Advice for entrepreneurs negotiating venture capital term sheets

I just got off the phone with a fellow entrepreneur in Seattle. He's CEO of a very cool start up that is in the process of raising its Series A. I am an investor in the angel bridge note. I'm not going to tell you the name of the company because they're busy negotiating a deal and the CEO would shoot me. But I do want to tell you and other entrepreneurs the advice I gave him.  This post has two parts: an outline of the financing situation followed by my advice.

I) THE FINANCING SITUATION (all numbers are fictional to protect the company):
There was a bridge note done in October of 2006. The company raised $1,000,000 at a 25% discount on the valuation of the Series A round (if there is one) and gave 20% warrant coverage.  Included in the bridge note terms was a maximum valuation of $4,000,000 for the Series A round. The note terms did not include pro-rata rights for the angel.
Along comes tier 1 venture capitalist and gives the company a series A term sheet. VC wants to put $4,000,000 into the company at a $9,500,000 pre-money valuation. The VC claims to want a 30% equity stake in the company and wants to have a 20% option pool for new hires. The liquidation preference is 1 times money invested. The company today is pre-revenue. There's lots more to say, but that's the gist of the deal.

MY ADVICE
The CEO called and was distressed about founder dilution and didn't want to give the angels pro-rata rights. My comments to him were:

• CONGRATULATIONS!! Close the deal! You got a 9.5 MM valuation for a pre-revenue company!!
• Don't get hung up on your dilution (or on valuation)- this is a mistake I see a lot of entrepreneurs make. They get worried about how much they own and that leads to a tendency to start to optimize on economics. Fight this -- don't worry -- and get the deal done.
• Give the angels pro-rata - Now this may have to come at the cost of the big VC or the founders , but my advice to the CEO is that life is long and you don't know whether this company is going to make it (in fact odds are against you)....so if you want to do another company, you want the group of people who want to support you to be as big as possible. Those people who support you when you've got nothing --who took a risk on the company not because of the company but because of you...those are the people you want to keep happy and close to you. Do the right thing by them!
• Be careful of the common VC strategy of pumping up the valuation but requiring a extra large option pool. That's what I see in this case. 9.5MM for a pre-revenue company is a lot...but the VC is requiring a 20% option pool which is also a lot and has the affect of lowering the effective valuation (from the VCs perspective).
• All VCs have models of how they want to deals. In this case, the VC wants to own 30% after the deal is done.  This is negotiable! The difference between 28% and 30% is negligible. The reason for these models is the VCs only want to spend their time and money when they have enough at stake. The second reason for these target % ownerships is to give the VC a pressure point when negotiating with entrepreneurs. The first reason is valid the second reason is bs.
• Focus on the other terms in the term sheet like liquidation preference (1x), board structure, pro-rata rights
• Oh, and congratulations, get the deal done!

Comments

[David Stern]

Good advice Andy. It is a great time to be an entrepreneur in Seattle, especially with so many funding options in the Bay Area driving up Seattle valuations! (Disclaimer: I'm a Seattle native at a Bay Area venture firm...so excuse the self-serving comment).

With regard to terms, in competitive times like these for venture firms, the caveat has to be that if there ever was a right time to haggle over dilution, it is now.

Regarding pro-rata, that is good advice. But don't the angel investors, who will be materially harmed, also have to think about the value of having the Tier I firm driving the company? Would the angels think the same about their pro-rata rights if the funds came from a Tier 10 (whatever that means) fund? What do you think would happen if a Tier 10 venture firm did the A, and Sequoia came in on the B but only if Tier 10 had to give up some of their pro-rata or lose the deal?

[nicho fairbanks]

I've never raised money before, and I'm dying to learn how it all works. Can you explain, in plain English, the terms of the bridge note and the series A funding in this example? 20% warrant coverage? Pro rata rights? Huh?

Or, alternatively, I guess you could point me to a page that explains Term Sheets for Dummies.

Great blog, by the way. Thanks for the work you put into this, Andy.