheet provision might say:

Standard representations and warranties by the Company. Representations and warranties by Founders regarding technology ownership, conflicting agreements, litigation etc.

            Try the Nancy Regan defense. Just say no. If that does not work, then focus on setting limits to your liability. Even the most rabid east coasters will accept a limit on liability to your shares in the company. This issue should not come up on B or later rounds.

(4)            Option Plan Vesting; Founder Vesting; Option Pool Provisions. I have noticed an increasing number of VCs that are looking for five year vesting on options (as opposed to four year vesting that has long been the norm). Your term sheet could say something like:

All employee options to vest as follows: 20% after one year, with remaining vesting monthly over next 48 months.

            The investors that like the five year vesting argue that you don’t get close enough to an exit in four years and they are going to have to reload and give away more options and dilute everyone etc. All good points, by the way, and, it might also be a tacit admission of the 8 years to exit issue that I pointed out earlier.

            Your problem with this approach is that it will be an impediment to hiring the best people (all of whom are expecting a four year vesting schedule). In today’s market it may not matter so much since there is a lot of talent available out there, but as things get better it may. I would resist on this ground and see if the investor does not give it up.

            Then there is founder vesting. You might think of this as adding insult to injury, but VCs investing in true early stage series A deals frequently want the founders to agree to some vesting schedule. It is not like option plan vesting just discussed where there is broad agreement on four years and a few looking for five. Here, as the saying goes, you get what you negotiate. Having said that, experience indicates that most VCs will agree readily to something between 25% and 50% fully vested and the rest over three years. BTW, this only applies to true founder shares. To the extent that you pay real dollars for stock, that you keep. The arguments to use in connection with this point have to do with how much time and sweat you have into the business. The more you have in the business; the better your argument for more immediate vesting.

I have been dreading getting to the option pool discussion because I get an inordinate number of questions about how big the pool should be and should it dilute everyone or just the founders. Unfortunately, the answers are not great for the founders (not necessarily bad in a business sense, but you are going to eat the dilution). Your term sheet will have a provision along these lines (BTW, the pool will also appear in the cap table):

Immediately prior to the Series A Preferred Stock investment, [______] shares will be added to the option pool creating an unallocated option pool of [_______] shares.

            Unfortunately, because the data is only sometimes publicly available, the sample size for our data on option pool size in New England deals is small. Having said that, option pools for Series A deals cluster around 15% to 20% of the fully diluted capitalization of the company.

            Your investor is going to make her investment with the assumption that every option in the pool will be granted. So, if she wants 50% of the company, she means 50% after you have granted all the options in the pool. If the pool is 20%, that leaves 30% for the founders. You are not going to out fox her and get her to agree to a post money pool. (That is she won’t go for 50/50 pre-pool and 40/40/20 post pool. What she might do is 40 for you /60 for her pre-pool (or whatever the numbers are) so that she gets to the 50% place after the pool.)

            Keep in mind that all players will agree that they need a pool to attract quality employees. With that in mind if you can make a decent argument for a pool that is on the smaller side, the shares you save may end up in your pocket. 

            When thinking about the size of the pool, think about whom you need to hire. If you happen to have the key players in place (and they have founder’s stock) you may only need a pool sufficient for the rank and file. This might be a good argument for a smaller pool. BTW, experience indicates that option pools are rarely large enough. They have to be reset to some extent with almost every round of financing. VCs know this better than you do. Nevertheless, under the right conditions, you might save a percent or two on the pool size.

(5)            Board of Directors. Board composition is often highly negotiated. (I am not sure why because it frequently comes out with two for the investors, two for the founders/common holders and a tie breaker who is, at least notionally, independent.) In any case, you want to make sure you have an arrangement that works for you. Here is the NVCA approach:

At the initial Closing, theBoard shall consist of [______] members comprised of (i) [Name] as [the representative designated by [____], as the lead Investor, (ii) [Name] as the representative designated by the remaining Investors, (iii) [Name] as the representative designated by the Founders, (iv) the person then serving as the Chief Executive Officer of the Company, and (v) [___] person(s) who are not employed by the Company and who are mutually acceptable [to the Founders and Investors][to the other directors]

This provision contemplates a very full board; experience indicates that a lot of start-ups don’t have five board members when they close the A round. Look at it this way: Every substantial fund investor gets a seat on the board. Many (most) VCs like to travel in pairs. That means two seats for the VCs. Sometimes you get some smaller investors in the A round. They typically don’t get board seats. However, they sometimes ask for (and sometimes get) observer rights. If they do, you need a specific agreement with the observers so you can easily exclude them from anything that might implicate attorney client privilege. Sometimes the observers are strategic investors and you may want to exclude them from competitively sensitive information as well. It should go without saying, but you want to be sure that you are on the board. An important ask to add in for the founder is to provide that he is still on the board, even if he is no longer CEO.

(6)            Drag Along. My last candidate for a provision that merits some discussion is the drag. (I admit I could have put some other provisions here instead of the drag, like preferred stockholder veto rights, but I wanted to stick with the artificial constraint of my six point list, so I put them later.) You will never get it out (well, never say never, how about almost never). The drag ensures that you must sell when the VCs want to sell (without regard to the structure of the deal). Imagine that your term sheet has words like this in it:

Holders of Preferred Stock and the Founders and all future holders of greater than 1% of Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options) shall be required to enter into an agreement with the Investors that provides that such stockholders will vote their shares in favor of a Deemed Liquidation Event or transaction in which 50% or more of the voting power of the Company is transferred and which is approved by the Board of Directors and the holders of ____% of the outstanding shares of Preferred Stock, on an as-converted basis.

            In the off chance that you are getting a minority investment, you should resist this on the grounds that the tail should not wag the dog. However, in our imaginary deal, your investor is getting 50% of the fully diluted and you have 30% of the fully diluted. We sometimes see founders negotiate for, and sometimes get, vetoes on the drag.   We sometimes also see provisions where a majority of the preferred together with a majority of the founders are needed to approve the deal to drag everyone else. The investor’s argument is that she does not want you to be able to block a good exit. 

            Having said all that, I predict that you will lose the larger argument (i.e. there is likely going to be a drag), but you can, and should, place conditions on your participation in the drag. The footnote to the NVCA form term sheet puts it this way:

This provision is typically subject to a number of negotiated conditions, including: the representations and warranties required are limited to authority and title to shares, liability for breaches of representations by the Company is limited to a pro rata share of any escrow amount withheld, any liability is several and capped at the stockholder’s purchase price and that the stockholder receive the same form and amount per share of consideration as other holders of the same class or series of stock.

You should get these qualifications on the grounds of simple fairness. For example, the notion that you would be contractually obligated to accept liability beyond the purchase price in a deal you have to be dragged to seems patently unfair. I think most (all?) investors would agree.

My next post will go into six things not to negotiate (much).

There has been a ton of discussion on the blogosphere about Senator Dodd’s ill-conceived plan to make financing harder for start-ups. Check out Fred Wilson’s blog. It will lead you to lots more stuff (in addition to the more than 165 comments – when I last looked). I don’t think there is much I can add to the general dismay over the proposed legislation.

But I did post a comment about the genesis of the term “accredited investor.” One of Dodd’s proposals is to raise the bar on who qualifies as an accredited investor. In short, for a person to be an accredited investor, he or she has to have a net worth in excess of $1 million or an annual income for the last two years of more than $200K (or $300K with spouse) and an expectation of the same in the current year. For more detail on the definition here is a link.

Accredited investors are people the SEC deems able to fend for themselves (generally). So, the standards of disclosure that sellers of securities have to meet are (generally) less stringent if they only offer and sell securities to accredited investors. (I apologize if I am dumbing this down too much. I don’t want to get too deep into lawyerspeak,) As a result, it is a far far easier process to raise money from accredited investors than from non-accredited investors.

The point of my comment is that the accredited investor definition was created by the SEC in the early 1980s and has not been amended since. The SEC thought that this level of wealth was appropriate to deem a person able to fend for him or herself thirty years ago. If you think about inflation, $1mm was a lot more in 1980 than it is today. So, why is it appropriate to have a “lower” threshold today than thirty years ago?

One argument might be that the SEC set the bar too high thirty years ago, but I don’t recall anyone really commenting on this in the time I have been practicing. On the other hand, no one (until Dodd) to my knowledge has been complaining that the level is too low.

The argument that convinces me that the existing definition is OK and should not be changed is that there is a vast difference between 1980 and today. In particular, there is a vast difference between then and today in the whole securities and investment world. The biggest difference, of course, is in the amount and accessibility of information. Anyone can find out tons of information about almost anything: people, technologies markets, securities etc. at any time of the day or night on a moment’s notice.

In addition, people are very familiar with how to obtain this information. In the 1980s there was a lot of public information available (nothing like today, but a lot) however it was actually hard to find. The SEC kept paper records. It was actually difficult and expensive to get the information. The rich could hire lawyers and accountants who knew how to obtain and understand the available data. The ordinary person could not.

To the extent that your ability to fend for yourself depends upon your ability to access information and gather opinions and insights from others, there is just way more reach than there was 30 years ago. So, despite inflation, I think the definition still works.

I was talking to an entrepreneur client yesterday (this client is a rock-star and a visionary in his space), and I just talked to another client who is working hard to do his first start-up (in a different space from yesterday’s client).

The rock-star has name brand VC (that he does not actually know) making cold calls to him trying to get into his next venture. For the other guy, it’s an uphill battle. No surprises here. 

Here is the issue. In each case, I have met with the client and discussed what is “market” for terms in series A investments. Now, I actually know what market is in Boston/New England because our firm does the research on New England deals every quarter. We actually have a database with the terms, the valuations, the investors etc. And, to make the point again, we update every quarter. To my knowledge, no one else does that for New England. (Note that I stress New England because Fenwick does something similar on the West Coast.)  BTW, we also publish some of the data in EEC Perspectives.

I can assure you that I have been in plenty of conversations in which a VC, lawyer, banker or other person has baldly asserted that XXX is a current market term, and I know that that only a small minority of deals had XXX last quarter (last year, whenever). I had a VC assert in a negotiation that his fund only did deals with dividends. But I knew, based on our research that this particular fund did about half their deals with dividends and half without. We can tell you the actual range and distribution of dividend rates on deals that had dividends in the last quarter… and so on.

But who cares?

The rock-star can (and will) get any deal he wants. He just wants to know what are the best terms (i.e. no participation etc.). He doesn’t care, nor should he, whether they are prevalent market terms or not. He is going to ask for and get the best terms.

The other client is not going to have a lot of (any?) choices. He is going to take what he can get.

In either case the facts (i.e. what is going on in the market) don’t matter. 

Now, you could point out that there must be people in the middle, for whom such knowledge could be useful for negotiation. Unfortunately, one of the characteristics of the market we are in is that it is really tough to raise money if you are not a rock-star.

Healy Jones has some good thoughts on the current push for form documents for seed transactions on his recent post. There has been a raging, and sometimes cantankerous, discussion on series seed form documents in the blogosphere.  In addition to the Healy Jones post, check out Brad Feld and Jason Mendelson.  Here is my point of view. 

Healy asserts that standard forms are not likely to drive the time to close. I agree; the interactions between the investor and the company drive that time to a much greater extent than legal documentation. 

Healy also thinks that forms do not reduce legal costs. Here’s what I think: With respect to legal costs, they have gone up over the last seven or eight years (since the NVCA forms project began) but not as dramatically as, say, legal costs for M&A transactions. I also think if you get two attorneys who are experienced (and willing to work with the NVCA forms) the amount of discussion is way less than you might think. 

With respect to making seed rounds easier, I think Healy is  right that what drives the ease of closing are the investor and the company not the interactions of the lawyers. 

The bigger issue with standardized seed docs is that seed/angel investors are way too disagregated. They themselves don't have consensus around what their concerns are. Before the NVCA forms everyone agreed that investors should get reg rights, drags, co-sale rights, etc. It is just that there were lots and lots of ways to draft each of these rights with the result that lawyers got bogged down in arguments around whose words were better and what was the exact intended scope of each provision (nobody, of course, disagreeing with the core concepts). 

Seed/Angel investors don't have an analogous set of well defined concerns. Some like common stock, some like convertible notes, some like preferred stock, some like secured notes, etc.

To the extent that seed means seed money from VCs, then you might get some level of consensus and be able to build forms. As I have noted before in a prior post, Ted Wang from Fenwick has posted a set of "Series Seed" docs that, I understand (but I am not sure), are basically a trimmed back set of the NVCA docs. These might gain some traction in the venture community, but an investor who is not from this ecosystem and who has an attorney who is not from this ecosystem is not likely to buy into them. Most of the seed/angel investment that gets done is outside the venture ecosystem. That is why the seed forms are not likely to get broad acceptance.

For a cash-starved start-up, applying for and filing a federal trademark application can seem unnecessary.  Many start-ups are happy enough (and sometimes rightfully so), running a Google search to see if anybody out there conducting similar business under their brand.  There comes a time however when this is simply not enough...........................................................

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I attended the MIT $100K Competition kick-off dinner on Tuesday. I never fail to learn something at these events. 

The domains that people are exploring for new businesses are constantly evolving. In particular, what can be done with social media as a platform or a source of data is striking. There are plenty of companies around that are using social media (be it Facebook, Twitter or something else) as a platform for their business. Farmville is, of course, a huge example of this phenom. But, it’s clear that there is a lot of raw data out there in tweetstreams and other places that can be used for many business purposes. Advertising is an obvious one, but by no means the only one. My sense is that folks are just starting to scratch the surface of what can be done with these platforms and the data they generate. 

Here is a prediction, if this year is the year of mobile, next year will see and explosion in the social media derivatives (for lack of a better term). 

Scott Kirsner’s column in Sunday’s Globe caught my attention for a couple of reasons.

First, the levels of investment in cleantech companies in California as compared to Massachusetts is way more skewed than I would have said. But here are his numbers (attributed to The Cleantech Group LLC), and I don’t have any basis to dispute them.

Massachusetts numbers seem scary low to me. If I did the math right, last year there was approximately 6 times as much cleantech investment in California as in Massachusetts, and, as Scott Kirsner points out, of the Massachusetts amount $100 million went to one company – A123. Texas is closer to Massachusetts than Massachusetts is to California. 

Part of the point of Kirsner’s article is that there are some systemic issues that adversely affect investment in cleantech. The principle one being that many of these companies are capital intensive. He compares them, with some justification, to biotech companies that are also capital intensive. But, as Scott points out, the biotech industry has an established practice of getting investment from large established companies in the form of joint ventures, which the cleantech industry does not have.

But, actually, it is worse than that. Big pharma understands that, at some level, it is dependent upon technology and innovation for its product and continued profits. The traditional energy industry (and oil and gas in particular) actively resist new technology. There are still plenty of people who think the future is in “drill baby drill” not in solar, wind, tidal etc. There are actually people in responsible positions that don’t’ think there is an energy problem that can’t be solved with more wells. Big pharma is basically a tech business; big energy is not. Don’t hold your breath hoping that the biotech model will bail out cleantech.

I think that Scott is predicting a not so great year for cleantech investment in 2010. I, and others, have made the next point before, but very large capital needs and long horizons to exit (to say nothing of an uncertain exit market) are not a formula that is attractive to venture capital investment.

There is going to have to be a new approach to cleantech investment for a variety of reasons including the ones just noted. Whether this means developing an industry co-investment model similar to biotech (seems unlikely any time soon for the reasons noted above) or whether it means more government partnership (seems unlikely given the debt burden our government has just taken on) is not clear to me. 

Here is a prediction. China, where there is a lot of capital and where they are more interested in funding jobs (even at economic losses) than in garnering profits soon, will have both the money and the patience to invest in the longer term enterprises that will be needed.

Maybe there is another model out there. An IPO market would help since the public might be source of the needed capital and patience. But, without something new, you should expect to be importing your energy solutions from China.

Sim Simeonov has a great post on founder agreements, which I have noted before. One of the classic issues (terminating an agreement with a "co-founder") came up for one of my clients last week. I was surprised that it was the first time for this particular client because it seems to me to be almost an obligation on the part of start up clients that they make clear promises to pay (money and equity) to people they heartily believe will perform some much needed function, write some much needed code, obtain much needed financing – whatever, and those people don’t perform but nonetheless seem to think they should be paid in full.

Outrage is the first reaction-- "I am not going to pay that SOB…" I sympathize, but legal action is not a solution. (It is like taking an overdose of chemotherapy.) You are a start up. The distraction and the cost are rarely worth it. Ignoring it is not the solution either. (Best case, you are going to have to explain the potential dispute to some investor. Worst case, it could cloud your IP rights (do you really own your software?). I promise it wont go away.)

In the end we negotiate these things away (almost always). While I don’t think this problem (the nonperforming co-founder or consultant or early hire) ever totally goes away, I think you can help yourself by being very clear about performance expectations up front. (You get paid against delivery; you vest upon delivery etc.) You can also help yourself by careful hiring. In the end, though, I am hard pressed to think of a start up client that has not hit that speed bump.

From time to time, I make reference to vast numbers of blog posts and the like that refer to the broken venture model (or its equivalent).  Here is a recent post from Dharmesh Shah on this topic.  I don't agree with all his conclusions, but it is one take on the general malaise in the venture industry and it is a good read.