Negotiating a Win Win Deal in Every Term Sheet
Paul Hsiao, General Partner @ Canvas Ventures; Julie Lein, Managing Partner @ Urban Innovation Fund; Emily McCormick, Reporter @ Yahoo Finance
Ascent Conference 2019
Emily McCormick [00:00:04] So let’s just start high level here. You have a deal on the table. It’s time to iron out a term sheet, or is it because, Julie, one of the things that you’ve mentioned is that maybe not every company is actually in a place where a term sheet makes the most sense.
Julie Lein [00:00:19] Yeah. Hey, everyone, it’s great to be here. And it really interesting topic. So my name is Julie. I’m the co-founder and managing partner of the Urban Innovation Fund. We invest in early stage precede in seed stage startups that are shaping the future of cities. So in areas like transportation, real estate, tech, the future of work, and the reason that I ask the question whether every deal needs a term sheet is at the early stage. You don’t always need a term sheet. In fact, you could set your own terms and do it through a safer note. So that’s what I was throwing out there.
Emily McCormick [00:00:50] One of the things I want to ask about just piggybacking off of that with a safe note, though, when you’re kicking that can down the curb and you’re sort of pushing off that valuation that’s being made by a lead investor, is that actually going to cause issues for a company down the line since that is, of course, one of the trade offs with the safe note?
Julie Lein [00:01:06] I think it’s now so pervasive in the early stage financing landscape that I think many investors have a preference to price it just so you know where you stand. But it’s now so commonplace and especially with post money caps, safes, where you actually know what the dilution is or at least have a stronger sense of what the delusion is. I don’t think it creates as much of a problem. And plus it’s a lot cheaper for early stage companies and faster. So I think that’s why a lot of startups have moved toward the safe or convertible note model at the early stage
Paul Hsiao [00:01:39] Emily, I would just say two things. So I think the two issues we’ve seen with the converse over the years, we had one company that had about five million dollars raised through convertible notes.
Julie Lein [00:01:51] One hundred and five?
Paul Hsiao [00:01:53] Yeah.
Julie Lein [00:01:53] Oh, my God.
Paul Hsiao [00:01:54] And so that particular one took it to. And could a lot I mean, it was hard to convert into equity, so that’s sort of one thing to encourage you to do that high quality problem. Nevertheless, I would say the other thing that we typically see the founders don’t recognize to convert is the ultimate solution that you you sort of have to sort of go through when you get to the equity realm because everything’s a price ceiling and you just you forget how much dilution you’re taking. So that would be a very typical gotcha. I do agree with you here that if you’re sort of raising below a million or to convert, as far as you know, I think Fenwick and a few others have, you know, this was a product of Y and they’ve done a good job. But if you’re really raising more than two million, I think this is to your benefit to get actually a price from Pigott as well as Susta terms as some of the conditions very clean going forward for us.
Julie Lein [00:02:52] I definitely agree. And one thing that I would just throw out there for consideration is a lot of companies have started doing cascading caps so they’ll raise notes or safes and they’ll, you know, try to incentivize folks to get in earlier by doing the first half million at one cap than the next one, another cap. And I think that’s where you can get into a lot of problems around dilution and not knowing exactly where you stand. I think that the attempts to put out a post money save or post money cap save has helped with the situation somewhat. But I agree this idea of just doing a lot of notes or saves and piling it on without recognizing what the dilution is, I think is not beneficial to anyone around the cap table.
Emily McCormick [00:03:32] Sticking with that topic, how much dilution is too much? And I know that’s going to vary between rounds between the size of the company was between the size of the amount raised. And how do you factor in just this notion of the option pool being able to incentivize new employees to come to the table? How do you fit all those pieces together? He will start with you on this one.
Paul Hsiao [00:03:50] Yeah, I mean, look, when you get a term shell, I would just say, having been in intrapreneurs see twice now, you take a deep breath and say, thank God someone’s going to fund my business. Right. So let’s just start with that first. It is hard to raise capital out there, right? I mean, a lot of people try roughly only 7000 companies get venture back in over a year. So I would sort of pat yourself on the back a little bit on that. I think the question about dilution to your question, Emily, is so much of it is actually about supply demand that if you have a lot of demand and you can actually drive the dilution to your advantage, this is a really subtle point. That is a nonevent, just like 15 years now is always about if a lot of people want to get an extra float and you demand is double or triple that, naturally the your primary price goes up. It’s as simple as that. And so let’s do something. Remember, when you get to before you get a term sheet, most of the work is about driving the process so that you could have multiple terms. She o at the same time, not sequentially. And that was sort of best determined other than on the dilution. I mean sort of the rule of thumb, 20 percent, 30 percent sort of star sort of goes up on there.
Emily McCormick [00:05:08] Julie, do you have anything to add to that?
Julie Lein [00:05:10] Yeah, I would just say that. So where we invested the preceding seed, I would say that seed is less of a stage and more of a continuum. Now, TechCrunch said that over the last year, the average startup raises about five point six million before a series, and that’s rarely in one round. But, you know, just pause to think about that. That’s nearly six million dollars before you go on to raise a series, which is a lot of money and frankly, a lot more than a typical seed round. And what we’re starting to see is that, you know, a company may get started, they might bootstrap, raise some friends and family and maybe some angel funding. Then they’ll do a precede, which is typically less than one point five million nowadays. And typically the dilution is fairly low. But, you know, you’re giving up some percentage then they might do, you know, a more typical seed round, which is now one to three million, although, you know, frankly, they’ve gone up in size and that’s usually where we’re seeing somewhere between twenty and thirty three percent overall dilution. And then they might do a seed to a post seed mango seed or whatever you want to call it. But, you know, there’s more and more of these rounds that are, you know, essentially trying to build themselves as a discount into the series. And so when you add on all of those kind of interim rounds, you may be giving up quite a bit of your company. And especially if you have done it in the form of convertible notes or saves, you may not have a strong understanding. So make sure you do work with your lawyers to really understand what you’re giving up and that you’re pricing each round accordingly. And frankly, the benchmarks have gone up. You know, I understand why startups are raising more capital before the series because it used to be that if you had a million dollars in recurring revenue, that was a really nice threshold for a series. And I do think that the benchmarks continue to. Higher and higher, and so it’s appropriate to capitalize yourself more so so that you’re more attractive for a serious investor.
Emily McCormick [00:07:06] When we think about valuation, and especially a lot of these companies have been making news recently, just these overexuberant valuations that perhaps started in the early stages of these companies, they just continue to have these up rounds. Are we seeing that more anti dilution protections are in place? Because at the same time, we do have quite a number of unicorns in recent years that have undergone down rounds, have had to have these investor protection. So what has been the trend there?
Paul Hsiao [00:07:31] You know, I think the institution has always been there pretty much every term sheet and is sort of they call it a sort of average weighted institution delusion and is a fancy way of saying there’s a simple mathematical formula if it’s at a lower price, you were existing and thus the investors coming in are compensated for sort of the risk to took. So I think the high prices that you’re referring to, when they raise money at a lower price, you know, the what people are negotiating, perhaps you might be alluding to is the liquidation of funds. When there’s an exit, that’s where is beginning to kick in in a higher price rounds. But I think in the early stage of assuming folks in the room are sort of still in the early phase, see, a would be those things are those liquidation preference haven’t quite kicked in, whereas it was very prevalent back in the 08 03 timeframe.
Julie Lein [00:08:24] Yeah, we don’t tend to see it or do it at this early stage.
Emily McCormick [00:08:27] And Julie, when we look at some of the term sheets that you’ve been part of, the negotiations and deals would have been some of the major sticking points.
Julie Lein [00:08:35] Yeah, I mean, I think for founders, the big thing everyone always focuses on, obviously, is valuation, and that makes a lot of sense for your business because you don’t want to give up a ton of your business, especially too early on. I think that one of the common stumbles that founders have is they oftentimes maximize just for valuation, which again, understandable as a founder, but something that you need to think through carefully because you don’t want to create such a high threshold for your next financing round that you’re getting yourself in trouble. And so, you know, for a long time, I think when it comes to and seed precede, we generally think of it as a sub five million dollar valuation seed. We think of it as a sub 10 million dollar valuation. There are definitely a lot of circles where people try to raise that much higher valuations than that. And I think that’s fine. As long as you understand the risk calculation, which is for your next round of financing, if you’re going to raise at a higher valuation round, you actually need to do enough to prove that you merit that 20 million, 30 million dollar valuation. And I just think that becomes a lot harder when you’re early stage and you’ve essentially given yourself a year, year and a half to do it, which is, you know, typically what happens between funding rounds. So just something that I think founders should be cognizant of, which is, of course, go out there, maximize your valuation to the point that you think is fair, but just recognize that it may have implications down the line that you want to think through.
Emily McCormick [00:10:00] Paul, Anything to add to that agree valuation is the biggest sticking point or what have been the other friction points in some of these negotiations?
Paul Hsiao [00:10:07] Yeah, it tends to be an emotional journey where once you raise money the first time you get a term sheet, you’re like, wow, I have to ask for permission for pretty much everything. Right. Money at remember, this is my company. Why are you telling me what to do? So that usually starts there. And then you get over that and then you sort of everyone focus on the details. So some of the protective provisions or what the options for the premium, I think ultimately what you really want to do is figure it out. I mean, you know, who’s giving you the terms sheet? Assuming the person is joining the board, I would really call his or her CEOs and founders that that person has worked with, especially in the ones that have gone sideways, because by and large, people, when it go sideways, a lot of people don’t go back to the legal docs. The behaviors, what they have done before are very consistent. That will give you a really good feel for what you know, everyone goes through bombs. And so seeing how that board member reacts to your shareholder reacts is really, really good, especially with your investor. And so that’s sort of my recommendation. Everyone, you know, I’ve done a lot of times she’s now a villain, goes through a different everyone sort of gets fixated on one other issue. But the really, really smart ones or experienced ones would sort of want to talk to the folks I’ve worked with in the past. And I highly recommend a just a really good practice.
Emily McCormick [00:11:33] Looking big picture, Where are we right now on the continuum between being founder, first, founder friendly and really protecting the interest of the venture capitalist? Have we seen any shift in where we lie on that spectrum?
Paul Hsiao [00:11:47] I think the power shifted to the other side, I would say, what would you say? You probably started about 10 years ago and it has accelerated over the last two years. I think the market on the early stage saw it on the terms are fairly stable. There’s not there’s really not a lot and there’s really not a lot to negotiate here if you just sort of go into Dongfeng work, work, don’t know a good one. One of the this stuff is fairly standard. So there’s not a lot I think there’s a momentum question whether the the velocity of the series crunch is there and then we’re seeing more sort of investment, sort of fund raising takes longer now.
Julie Lein [00:12:27] Yeah, I definitely agree. And I would say at the early stage, the dynamic is definitely a founder friendly one, because, you know, when we make evaluations at the early stage, we want to work with a team. A lot of it is about evaluating the team and making sure that this is a long term partnership that we want to have with the founders that we meet. What I would say is happening in the news now with we work in Uber and some of these others, we’ve obviously had these very publicized, you know, founder run companies that once they started coming up closer to IPO stage, they’ve had a lot of resistance around their founders. And frankly, that hasn’t trickled to my world because we’re too busy wanting to partner with founders to really think about that. I do think that this opens up a more existential question about board governance at the later stage and what you want your founders to get away with. But I do think at the early stage, you know, for you guys, as you think about partnership, I think that there are a lot of ways to run a really streamlined fundraising process, a lot of which has to do with, you know, the partners that you want and making sure that it can go smoothly enough. And frankly, I do think that there is a series, a crunch. I think they said something like it was less than eight percent of companies that received some form of seed funding actually made it to the series, which is obviously very low. And so making sure that you, one, give yourself enough runway that you’re not back out there fundraising, you know, four months later, I see that happen way too frequently. And I think you get investor fatigue and investor burnout as a result and to just making sure that you can do the process really, you know, quickly by doing things like if you’re going to raise a small amount of funding, you know, do it on a safer note, set some terms that seem reasonable to investors and really try to make the process as streamlined as possible. I mean, I think for us, of course, we would love to price it if it’s an appropriately large round. But I do think that there are just faster ways to get it done for early stage founders.
Paul Hsiao [00:14:33] And we’ve got maybe just curiosity. How many people have raised a bunch of money already? Just raise your hands. OK, how many you want to raise money? Got it. OK, thank you.
Emily McCormick [00:14:45] And some of the names that you threw out, the Uber, is the list that we work, names that might be familiar to all of us. Was that symptomatic of a problem in venture capital? And some of the trends that you’ve seen? There is an issue with the founders, the investment banks. Once you get to that point of exit, can you just describe a little bit of what we’ve been seeing in this IPO market this year?
Julie Lein [00:15:06] I think that what we’re seeing is a exuberance that was met with a lot of skepticism, especially for companies that frankly were really high growth but hadn’t found their way to profitability. And so, you know, where I sit in the capital SAC, which is really early stage finding those founders that have a, you know, kind of transformational idea, it doesn’t impact us as much because we are ultimately looking for that growth and momentum. And, you know, really, I would say maniacally tenacious founders that just will stop at nothing to make sure that their business is successful. But I think what happens is along the way, you set up procedures and protocols. So I would say most early stage founders that I see resist having a board until at least they’ve raised enough late stage seed capital or series where they formalize a governance board. But thinking through those things early and often and making sure that you actually do have processes in place to have a well functioning board, avoid conflicts of interests. Think about, you know, having a successful process for each of the subsequent fundraising rounds, especially your IPO. I think those are all things that are helpful and maybe there is just too much exuberance along the way to curtail some of those instincts.
Emily McCormick [00:16:23] Paul, thoughts on this year’s IPO market so far and what we’ve been seeing, especially on the valuation side, especially on where these stocks, many of them trading under their IPO pricing and just seeing those lower valuations?
Paul Hsiao [00:16:33] Yeah, I mean, I think for us, we manage about four hundred seventy five million dollars. We invest primarily in Soozie. We do a little bit of B, a little C, and over the years we’ve been fortunate to help create sort of six of these billion plus value companies, a couple of them more than four billion. Our view on the New York market is actually pretty exciting. We saw data when when IPO that’s been a phenomenal company that the founders of Bill would use very little capital. You know, Mongo DB is done a really heck of a job over the last couple of years. And then you think about peloton, you think about all the other consumer names. Etsy has done a great job here. So I think the New York Taxin for those of you who are building tech companies, New York is actually, from our perspective, is a really healthy ecosystem. They are, you know, some of these names that have had to raise a lot of money, the sort of talk of the town. I would just say that a lot of really good role models here in New York as well. And I that’s where we’re spending a lot of time working with these aspirational Shaam deep domain funders that want to build annexion companies.
Emily McCormick [00:17:38] And bring it back to this term sheet conversation. Then what do you think was put in place to provide for that success?
Julie Lein [00:17:47] I think a board is one of those things where I mean, maybe we haven’t touched on it enough, but having a board, in my experience, has been a really good thing. And I say that not just as an investor, but you do inevitably have ups and downs. And the best functioning boards are the ones that you can turn to during especially some of the rough moments to figure out a really good strategy. So we’ve had a lot of boards that we’ve been on, whether we started at the seed or whether they decided to form one later. I think that it really helps the founders, especially when you’re going through turbulent times and especially when you need some capital and you really need believers who have been there early on. Because, you know, if your business isn’t doing the projections that you had expected and you need kind of cash lifeline, guess where the best place to find it is. Insiders who get it, who believe in it, who think that you guys just needed a little bit more time and runway to really prove it out. And I’ve seen time and again that insider capital can make a really big difference in bridging some of those key moments and opportunities when you’re having downturns. So I would just say having a really strong board and leveraging your board, I think is underrated and has yielded some great outcomes in my experience.
Paul Hsiao [00:19:00] What a great question. I would say to the company, you build a company, we build the people you have on the bus with you. So where we tend to see a small sort of is smaller on the option. Pol. Sci. in New York, where it’s just you want to hold on for more, which is OK, but just think about the equity that requires to truly recruit a great team with you to build the company. And so that is that was sort of the foundation for years to come. If you could have amazing people around the table with you.
Emily McCormick [00:19:38] When we just look at processes, how much of the information, the deals, everything laid out in the term sheet actually gets finalized in those legal contracts. So, I mean, this kind of goes back to that first question of how necessary is the term sheet? How much of that becomes more binding?
Paul Hsiao [00:19:55] I would say about 90 percent. Now, some people have gone to the oversimplified one pager, you know, this a fluctuation between a one page and five is all trying to communicate the same. I think for those of you who haven’t picked up on doing a commercial here, wrote a really good book, you should just sort of pick up a book on how to sort of read the terms of what is one page of six page one page. It tends to create more problems down the road because there’s just a lot of things not truly floorshow. It looks simple on the way in, but actually creates more legal fees down the road, but otherwise usually is about 90 percent. For us.
Emily McCormick [00:20:30] It’s about right. Would you say that that’s about the right proportion?
Julie Lein [00:20:33] Yeah.
Emily McCormick [00:20:34] How about transference?
Julie Lein [00:20:35] Yeah, I think that’s right. I mean, I guess I would say at the early stage what we see is, you know, either founders who come up with their own terms and they basically shop it around to investors and say, hey, join the save for no at, you know, a four million dollar valuation cap. We’re trying to raise five hundred K come on board or don’t come on board, basically. Or you can come to investors saying, hey, I have a term sheet from X firm and you know, it’s a price down. Here’s the valuation, here’s all the terms, you know, get on board. And I do think that there’s some momentum that’s created by actually having that term sheet and saying, you know what, a sophisticated investor came out. They put out terms, they’re taking governance role. You know, they’re just a level of sophistication that and frankly, it gives you confidence that somebody is really holding the hand of the company. But I think, again, you could get it done either way at the early stage.
Emily McCormick [00:21:27] How much negotiation is too much negotiation? Because you probably don’t want to accept every term as it’s laid out in the initial version, but you probably don’t want to contest everything either. So what is that right balance?
Paul Hsiao [00:21:39] Well, you have to do a deal that you are happy with, and this is where advice and sort of what your understanding of the market really matters. We have seen entrepreneurs get bent out of shape because his friend says something to him and it just got stuck in the head. And then years down the road, we laugh about it because it’s like a lot mean advice, which is terrible. So the negotiation usually kicks in when someone else’s voices in your own head. And so I would just sort of advise when you get advice from others, talk to funders will raise money, not those who have read TechCrunch or articles or hearsay. Everyone is an expert in this field, especially when it comes to terms. I would just highly encourage you to really understand nuance, because to negotiate this is you negotiate roughly 15 things all in balance here and don’t let one thing weight the others.
Julie Lein [00:22:46] Yeah, I would say, look, there are times where people are really passionate about certain elements and, you know, whether it be around compensation or the way that, you know, vesting works or, you know, there are certain things that you can get kind of hung up on. But at the end of the day, to Paul’s suggestion, you know, just keep in mind the fact that both sides want to do the deal. You know, the fact that a VC came to you and said, we want to partner with you, that’s not a light thing. I mean, that is a very long term relationship. It could be 10 years, maybe even longer. Of course, nobody wants it that way. But, you know, it can be a very long term thing. And so just keeping in mind that both sides want to come to a reasonable outcome, and that means that there will be compromise on both sides. But ultimately, it’s a it’s a really great thing and hopefully a very positive partnership for the long term.
Paul Hsiao [00:23:36] It’s a hard thing to do because in the capital, I’ve been there as well. It’s one thing to remember you cannot fire your shareholders or board members. So just remember that pick, you know, pick your shareholders carefully.
Emily McCormick [00:23:49] And maybe if you could each kind of go back to one of the actual experiences that you’ve had with a specific company. Just to put this in perspective for the audience, you know, what was maybe an instance where there was this hurdle, there was this friction point in how were you able to negotiate that and find a middle ground?
Paul Hsiao [00:24:05] I would say we recently created a company and, you know, the sort of a disagreement to Julie’s point of evaluation. Right. And the sort of the benign aspro was maybe. Three million dollars, which in early stages could be a lot, and how we got there was effectively would just say, look, we know this is market, your friend sort of disagree here are sort of disguised examples of all the dilutions stuff folks take after raising X dollars in a similar space. So in that case, it turned out to be easier to resolve because it wasn’t just sort of an opinion thing that you could actually and then did and you had to sort of think about whether that was sort of what he was willing to take or what he wanted to continue to sort of effectively raise and trying to get a better price. And so that in that particular case, we were able to just generate a market data to resolve them.
Emily McCormick [00:25:08] Julie, I’ll give you the final word to you.
Julie Lein [00:25:10] I would say one of the things that we see very commonly is, again, when founders are maximizing for valuation, they’ll come to us and, you know, they might be pretty early on in their product kind of development in sales. And then they’ll come in and say, hey, I want to raise a series A, you know, I’m raising 10 million bucks at a twenty five million free money. And I’ll say, OK, that’s not my stage. You know, we invest a precision seed and for where you are is a company. I you know, this isn’t just me being biased, but I’m trying to be genuine. You know, you don’t have that much in sales. I think you should be thinking about a seed round and, you know, the company will go off, you know, pitch a bunch of Ceruzzi investors and then they’ll come back six months later, you know, saying, oh, we decided to change tactics. We’re raising a seed now. It’s two to three million. And at that point, I mean, it happens quite frequently. And I think you lose a lot of credibility in the eyes of the investors, because to me, I say, OK, I appreciate the fact that you wanted to build a big company and you wanted to bring in more capital. But were you on appealing to serious investors? Will you be appealing, you know, if you go back out 12 months later? And so I just think that being thoughtful about both the size of the raise as well as the valuation for where you are as a business is really important because, you know, you kind of have one chance to really put yourself out there and give people a first impression. And you don’t want to come across as somebody who, you know, just kind of misestimated the scope of what you can and cannot raise.
Emily McCormick [00:26:38] Amazing. Julie Lein, Paul Hsiao, thank you so much for joining me. I’m Emily McCormick. Thank you all.
Paul Hsiao [00:26:43] Thank you.
Julie Lein [00:26:44] Thanks, Emily.
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