A founder-friendly term sheet
blog.samaltman.com
blog.samaltman.com
Of course, the question is whether this will catch on and stick, even during bad times. When markets are sunny for investors, it is not too hard to bend for the founder concerns. When things are tight, though, the pattern has always been one of merciless slaughter of the founder interest, as evidenced by any down round within memory. So too, in bad times such as the dot-bust period, atrocities like participating preferred and multiple-x liquidation preferences frequently reared their heads and would, I think do so again in any new time of debacle. While individual investors such as Mr. Altman may refrain from this sort of thing, I wonder whether such moderation would ever become the norm. I would tend to doubt it.
I also think that even this particular term sheet, though undoubtedly fair to founders in its overall sweep, would need to be adapted to avoid unfairness as it is applied to various cases. If a founder has built large value by the time of Series A, it is very non-standard to require that founder to put the entirety of his stake at risk of forfeiture all over again as a condition to getting funded. That, I assume, would be an obvious point of negotiation and one on which any investor would very likely yield when pressed.
These are mere quibbles, though. It is really the spirit of the thing that counts and not the legalese as such. Just as the best contract in the world will not really protect you if you happen to be dealing with a scoundrel, so too the flimsiest of contracts will likely not cause you too much trouble if you are dealing with someone of honesty and integrity. This term sheet reflects the right values that an investor should bring to a deal and, if you get that as a founder, you are 99% of the way there as long as your business interests can match. In the end, that is what counts most of all.
It would be interesting to see the stats for investor payoff when that dilution is included. The few cases I know: Anytime the founders were singled out for big dilution the result was sizeable loss for investors (and everyone else, because the companies eventually got sold for parts.)
Founders and Investors should be incentivized to work together for the benefit of the company, not work against each other to the benefit of themselves.
tl:dr; Sam is right, and I hope this becomes standard practice.
1. During initial funding ("pre money") talks the founder is incentivized to ask for a small option pool because she doesn't want to divert a lot of her stock into the option pool
2. After the option pool has been exhausted through new hires the founder then asks the board for a larger pool, which is now created from the combined stock of the founders and the investors - thus the founder is diluted less than if the expanded pool had been created at the start.
Keep in mind that not all founders are this savvy when it comes to deal terms, and most investors will push founders to issue a larger option pool than needed. The investor will say something like "we want to be sure we have enough options available to recruit the best employees" or "we don't want to have to issue more options later because it would be a distraction". Both of these arguments have a kernel of truth in them, but they're not very good. You can always issue more options later and it's quite simple. What they're actually saying is, "I don't want you to come back and dilute me later when you could dilute yourself now instead". How thoughtful!
In a perfect world, this would have no effect on you. In the real world, it sometimes causes people to create option pools that are too big/small, since it's a confusing topic and it can be really hard to predict exactly what you need in advance! How people then act in those situations differs massively, but only affects things on the margin (e.g. perhaps the founder will issue a slightly more generous equity package to a new employee because "I have this whole option pool to spend").
tl:dr; this should have very little effect on you as an employee, but if your company's option pool came out of the pre, then the founders probably wasted valuable time and energy figuring this out with an investor who shouldn't have asked to structure it this way in the first place. Unfortunately, like many terms in financing (see the rest of Sam's post), this is too often the case. Fortunately, it will have little impact on the company or your experience, so don't worry about it :)
If we were taking outside money tomorrow, this would be a point of contention. I understand the idea behind a vesting schedule for founders (the investors don't want you to walk away two days after they invest), and I might grudgingly agree to something like that. But no way would I ever agree to make 100% of my founder equity subject to vesting or repurchase. The bottom line is, I've spend 2+ years working on this company, and without the work I (and the other co-founders) have put in, there is no company, no valuation, no nothing. I'm not going to put all of that equity at risk just to make an investor feel good. If we're all supposed to "be in this together" and have aligned interests, they would have to accept that we've already earned the right to a significant portion of the company.
I guess what would make sense, to my mind, would be a standard N year vesting (where N is 3, 4, 6, whatever) but give the founders credit for "time served" so to speak.
In any case, thanks for sharing this, and for promoting the "founder friendly" approach. It seems right to me, since you want the founders to be taken care of, so they remain motivated to work as hard as they can on building the best possible company. I feel like it's short-sighted of investors to try to squeeze the founders too hard. Worst case, you wind up with founders who have no real incentive to bust their ass building the company!
1) Why should the investor retroactively pay your made-up salary for the privilege of investing? Valuation has something to do with the assets or future assets of the company; a salary is a liability.
2) How much is that sweat equity really worth if the company turns into the next salesforce/facebook/etc? Many millions upon millions. Any typical estimate ("let's call my salary $100k over the last 2 years....") is going to fall so short that it's useless.
Disclaimer: I am not actually founding a company, nor have I in the past, nor am I likely to build a company that requires VC investment, but this is what my attitude would be if I were.
And you obviously think taking the VC's money is more valuable than taking a bank loan/cash advance/going with another VC. Both sides have something to gain. Only thing is, if you're looking for VC money you need the money. The VC doesn't need to invest in you.
More startups should do this, including with adviser shares.
Few things are as demoralizing as needing to fire a co-founder in the first place, but if they keep the same equity stake as the founders who remain it's worlds worse.
I'm fine with the basic idea of vesting, and you're right, it does protect the founders (from each other) to some extent. What I have an issue with, is a scenario where you work, as a founder for, say, 3 years, and then take outside investment money, and the investor demands 100% of your founder equity be subject to vesting and/or a "zero price" buyback clause. I would never, ever take that deal. A lot of things can happen, and there is value which has already been created by the 3 years that was put in.. as a founder, I'd expect to retain some percentage of my equity based on that. The exact details would, of course, have to be negotiated.
Indeed. I'm surprised to see so many people here think that a 100% lock-in is reasonable. That effectively sets a zero value on the work done to date, while at the same time presuming that a company is established enough to be worth serious investment, which is paradoxical.
I don't see how this really protects founders to a useful degree either, at least not for very long. While some degree of vesting creates an incentive for everyone to stay on board and do their best to make the project a success for everyone, it doesn't need 100% of the money involved to do that. Even if it did, there wouldn't be 100% lock-in after presumably no more than a year, and then you're back to having a significant chunk of equity that isn't locked in anyway. So again, the argument that a 100% initial lock-in and 4 year vesting period are both necessary seems to contradict the idea that you start releasing a significant fraction of the locked equity after only one year.
Transfer Restrictions:
Bylaws and option plan documents shall include limitations on
certain transfers, including on secondary markets, to
competitors, or that may trigger public reporting obligations.
In the first Dot Com bubble, companies would IPO before reaching profitability and sometimes even before reaching significant revenue. For a number of reasons (scrutiny from Wall Street, public reporting obligations, Sarbanes-Oxley), companies that intend to go public increasingly choose to delay their IPOs.
In 2004, Google went public with 2003 revenues of $960m and profits of $105m. In 2012, Facebook went public with 2011 revenues of $3700m and profits of $1000m.
One way shareholders managed their longer time-until-IPO horizons is by selling their stock on the secondary market. Many startups (SecondMarket, SharesPost, etc) were set up to help shareholders of successful companies like Facebook and Twitter sell their private company stock to qualified investors.
The transfer restriction quoted above means shareholders can't transfer (sell) their stock until IPO or unless they have the consent of the board.
Investors tend to have long-term horizons and may not care about getting locked up in an investment until IPO. In any case, investors are well represented on boards. Founders have leverage with the board and can negotiate partial cash-outs (selling some of their common stock to investors), but in any case own their shares outright and can hold on to them until IPO.
Employees with incentive stock options, however, can get screwed. Options are not stock and (even after having vested!) will expire if the employee quits or gets fired. If the company is doing well, the Fair Market Value (FMV) of the stock may be much higher than the employee's exercise price, which means exercising the options will incur a large Alternative Minimum Tax (AMT) penalty. This means an employee might have very valuable, vested stock options but no way to keep them upon leaving the company because exercising can put them in a tricky cash flow situation where the IRS expects them to pay taxes on unrealized (and unrealizable, because of transfer restrictions) capital gains.
This term sheet is generally founder-friendly, but the transfer restriction is certainly not employee-friendly.
Your point about ISOs expiring is reasonable--I think a lot of companies are using RSUs partly for this reason.
Secondary markets have issues, but so do secondary offerings overseen by the company. There can be pretty big principal-agent problems, both around price and around timing.
I'm less familiar with the traps and pitfalls of RSUs, but in general they seem fairer than ISOs. I hope they're used more widely.
I'm more interested in the emergence of derivatives markets against RSUs. It's started already, and I wonder if companies are going to attempt to put that cat back in the bag, or just ignore it as it largely doesn't affect them.
While this might be ok in open markets with real competition, it's possible (and in fact common) for common stock in trending companies to be overvalued on secondary markets.
[1] http://en.wikipedia.org/wiki/Internal_Revenue_Code_section_4...
(1) Public reporting: Once the market for secondary sales gets to a certain point, the company is essentially public. As such, it has to register with the SEC and publicly disclose a whole bunch of information it'd rather not. This used to be triggered by having over 500 shareholders, although I believe the number has recently changed.
(2) Competitors: Stockholders have certain statutory information rights. Although you can limit those rights contractually, as a general matter, you don't want your competitors owning shares.
While there's no tax surprise later on, a company like Facebook can't offer a new employee "an RSU now worth $400K" vesting over 4 years, without triggering over $100K in taxes that second.
Or am I misunderstanding how RSUs are taxed?
http://turbotax.intuit.com/tax-tools/tax-tips/Investments-an...
If I asked for these terms from a firm today, would I get laughed out of the door? (Not that that should stop one from asking).
For instance, if investor is required to travel for Board Meetings they will require company to pay for it. Also some investors will make companies do regular financial audits with a firm of their choosing and force the company to again pay for it.
My biggest questions is, were does the 2% annual fee that investors charge their LP's go? I know some firms have on-site staff to help their companies with recruiting, PR etc, but most don't.
Legal fees for investor related actions don't benefit the company at all unless they happen before the checks are signed.
The legal fees are paid after receiving the investment. If you negotiate for a pre-money valuation, and the terms require you to pay the legal fees, you simply take it out of the valuation.
The VCs can offer slightly more money and have the company pay the legal fees, or offer slightly less and the VC can pay the legal fees. There is no difference between these two things.
May be the case, but unless you can negotiate a deal with your law firm that the fees are contingent on closing, if the deal falls apart you've still got the legal fees to pay, and no investment cash to pay them with.
I'd suggest adding an acceleration clause removing the repurchase right upon founder termination by the company if that hasn't been dealt with elsewhere. Four years is a long time.
Perhaps that's exactly why it's there. If you can't commit for four years, should you really be founding that specific company? Maybe a different idea, or a different team that you are willing to commit 4+ years to would be a better choice.
This is my favorite part. For example if you have an early exits and don't use the pool the founder still is diluted for shares never optioned.
Or to frame it more generally, complexity increases transaction costs.
Huh? That makes no sense.
Incidentally, this SS makes it clear that you are negotiating over essentially 3 numbers (as price per share doesn't matter) in a first investment. And those #s don't change with whether the option pool is created pre or post investment, that just changes how you talk about them a bit.
EDIT: See, like this https://docs.google.com/spreadsheet/ccc?key=0AjHAG0M-0vxXdGt...
EDIT: That is, price per share isn't an independent variable (it can be calculated as a function of the other variables) -- but it can't be arbitrarily set.
1) The founders haven't been working especially long on the company and haven't incorporated (maybe they have an LLC, but not a C Corp). In this case it actually is pretty common for the # of founder shares to be set at the time of investment. Founders pay far less (really just a token amount like $.01) than investors. In this case the price per share is independent (and kind of meaningless. Do you want 3.5M shares worth $1 each, or 35M shares worth $.10 each. Though there are psychological norms people tend to stick to).
2) The founders have been working on the company for a while and incorporated well before taking investment. This is the scenario you describe. I added a 2nd sheet ("scenario 2") to cover this case.
As you can see it also contains no circular references.
As you said price per share is no longer arbitrary here as it's fixed by the # of founder shares created pre-funding. Sometimes you might do a split (or reverse split) here to adjust the price per share to the same psychological norms as above.
Founders usually purchase all their shares up front, so this term says that the company can buy a percentage back if they leave before 4 years.
A: "I want to sell to a third party."
Company: "We have a repurchase right."
A: "Well, I'm selling for $10 a share."
Company: "We don't think that's the right price."
A: "What do you think is the right price?"
Company: "We would need to hire an auditor to determine that, and you would have to pay for him."
Auditors for independent valuation should only come in to play when there is no price, for instance, when a block of shares is offered to existing shareholders or the company and they can't agree on a valuation.
Drag along / tag along clauses definitely can complicate this.
In the case of Sam Altman's founder-friendly term sheet, what you're describing is covered by the 'ROFR/Co-Sale Agreement' section.
The repurchase right here refers to what happens if a founder leaves before their four-year vesting schedule is up - the company has the right to repurchase their unvested stock, almost certainly (although his term sheet doesn't specify) at the original near-zero issue price.
Since founders typically own 100% of their stock for tax purposes (hold it for a year, only have to pay long-term instead of short-term capital gains), the only way companies can subject founders to a vesting schedule is to have the option of buying the unvested portion back.
The standard mechanism for this is accelerated vesting - I think Nivi wrote the definitive bit on it, here:
1) if you want to sell your stock to someone else before IPO, the company has to approve the sale. If they don't like who you're selling to (which could just be because they don't want voting shares belonging to outside people), they can choose to buy it back instead. If they don't like your price (too low or too high), then you and the company have to negotiate a 'fair' price.
2) The company has the option, but is not required, to buy back any unvested shares that you have already exercised if you leave.
http://www.avvo.com/attorneys/20007-dc-eric-koester-1214516/...
There are several pages of articles & you might have to read and re-read a few times. It's dense, but clear.
Thank you very much for sharing this. Two questions:
1) Without an option pool, how do you prevent founders from issuing more options to themselves?
2) On the other side, do the Participation rights include the right to purchase into the option pool when it is created? i.e. is creating the option pool a "offering of new securities".
1) The Board has to approve all new shares, so founders would have to go to a vote in order to give themselves a new chunk.
2) There won't be an option pool created. The participation clause is in relation to new rounds of funding. As new money comes on board, new shares will be added and the pro-rata participation means that Sam will be able to invest alongside the new round to maintain his percentage of ownership.
Shouldn't liquidation preference clauses read more like: "We have the OPTION to get back our capital OR ELSE everything is split pro rata."?
Also... can you explain the dividend clause? I understand the preference (preferred dividends get paid first), but what is the significance of 8% (8% of what)?
If they choose to participate pro-rated they convert to common first, and participate equally with everyone, without the preference.
The investor would chose to convert to common when the sale price is greater than the post-money valuation of the deal. On this basis their pro-rated participation will be greater than the amount invested.
If the sale price is less than the post-money valuation of the deal, they would be sensible to keep their preferred stock, and exercise their 1x preference, meaning they get their original amount back 100 cents on the dollar. The remaining is then split between the common shareholders proportionally (in effect without the dilution from the investor that exercised their preference).
Mark Suster (@msuster) from GRP put together a good spreadsheet [1] that shows the preference effect on sale, including preferred non-participating stock and preferred-participating (PP) stock (essentially double dipping into sale proceeds).
Brad Feld (@bfeld) from Foundry Group has a good write up of the different types of participation on his blog [2].
[1]: http://www.docstoc.com/docs/47831420/Venture-Capital-Valuati... [2]: http://www.feld.com/wp/archives/2005/01/term-sheet-liquidati...
8% of the amount invested. This is a standard term to allow investors to get paid if the company is in business a long time is cash flow positive, but not likely to have a liquidation event. VC funds typically have a 10 year life and need are way to return money to their LPs.
+1 for that - common shares mean non-founding employees have to pay through the nose if they want to exercise early.
Then, for yall, I uploaded the docx in my public dropbox folder: https://dl.dropboxusercontent.com/u/20673425/sharing_dont_de...
If I ever get the chance to invest back into another startup one day I wouldn't think twice to use a straight forward term sheet like this.
I see the point that this is just a price negotiation. However, I don't understand why the form of presentation is so important to people. If you get a standard term sheet that says $2M investment at a $6M pre-money valuation and a 15% pool, it takes about 2 minutes to do the math to see this would be the same as a term sheet that said $2M on a $4.8M pre-money valuation, with the 15% pool coming in and diluting all parties after. The discussion on this thread seems to lean toward the idea that the latter term sheet is more founder friendly. I wouldn't see the latter term sheet as more founder-friendly, I would see them as equal.
Why do VCs continue to write term sheets the standard way? After all, if they thought entrepreneurs would really prefer the latter term sheet, it would obviously be in their interest to write it that way, and VCs are not dumb. I think they think that entrepreneurs prefer it the standard way, they like a cosmetically higher pre-money number, and I suspect they are generally right. I don't think on this matter they expect they are fooling the naive entrepreneur: this is pretty basic, and I doubt many would want to go into business with someone who couldn't grok this.
Now, diluting after but keeping the $6M pre-money... now that's founder friendly! Who doesn't like higher valuations! I suspect this is what a lot of people mean by founder friendly.
> Lawyers
As a founder I disliked this clause, I didn't understand why I had to pay the VCs legal bills. The major bummer on this is that VCs have less incentive to really grind down the amount if the company is paying, I agree with that.
But I have seen a lot of entrepreneurs grind on this particular term, and I think it's nuts to make this a point of principle.
VC's annual W-2 compensation is the management fee minus expenses. In the traditional customary structure of company pays, the deal expense comes out of the invested capital and doesn't impact annual compensation.
When you grind your VC on this point, you are saying this: listen you jerk, I am going to make you pay this out of your personal paycheck this year. And I'm going to make you go back to your partners and explain why, rather than customary deal terms, his partners have to eat their share of this bill personally.
Now, maybe it ought to be that way, I don't know -- I'm more with the other commenters that say what's the difference, just ask them to add $25K to the round size and scale up the pre-money accordingly and call it a day.
But running a business deciding what battles to fight or not.
As a founder, you can work valiantly to ensure that $25K of your $5M round comes directly out of the pocket of the guy who is going to be your partner in building the business for the next 5 years, instead of the family offices and endowments that are his investors, where it is customarily paid, but I think there are other points of negotiation you'd get more leverage out of pushing. Ask the VC to gross up the round size by the attorney's fees and use whatever leverage you have on more important points.
Incidentally, "company pays" can be a reasonable structure for angel investors as well as VCs: Say you have a $1M round with all angels, and for some reason your deal can't use one of the free open source docs out there. If there is a need for a lawyer (let's say you are raising from US investors but it's not an American company and they might reasonably want to understand any risks associated with this): if your lead investor is putting in $200K and then 16 other individuals are each putting in $50K, it's not reasonable for the lead to be out of pocket on the cost personally, and splitting the bill 17 ways makes no sense either, it would be much more sensible for the company to pay, and if need be the round be made slightly bigger. The same principle could apply to institutional rounds with multiple investors involved.