Venture capitalists and angel investors can say they are founder-friendly. But their “standard” term sheets and funding agreements may tell a different story.
Four attorneys with deep expertise in startup fundraising weighed in during a roundtable discussion with me, Eisaiah Engel, co-author of Founder Friendly Standard, a checklist for entrepreneurs to address all the “other” terms in a financing besides valuation and percentage of the company purchased. The attorneys shared their insights on what makes a term sheet founder-friendly, how “standard” term sheets compare to each other, and how to avoid mistakes when negotiating venture financing.
Roundtable Contributors: Eisaiah Engel, Co-Author of Founder Friendly Standard (Moderator), Jennifer Rohleder, Principal, J. Rohleder Law; Zev Safran, CFA and Attorney, Safran Law PLLC; Keith Strahan, Managing Partner, Fulton Strahan Law Group PLLC; Ryan Juliano, Vice President, Head of Platform, and Attorney, Howell Legal Inc.
Eisaiah: When it comes to arriving at a founder-friendly term sheet, what legal rights should an early-stage founder build in?
Jennifer: It depends on the founder’s objective. When you are building a new business, it is either “I am going to build this and get it to a point that Google or somebody else wants to buy it” or “I believe in the mission, I love my company, I want to grow it for the long term.” If it is the latter, then control becomes a much higher priority.
Ryan: Yes, the key is control, which manifests itself in a few ways. Mostly it is in board representation and the percentage of company stock a founder holds. But there are other issues to keep an eye on like enhanced voting rights – where one share of stock (for instance, the investor’s share) has more voting power than another share. Some agreements give founders guaranteed board seats for as long as they are with the company. Others provide protective provisions that benefit the investor, such as the right to veto certain company actions. You will want to limit those to maintain more control.
Lack of control is a common issue we hear from entrepreneurs who do not negotiate founder-friendly terms. How important is the management structure to maintaining control of the startup?
Zev: It is easy to ignore the company’s management structure and governance when you are trying to develop a product, build a team, and raise money, but it can come back to haunt you. It is critical to look beyond the initial fundraising and stay conscious of shareholder voting rights and what the board of directors will look like. A lot of term sheets sidestep these issues.
Keith: You need to protect your rights through some sort of founder agreement between you and a co-founder. And make sure your entity is formed correctly. Your entity needs the right legal protections so that later investors cannot come in and completely take control over your company, which we have seen.
Ryan: No matter what rights you put in place, though… If the time comes that you need the investment and you do not have leverage, the investor will be driving the terms. Any protections and rights you have put in place can go out the window if the investor requires you to restructure.
So, maintaining legal rights and control are key considerations. How do “standard” term sheets differ in that regard? Jennifer, can you talk about the Gust Series Seed documents?
Jennifer: The Gust Series Seed documents do not guarantee founders any control whatsoever, although it looks like they do. With the investor’s preferred shares, they are only given the right to elect one board member of a three-person board, so it looks as though the founders control two-thirds of the board. But when you dig deeper, you find the board member elected by the investors has rights above and beyond a normal board member, including an overriding veto on all the main control elements of the business.
That sounds potentially risky. What types of business decisions could the investor override in the Gust Series Seed term sheet?
Jennifer: It includes whether the business will take on a loan, sell assets, or change out executive officers. The Gust Series Seed term sheet also gives investors the right to prevent your startup from getting acquired if returns would be less than 5X.
Ryan, what about the Y Combinator Safes – how founder friendly are they?
Ryan: Safes are actually silent on voting rights and board composition. Safes don’t give the holder any equity rights; they are structured so they convert into stock at a next equity financing. You usually use Safes if you are going through a standard “ladder” stepwise, and you are probably doing your next round of financing on traditional venture capital terms like the NVCA model legal docs – which do give investors a number of control rights. So, while Safes are silent on important founder control rights, you should think ahead to the next round of financing, where investors will anticipate that you will be giving up those rights.
Zev, you are well-versed in the 500 Startups KISS documents. How do they handle issues like voting rights and other forms of control?
Zev: The KISS documents sidestep voting rights issues to a large extent and defer those for consideration later in the process. But those rights are critical for founders to think about early on in order to maintain the operational control that they need to manage and build their companies.
Keith, how do the NVCA model legal documents compare?
Keith: We do not recommend the NVCA model legal documents. They are highly editable, and they can be negotiated, but if you use them, make sure you have a good attorney on board who understands them. Because there are many default sections in the NVCA documents that are not founder friendly.
There is also the Sam Altman “founder-friendly” term sheet. Jennifer, what is your experience with that in terms of control and legal rights?
Jennifer: Sam Altman is portraying his term sheet as being founder-friendly, and to a fair extent, he is right. His document is more straightforward – there is not a lot of complex detail. Investors receive preferred shares, but the only preference relates to dividends, which are a red herring because at the seed stage you are not declaring dividends. The Sam Altman term sheet does not dictate the composition of the board, and the preferred shareholders do not get to weigh in on hiring and firing executive officers, the sale or acquisition of the company, or other aspects of the business. But the investors’ Preferred class of shares give them an overriding veto on any company action that would dilute or in some way change the value of those shares.
What if a founder decides to exit the company – or is pushed out – and wants to retain the ability to work in the industry? How do “standard” term sheets stack up on the issue of non-competition?
Zev: The KISS documents do not have an explicit non-compete agreement incorporated in them. But often, you will find venture capitalists asking founders to agree to a non-compete. It is the wrong time to be thinking about this. When founders are negotiating for funds, they are not thinking about leaving the company; they are thinking about building the company. Non-compete agreements really can restrict them from finding work in fields they are passionate about. It is not unfair for an investor to want the partner they are funding today not to compete against them tomorrow, but it has to be offset by what the founders want. No founder should be forced to litigate the right to work in the field they are passionate about just because they did not think far enough down the road.
Keith: The NVCA documents have bracketed the ability to include non-competes, but it is optional and can be deleted. Most likely a venture capitalist investor will try to include it, so you need to be vigilant to ensure it is not in your documents.
Ryan: When it comes to a Safe, signing the document in and of itself generally would not create any problem for working in your industry after you leave. But it is another point in which the Safes are silent because they are a bridge instrument to a next round of financing. I would think about what those next documents are; often it is a standard set of agreements on the NVCA’s forms. Sometimes you will see non-competes in those documents, but they are becoming rarer.
Jennifer: It is particularly a problem if the founder gets fired and is restricted from finding other work, because then he or she can be exploited when it comes to selling equity. You are going to have to sell it back to the company at a fire sale, which is a sad situation. The structure of the Gust Series Seed term sheet permits that to happen. However, it does not guarantee it will happen because it is based on the actions of the individual investor. The Sam Altman term sheet is silent on non-competition, so you are not forced to sign a non-compete to get the investment dollars. The founders would be able to exit the company and do something that either directly or indirectly competes with the business they just exited.
When founders need funding, there is often pressure to move fast. If they jump into an agreement too quickly, what mistakes might they regret later?
Ryan: With Safes, the most basic issue is that the amount of your company you are giving away is obscured by the way the terms work. You are not giving away a fixed percentage most of the time. And it is not set up with the standard pre-money or post-money valuation. They either convert on a valuation cap or a discount to your next round of financing. Raising too much on a Safe, especially with a high discount or a low valuation cap, can result in giving away too much equity. Equity is key to control. If you can maintain ownership of 80 to 95 percent of your company in the first round, it is unlikely you will lose control. But if you are down to 40 or 50 percent after the first round, you could get in trouble fast.
Aside from the amount of equity they give away, what other investor terms might an entrepreneur later regret?
Ryan: Sometimes investors ask for pro-rata rights, which gives the investor a right to invest in the company’s next rounds of financing. If there are a lot of smaller investors, or investors who might not be adding value anymore, you don’t want them putting in more money and squeezing out new investors who are adding not only new dollars but potential connections and guidance. So, the terms of the next financing are going to be really important.
Zev: There are a couple of potential stumbling blocks that are easy to miss when you are caught up in the excitement of a fundraise. Founders need to look carefully at how their shares vest and the terms for shares issued to investors and employees. It is also important to pay attention to who has the authority to make strategic hiring and financial decisions.
Keith: Investors who use NVCA documents are going to be looking for control from the beginning. One of the most important terms to look out for in the NVCA documents is board composition. NVCA documents conflict with the Founder Friendly Standard around who gets to elect the board.
Jennifer: The entire point of a contract is that it is permanent, so if you make a mistake in accepting a term and you realize it later, you cannot just fix it. You will have to negotiate the fix, if one is available, and that can be costly. One way to avoid this problem is to not take investor money.
Is bootstrapping a realistic approach?
Jennifer: As an attorney just outside Washington, DC, I am seeing it is commonplace for early stage companies not to take investor money. They will look to friends and family, and they will use revenue-based growth – trying to get a product or a service into the market, generate revenue, and iterate quickly to grow the business. When they get to the point where the business needs an infusion of cash, they are in a much better position to negotiate with investors. I recently posted a Twitter thread about this featuring quotes about bootstrapping from 25 entrepreneurs.
Thanks to each of you for sharing your insights on how founders looking for funding can negotiate founder-friendly terms. This raises important questions about who gets to set ‘standard’ terms for startup financing.
Looking for more insights into how standard terms sheets stack up against Founder Friendly Standard? Check out this side-by-side comparison of popular startup fundraising documents with analysis from the attorneys interviewed in this article.
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