How founder-friendly is it?
I conducted a study in 2019 with attorneys who reviewed the six most popular startup financing documents—all of which were produced by investor-funded organizations. After pouring through 298 pages of legalese, the attorneys found the top six financing documents were, on average, only 38% compatible with Founder Friendly Standard. The Y Combinator (“YC”) Series A Term Sheet Template was not the most founder-friendly nor was it the least. See for yourself by viewing our infographic where you can drill down and compare the term sheets.
Founders who want to be their own bosses shouldn’t use the YC Series A Term Sheet Template
Review written by K. Adam Bloom, Startup and Entertainment Attorney, on September 7, 2019.
To write this comparison, I used the Founder Friendly Standard to grade the Y Combinator Series A Term Sheet Template.
Section 1.1 of the Founder Friendly Standard says:
Individuals who work for the company and are instrumental in its inception (“Founders”) receive a class of equity such as Common Stock which provides no less than twenty-four (24) votes to one (1) vote of stock held by investors or employees.
Y Combinator Series A Term Sheet is incompatible with Section 1.1 of the Founder Friendly Standard. There is no super-voting equity for founders.
Section 1.2 of the Founder Friendly Standard says:
Investors receive a class of equity such as Class A Preferred Stock which will have one vote per share with a higher par value justified by a liquidation preference.
YC Series A Term Sheet is incompatible with Section 1.2 of the Founder Friendly Standard. While the term sheet provides a liquidation preference of 1x the original issue, it lets the Lead Investor appoint one member (“Preferred Director”) of a three-person board. Investor shares also have special veto powers when adjusting Preferred Stock to let new investors in, selling the company, or changing the number of directors on the board. This is akin to giving investors super-voting equity, not one vote per share.
Section 1.3 of the Founder Friendly Standard says:
Employees and contractors receive a class of equity such as Class B Common Stock which carries one vote per share and does not have a liquidation preference.
Y Combinator Series A Term Sheet is compatible with Section 1.3 of the Founder Friendly Standard. Although the term sheet doesn’t provide for a third class of stock for employees, one would expect employee equity to receive 1 vote per share with no liquidation preference as this is not special treatment.
Section 1.4 of the Founder Friendly Standard says:
The first board consists only of Founders. The term of the board is one year. After the first year, a new board is elected by the equity holders at the annual meeting. Board decisions are made by a majority vote of the board. Board members cast no more than one vote each on any decision. Board committees are disallowed for at least the first two (2) years.
Y Combinator Series A Term Sheet is incompatible with Section 1.4 of the Founder Friendly Standard. The term sheet provides that two directors are elected by the holders of a majority of Common Stock, and one Preferred Director is appointed by the lead investor. While it looks like the founders would control two-thirds of the board, further provisions require the Preferred Director and the majority of the holders of Preferred Stock to approve actions like adjusting Preferred Stock to let new investors in, selling the company, or changing the number of directors on the board. These veto powers can put the investors, rather than founders, in control of the company. Founders, isn’t the point of starting your own company to be your own boss?
Section 1.5 of the Founder Friendly Standard says:
New equity of any kind, including stock option pools, dilutes all equity holders equally. Therefore, no investor in the company has anti-dilution rights of any kind.
YC Series A Term Sheet is incompatible with Section 1.5 of the Founder Friendly Standard. The conversion of Preferred into Common shares is subject to the “Broad-based Weighted Average anti-dilution protection.” This means that if the company raises money in the future at a lower valuation than the valuation used in the current round, the current investors will be partially protected. Down-side protection seems unnecessary in such an early round of funding. Early-stage companies are risky by definition. Do you think investors and founders should share that risk equally?
On a positive note, the Y Combinator Series A Term sheet calculates the option pool on a post-money basis. That helps reduce the trickery that my colleague, Jennifer Persico Rohleder, points out in Section 1.5 of her analysis of the Gust Series Seed term sheet.
Section 2.1 of the Founder Friendly Standard says:
Founders agree in writing they will give and receive performance reviews at the end of each fiscal quarter for the first four (4) years.
YC Series A Term Sheet does not address section 2.1 of the Founder Friendly Standard. The term sheet is silent on this issue.
Section 2.2 of the Founder Friendly Standard says:
Sweat equity vests each month over a period of four (4) years with a one (1) year vesting cliff. Vesting begins on the date shares are issued.
Y Combinator Series A Term Sheet does not address Section 2.2 of the Founder Friendly Standard. This is a big issue to be silent on. What if a co-founder holding 25% of the equity leaves after a few months? Watch out for how vesting gets addressed in any follow-on documents that may be needed to finalize the investment.
Section 2.3 of the Founder Friendly Standard says:
Founders keep all information confidential and assign the company all intellectual property created within the scope of their work for the company.
YC Series A Term Sheet does not address Section 2.3 of the Founder Friendly Standard. Watch out for how confidentiality and intellectual property get addressed in any follow-on documents that may be needed to finalize the investment.
Section 2.4 of the Founder Friendly Standard says:
Due to potentially devastating tax consequences, the company tells individuals receiving sweat equity in the United States to consult with a tax professional about making an election under Section 83(b) of the Internal Revenue Code. Founders who live or pay taxes outside the United States are similarly advised to consult tax professionals about applicable local and national taxes.
Y Combinator Series A Term Sheet does not address Section 2.4 of the Founder Friendly Standard. The term sheet is silent on this issue. Make sure you talk to a licensed tax professional in your state/province/country as soon as possible.
Section 2.5 of the Founder Friendly Standard says:
Non-compete restrictions only apply to employee or independent contractor agreements and do not survive termination. The company’s bylaws and other investor agreements are either silent on the issue of non-competition or expressly allow competition.
Y Combinator Series A Term Sheet is compatible with Section 2.4 of the Founder Friendly Standard. The term sheet is silent on the issue of non-competition, which makes it possible for founders to find work after they leave the company. Watch out for non-compete restrictions in any follow-on documents that may be needed to finalize the investment. Agreeing to a non-compete can have devastating consequences if you are underpaid and ultimately leave the company without selling your equity at a high price.
Section 3.1 of the Founder Friendly Standard says:
For at least the first two (2) years of operations, the company will not agree to pay the legal expenses of any investor as a condition of investment.
YC Series A Term Sheet is incompatible with Section 3.1 of the Founder Friendly Standard. The term sheet says the Company is responsible for paying the Lead Investor’s legal fees up to $30,000. How could this be used to extract concessions from founders in any follow-on documents to finalize the investment?
Section 3.2 of the Founder Friendly Standard says:
For at least the first two (2) years of operations, the company does not agree to binding arbitration with any investor.
Y Combinator Series A Term Sheet is compatible with Section 3.2 of the Founder Friendly Standard. The term sheet is silent on dispute resolution, which opens the door for founders and investors to go to court rather than arbitration. Watch out for arbitration clauses in any follow-on documents that may be needed to finalize the investment.
Section 3.3 of the Founder Friendly Standard says:
For at least the first two (2) years of operations, the company does not agree to binding arbitration with any Founder.
YC Series A Term Sheet is compatible with Section 3.3 of the Founder Friendly Standard. The term sheet is silent on dispute resolution, which opens the door for founders and investors to go to court rather than arbitration. Watch out for arbitration clauses in any follow-on documents that may be needed to finalize the investment.
Section 4.1 of the Founder Friendly Standard says:
Upon any transfer or sale of Founders’ super-voting equity, the portion of equity transferred converts to the class of equity described in Section 1.3. This also includes any transfer to a Founder’s estate, spouse, or heirs.
Y Combinator Series A Term Sheet is incompatible with Section 4.1 of the Founder Friendly Standard. Founders do not have super-voting equity in the term sheet.
Section 4.2 of the Founder Friendly Standard says:
The company has the right of first refusal on any transfer or sale of equity for up to forty-five (45) days, but it cannot veto a transfer or sale. This provision is void after a company’s stock is listed on a public exchange such as the NASDAQ, OTCBB, New York Stock Exchange, etc.
YC Series A Term Sheet is compatible with Section 4.2 of the Founder Friendly Standard—although not as much as founders might like. The term sheet doesn’t provide an outright veto right, but it does have stipulations. Investors get the right of first refusal to buy a founder’s stock. And if a founder finds a buyer for her stock, investors would have the right to sell to her buyer first.
Should you accept investment terms that are not founder-friendly?
YC Series A Term Sheet is compatible with five issues (sections 1.3, 2.5, 3.2, 3.3, and 4.2) in Founder Friendly Standard. The term sheet is incompatible with six issues (sections 1.1, 1.2, 1.4, 1.5, 3.1, and 4.1). It is silent on four issues (sections 2.1, 2.2, 2.3, and 2.4).
Y Combinator Series A Term Sheet states that all terms are non-binding except the 30 day “No Shop” provision. The implication is more legal documents are needed to complete the transaction. Combined with my finding in Section 3.1 above that the startup pays up to $30K of legal fees, the “No Shop” provision could set entrepreneurs up to make big concessions before the deal is done.
The problem, once you sign a term sheet, is your leverage and flexibility dramatically go down. It becomes far easier for investors to pressure you with this or that language (which they will usually claim is also “standard”) than it would’ve been during the term sheet phase. So, rushing to sign a short term sheet favors investors over startups.
José Ancer in “The Problem with ‘Standard’ Term Sheets”
Experienced investors will expect the final legal documents to be consistent with the National Venture Capital Association (“NVCA”) Model Legal Documents. To see how the 100+ pages of NVCA Model Legal Docs compare to the Founder Friendly Standard, read Keith Strahan and Josh Mathews’ analysis. (Spoiler: The docs are not founder-friendly.) You don’t want to forfeit your negotiating leverage until your deal is signed.
If you need to build more leverage to get the investment terms you want, consider walking away from prospective investors and bootstrapping. Read The Customer-Funded Business by John W Mullins for ideas on how you can adjust your business model to be cash-flow positive with customer funds—even as you’re investing in growth. Bootstrapping is short-term pain for long-term career fulfillment. You’re more likely to end up your own boss if you bootstrap.
INFOGRAPHIC: How does Founder Friendly Standard compare to term sheet templates from 500 Startups, Y Combinator, NVCA, Gust, and Sam Altman?
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