The perfect Term Sheet

It does not exist, obviously, because perfect is different for everyone involved, but there is a great discussion going on at the moment how something as close as possible to perfect could look like. Thing biggest thing I agree with is that there should be a good template to use because these things are so freaking expensive, especially because lawyers from two different sides are payed to drag the talks along as they are paid by the hour, so you really have to have good lawyers and make sure they understand that this is about an easy deal.

I am very fortunate to have had good contracts, with wonderful investors, but I’d like to link you through the discussion because there is a lot to be learned here.

It all started with Chris Dixon’s wonderful post on “Ideal first round funding terms”. He says to make it work like this:

Investors get common stock or 1x non-participating preferred stock. That really means that if an investor invests a million for 20% and you sell the company for less than 5 million, they get their million plus dividends, and you split the rest, but if you sell for more, they can convert to common and get 20% of whatever the sale price was. While I still think common is best, I get the point here, because what Chris says and I agree, is that getting their million and then still 20% from the rest or even more (multiple liquidation preference of e.g. 3 giving them 3 million before anyone else get something) is just stupid. You are in one boat, or at least you should be.

Pro rata rights are fully ok too, meaning they can, if they hold 20%, get 20% of the next round to keep their 20%. This is just how this stuff works. Of course you have to understand that in a down round you might end up loosing a lot of shares.

Founder vesting with acceleration on change of control is really only valid if you have options. But you should be able to sell some of your holdings at some time, with everybody having a right of first refusal.

That might end up costing your $10k, which should be the max.

The only thing that should be clear is that an investment contract is full of “communicating pipes” as one investor put it to me. A wonderful term. If they want preferred stock instead of common, the valuation goes up as their downside goes down for example. They might want a term you do not like, then something ends up in the contract they might not like. But as Chris said, it should just be a standard contract and then we can save all of us a lot of time and money.

Chris also suggests going with a law firm that knows startup financing and yes this is very important. As for board seats, which is more a US thing, you should have something like 1 investor, 1 founder, and 1 independent. Possibly make that 2/2/1. This is really something we agreed on here in the voting rights. The idea is that if all investors and one independent director say X, then X is something I as a founder should accept. Sounds harsh, and you can move that around to saying that at least one founder should agree, and then you are fully fine. Just make sure that not everyone has to agree :)

Founders salaries should be at a level where the founder cannot really save money, but does not have to think about it either. If angels invest next to VCs they get the same rights excluding control rights. The other option here is to pool people. Because the thing is that it can be a pain to track down 10 angels just to do a small thing because they all have to agree. And these are busy folks. :) Options should be in the contract somewhere so it is sure what else will be distributed.

Then discuss valuation and amount raised, so that you are relatively sure that you can beat your post-money valuation in a next round.

All in all, very good points.

Then comes Fred Wilson with more points, namely that he agrees (good :)) and that they are actually using something like this. he ads another good point: if your first contract is that simple, further rounds do not have to start complicated.

Then comes Brad Feld with his post. The good thing he points out is that what would be even better would be if we really had one set of documents that people agree on. Because even though templates might be similar they are always slightly different. I really hope this will happen as it would make things a lot more simpler.

Another thing would then be somewhere where investors and companies could say that they used that contract for their investment, editing only X and Y. This would mean that both investors and companies could point to it and say: they did it too, now stop arguing.

Oh how easy life would be ;)

Update: and while I am at it, check out this post by Fred Wilson on milestone based investing. I couldn’t agree more. Especially because you end up discussing milestones in a much too early stage.