Common Terms & Their Implications
While each firm follows its own set of internal rules, when dealing with new startups, most VCs share relatively standard expectations about equity, control, and governance.
The following terms, while not comprehensive, are commonly found in term sheets. Understanding terms—and their consequences—at the outset may help you in negotiating. But before entering negotiations Ghosh recommends, “always consult a legal professional.”
When you raise money at a high valuation, you relinquish equity, because of the high risk your venture poses to investors. The risk diminishes when your company can demonstrate that it’s already worth the amount you’re raising. VCs typically stipulate preferred equity to ensure that, in case of a liquidation event—bankruptcy, sale, or IPO—they will receive their investment back first.
Let’s say you want to raise $10 million and have a $20 million valuation. You staked your company at $10 million and a VC put in money at $10 million, giving you each 50% equity.
How much money would you make if your business sold for $10 million now? Most founders assume they’d receive their half–$5 million—back, due to the 50-50 split. But, in the case of preferred equity, in this scenario, the founder would receive zero, and the VC would receive the full $10 million it invested back.
In addition to receiving the original investment back, participating preferred allows the VC to claim an additional payout. For example, if a VC holds 15% equity in a company, the term guarantees that, before any other shareholders are paid, the firm will receive the amount it originally invested. Plus, the VC will receive a percentage of any remaining cash after everyone else is paid.
But if you ask for a high valuation before your company has earned that amount, VCs might offset the risk posed by asking for 2x preference.
Say your company’s worth $10 million and you own it all. You raise $30 million, accepting terms that state a 2X preference. If the company sells for $50 million, the investors get $50 million back.
What would your share be? Zero.
Essentially, you started with a business that was worth $10 million but, because of the 2x preferred, you’ve lost it all in exchange for the investment. If the company sold for $60 million, you recoup only $1 million.
Focused on the potential upside, frequently, entrepreneurs don’t understand the severe impact 2x preferred can have if things don’t go as planned.
Increasing the total number of outstanding shares in a company—as often occurs in a subsequent round of funding—can dilute the owner’s equity.
Imagine an investor who owns 200,000 shares of a company with 1,000,000 outstanding shares. If the company is valued at $5,000,000 and the price per share is $5, the investor has a $1,000,000 stake, or 20% equity of the company. If the company enters a new round of financing and issues 1,000,000 more shares, increasing the total shares outstanding to 2,000,000, with the same $5 per share price, the company has become a $10,000,000 company. This instantly dilutes the investor’s ownership from 20% to 10%.
Vesting and Options
Because investing carries such risk, VCs build safeguards, like vesting and options, into the agreement, in case the founder leaves.
Vesting may require a holder—including the founder—to temporarily relinquish shares already possessed for a specified time before they can be earned back.
Options provide a way of attracting talented, high-level staff.
Option pools ensure that shares will be available to new staff without diluting the shares of all shareholders. Typically, VCs create option pools from a percentage of options taken from the founder’s share.
Creating option pools can spark tensions. Since options often come from their share, many founders favor a smaller option pool. The first investor for Series A typically favors creating a large option pool to minimize their dilution if (or when) more options are created during subsequent rounds.
How much influence will you retain over the direction of your company once you sign a deal? Many founders believe that, because they hold a greater amount of equity than the investors, they retain control. But that’s not true which leads to the fifth truth every founder should know before signing a term sheet:
The deal is not just an exchange of venture capital in return for equity. Investors expect to exercise control, influence governance, and limit the decision-making power of the founder/CEO. Term sheets commonly include control rights, and these present another point on which founders and investors frequently misalign. It’s important to understand that decision-making control shifts once you accept terms from a VC.
Governance & Control
If your company doesn’t have a board when you’re raising funding, the term sheet will most likely establish a board and stipulate its decision-making powers. The board consists of a small, typically odd-numbered group of experienced leaders—usually 3 to start—chosen by the lead investor. Your board may grow in subsequent rounds, but it will customarily consist of an odd number, to prevent deadlock when voting.
In addition to determining your budget and setting expectations for performance, your board wields decision-making control over most financial decisions, including giving away equity, investment, and future hiring. Charged with ensuring the company’s success, the board is empowered to hold the founder/CEO accountable.
Having invested time and money into your venture, VCs are motivated to see your company succeed—even if that means replacing leadership.
“Many founders are surprised to realize learn that, though VCs own a minority of your company, they have the right to remove you. Not only do investors have this right, they exercise it and remove founders from the CEO role about 45% of the time.”Shikhar Ghosh
The most astute and successful founders can recognize their weaknesses and either proactively hire specialists or embrace guidance on hiring decisions from the board.
After understanding the impact that terms have on your venture’s future, don’t forget that timing itself can affect the terms you’re offered. Your strength in negotiating varies depending on the risk associated with your venture and risk is tied to timing. When you’re raising for the first time, you’ll have less negotiating power because you have not yet proven your hypothesis. Similarly, your leverage decreases when you enter a flat or a down round. With that in mind, delaying raising large amounts until you can refine your business model may allow you to get more favorable terms from VCs.
Receiving a term sheet signals a victory. Investors believe that your product’s potential for revenue may outweigh its risk. Before getting swept away by the emotional tides receiving a term sheet often evokes, take time to review the terms in context. Ask questions and make sure that you and your investors align. Want tips on how to manage your relationship you’re your investors and board once you sign the deal? See