Keep It Simple
One of the start-ups I work with received a term sheet a few days ago for a first round of financing. As a very early stage company, this was not a big round nor was it at a high price. But, this is the type of financing that early stage companies need to get going. Up until now, this company had raised a few hundred thousand dollars of angel financing. If this new round closes, it will allow the company to launch its new Web service.
As I was helping the CEO review the term sheet, I was surprised at some of the bells and whistles that the venture firm had put into the financing terms. Without going into all the details, I would say that the venture firm had pushed toward some of the limits on what they could expect in an early stage round.
One reason why I like clean and simple terms for early stage financings is that terms for later rounds always get 'worse'. Later stage investors, who generally pay a higher valuation for the company, feel that they should get some nicer bells and whistles than the earlier stage investors. Rather than no dividend on their preferred stock, they will ask for an 8% dividend. Rather than having a capped participating preferred, they will ask for an uncapped participating preferred.
[By the way, if you are baffled by these VC terms, you should read the Term Sheet series on Ask the VC.]
Another reason to have clean terms is that it gets the VC onto the same side of the table as the entrepreneur as quickly as possible. As an early stage investor, you only really make money when the company has a nice exit. You can't do much by trying to juice up the downside with a few nice financial terms. And, certainly, you don't want to do this by taking away the upside from the entrepreneurs. This leads to the start-up employees defaulting to the 'living off the fees' mentality that I described here. This is the antithesis of what start-ups are about.
So, what's the right structure for an early stage deal?
- Convertible Preferred Stock
- Simple 8% dividend
- 1x Lquidatoin preference
- Participation after the liquidation preference, but cap that at 2x the original investment
- Weighted average anti-dilution protection
- Keep the Board small
There may be other questions on terms. Put them in the comments, and I'll respond.
I like the structure above because it is clean and simple. It gives the investors the preferred treatment they deserve for putting up the money. It gives the investors a modest 8% return via the dividend. It gives the investors preference in getting to a 2x return, which is very modest for an early stage VC. But, for outcomes bigger than that, the investors and entrepreneurs are directly aligned as the investors would convert to common rather than take their capped preferred return. Most importantly, you can push later round investors to stay close to this structure, which keeps some upside for the entrepreneurs.