Great talk, particularly valuable for those who are early on and thinking about their product design.
I had lunch with David a few weeks ago, and it was one of the most valuable hours in my career. I'm still in the midst of rethinking and reworking the product based on his ideas and feedback, and incredibly excited to be able to show it once I'm done!
The Internet is often described as a festering pit of electronic hate, but in the same way your gut is a festering pit of bacteria -- the vast majority are harmless, and you're actually better off for having them around. Ninety percent of people might be assholes, but we're all assholes about different things. So when one group declares themselves the voice of the majority, they get stomped like a goomba in Mario's biker bar.
When negotiating a round of financing it is critical to look at the whole of what is being offered, and not just fixating on a particular term (the classic example is overvaluing the pre-money valuation). There is a short term view (how much of the company are the investors buying for how much money) and a long term view (what happens if the company has a down round in the future? A mediocre exit? A home run?).
To help new entrepreneurs and future investors wrap their head around the whole thing, I've categorized the key terms and provisions. In this post, I will explain the categories and give brief descriptions of the terms. In future posts I will go into more detail on the categories and terms.
Size of the Pie
Price per share
Fundamentally, these terms are about how much the overall company is worth, and they are two ways of expressing the same value. If you have the pre-money valuation, you can divide it by the number of shares to get the price per share. If you have the price per share, you can multiply it by the number of shares to get the pre-money.
A larger valuation is often combined with other terms that can, in some circumstances, mean less money from an exit for Founders. Put another way, owning 50% of a company at an exit does not mean you get 50% of the purchase, and it can range all the way from nothing at all up to that 50%. There are also other good reasons (like anti-dilution provisions) to avoid a premature high valuation.
Size of the Slices
Option pool creation
At the founding of a company normally a small set of founders owns all the stock. They then agree to dilute their own ownership in order to bring in capital. In other words, the company is creating new, unowned shares, and selling those to the investors.
In a simple scenario, you then have three classes of stock ownership at the end of the funding round:
The diluted shares owned by the Founders.
The newly minted shares purchased at the round's Price Per Share by the investors.
An option pool, which are shares set aside to incent employees.
Kinds of Investments
We'll categorize these types of investment vehicles in four buckets:
Common stock - generic, no weirdness, just shares owned. Usually the lowest on the totem pole.
Preferred stock - this is whatever it is defined to be in the legal documents. One share of preferred stock can be converted into multiple shares of common stock, or get money out first, or inflate, or give extra voting rights. Whatever the legal document says. And each type of preferred stock (Series A Preferred, Series B preferred, etc.) is defined separately.
Debt - Convertible Notes and more traditional debt, normally the debt is at the top of the pile to get money when an exit occurs.
Options to buy shares - This includes option grants out of the option pool, warrants, and restricted stock (which is usually vesting options for Founders - don't forget to file your section 83(b) election within 30 days!).
From the company's point of view, debt is often good because it can delay or avoid valuing the company. The flip side is that for low value exits (when this is most relevant), debt is repaid as one of the first items on the liquidation stack, meaning it gets paid back before stock.
Options allow vesting periods and delay actual ownership of the stock, particularly good for cases where you don't want someone to own part of the company if they only last a short time with the company. Warrants act like options but are usually used as a way to incent investors to buy convertible notes.
Preferred stock is, as mentioned, whatever the deal docs say the preferred stock is. This is where things get interesting, and most of the terms I talk about below are ones that may be applied to preferred stock.
Finally, common stock is the relatively simple, straightfoward case.
Hedging Investor Risk
Liquidation preference and dividends
Investors take a lot of risk when they put money into a startup, most will want to hedge that risk in some way.
Conversion together with liquidation preferences and dividends allows the investor to get money out before the common stock holders do, normally to secure returns with low exits. With a 1x liquidation preference, for instance, the investor has the ability to make sure they at least get their money back before any common stock holder gets a cent.
Anti-dilution is a hedge against future financing rounds at a lower valuation. Normally this would mean that the future investors would get more shares per dollar, diluting the ownership of current investors. This is backwards from how it otherwise works, where earlier investors get more bang for their buck. Anti-dilution provisions are mechanisms for reducing the dilutive effective by inflating the number of shares the earlier investor has.
Redemption rights are a hedge against time. They allow the investor to turn their preferred stock back into cash (plus dividends) after a certain amount of time. This is their hedge against the company not being on a path towards a liquidity event on the timeline required by the investor (like the lifetime of a VC fund).
Pay to Play
Right of First Refusal
This section includes terms for investors to protect themselves against other investors, as well as the company hedging investor risk.
Pay to Play is a little bit of both, it incents investors of earlier rounds to participate in following rounds. If they don't, their preferred stock is turned into common, losing all the rights and provisions that make preferred stock preferable.
Right of First Refusal is the opposite, in a way. Instead of punishing investors who do not invest in following rounds, it ensures that the earlier investor will have an opportunity to make a sizable investment in following rounds.
Vesting is most often used for Founders and employees, and ensures that they only get their full number of shares if they stick with the company for a longer period of time.
Co-Sale ensures that if the company's Founders are able to sell some of their stock, other investors also get that opportunity.
Board of Director seats
Voting Rights determines how different classes of Preferred Stock and Restricted Stock get to vote. The difference between Restricted Stock and Options is that Restricted votes as if the owner had exercised their right to purchase the stock (and had fully vested), where unexercised Options have no votes. Preferred Stock is normally voted on an As Converted basis, meaning as if it had fully converted into common stock (based on its Conversion provisions).
Board of Director seats is very straightforward. How many seats and who gets to pick who sits in them.
Drag Along says that if the majority (by number of shares) owners of a Preferred Stock class agree to something (like the sale of the company), the others will go along with it.
Should you agree to the terms offered? There's no simple answer to that, the best way to make the decision is to actually model the offer with your company's ownership structure and then see how those terms affect you under different circumstances. What happens with a small exit? Medium, large? What happens if the next financing round is at a lower valuation, or has more restrictive terms?
The interplay between different terms is what makes or breaks a term sheet.
Neil DeGrasse Tyson, possibly the world’s favorite astrophysicist, has been making the rounds on television this month to talk about his new book on why NASA matters, after the agency’s decades-old space program closed down last year. Tyson says that if NASA is given the money it needs, the agency will stimulate the economy and inspire better, more innovative projects from students.
Even after identifying himself as a Google+ fanboy and having literally written the book on the social network, Guy Kawasaki had no choice but to ask the tough questions in his SXSW keynote interview with Google’s Vic Gundotra.
I don't dislike G+ from a technology point of view, or a user experience point of view, but it is true that the circle of friends that I have that use it are mostly Google peeps.
What I do dislike is the stupid crap Google has done to its other properties (particularly Reader) to try to force me to use it. I nearly "shared" this in Reader (which would have put it in my G+ stream), but having remembered this went to some trouble to make it happen in TypePad instead.