Congratulations. You’ve made a compelling case for your company to receive funding, investors are interested, they’ve done a couple of rounds of due diligence and probably visited you and your team at your site – if there is one.
Next step is a Term Sheet. Here are the pressure points within the term sheet that you and your lead (such as TechCXO) need to be prepared for:
The simple truth is that your early-stage investors typically have more leverage than you. They look at hundreds of deals and fund a handful. However, you’re not necessarily weak. Having interest from multiple suitors greatly strengthens your hand. Just remember not to dig into your position too hard. Investors are used to walking away from deals and you want that capital. Word travels fast in this small community, too and you don’t want to be cast as a hard case.
Our guidelines remain: no more than a 25% equity for investors in the Angel/Seed Round and no more than 30% equity in the Early VC or Series A stage.
Using traditional industry comparables as you would for M&A transactions is tricky for start-ups. Generally, the more mature your company and its metrics, the better the valuation. Some metrics such as cash flow and revenue may apply. Some metrics may not be available and you will need your Structure and Performance hurdles to aid valuation. The assumptions made and agreed to within those hurdles such as customer acquisition, revenue, retention, profitability, etc. will help set your valuation.
One to two Board seats to investors is the norm. There is an increasing trend of an equal number of board seats going to independent members, with the founder/CEO as the “odd” member of the new Board.
The Option Pool
The purpose of the option pool is to provide incentive for management, key employees, and advisors. This range can vary based on how many of the management members are also founders and have founders stock.
Many firms provide options for all early employees – typically under the assumption that they are being paid below market cash compensation and are in a volatile employment environment. With each new raise, the option pool is refreshed to ensure that there are adequate incentives for key new hires.
For stock option plan composition, a good rule of thumb is for 15-20% of the capital structure reserved for the option pool at this stage. Even better is if you can get this post-closing, so the new investors and founders share in the dilution. With further rounds of financing, this pool may get down to 10%. Target half of the pool for the leadership team (CEO, Board Members and direct reports to the CEO).
Key Rights and Preferences
Rights and preferences can get you down into the weeds. You’ll certainly need advisors to help you sift through this. Here are some quick highlights:
- Liquidate preference – usually 1X original investment
- Participation – conversion to common after the payment of the liquidation preference in order to “participate in the remainder of liquidation proceeds”
- Anti-dilution rights – to protect against future issuance of equity securities at a price below the price the current investors are paying
- Board of Directors participation – either board seat or observation right depending on the size of the investment and % of the company owned post investment
- Veto rights on certain corporate transactions – preferreds vote as a separate class on things like senior debt, issuing additional securities, liquidation
- Information rights – monthly/quarterly/annual reporting of financial results to investors
- Registration rights – ability to register shares in the event of a public offering
Structure and Performance Hurdles
The primary questions to be answered are: how big is your market and how much of it can you capture…and in what time frame. This is why we stress defining market niches so much during your preparation for funding. Other considerations such as the development of new applications and adding key team members can be factored in but there’s no getting around competing and winning in your defined market.