United States: Guest Blog Post: As VC Funding Cools Beware Bad Term Sheets

Last Updated: December 14 2017
Article by WilmerHale

By: Rajeev Jeyakumar, entrepreneur and VP of business talent, Toptal. Rajeev was the founder of Skillbridge, Inc., a former WilmerHale QuickLaunch program client.

Originally published on LinkedIn on December 6, 2017.

As a first time founder, I remember running from pitch to pitch trying to close that first round of funding, dreaming of a huge valuation that would be clickbait for the press, paper over my entrepreneurial insecurities, and be my user-growth silver bullet.

However, as any good investor and experienced founder knows, for a company to succeed, the deal must align interests of both parties across all future eventualities. This means that much more than the headline valuation must be carefully thought through. Balanced, transparent terms are needed to establish a trusted partnership, and keep all parties incentivized. With early-stage funding cooling how many "good investors" are still active? How does one reliably tell them apart? And how does one effectively assess "fairness"? Most entrepreneurs I know will tell you the honest answer is, it is tough!

In the early days, you are under tremendous strain—you are breathing life into a new company, establishing a skeletal operation, building an early team, iterating toward a half-decent product, and running on ramen fumes. So, from within this compression chamber, how does one separate saint from shark, missionary from mercenary, venture from vulture?

Alex Graham, Toptal finance expert and former venture capital investor, has one of the best makings of an answer:

  1. Find a cave, bury yourself in it, and immerse yourself in homework. Familiarize yourself deeply with not just the mechanics of term-sheet concepts, but also the spirit in which they are intended. Understand the most important terms and clauses, scenario model the range of structuring options for each and what they are intended to protect or avoid. Finally, understand these things from both the entrepreneur's perspective as well as the investor's. A few critical concepts in this regard include vesting, liquidation preferences, participation rights, anti-dilution provisions, drag-along and tag-along rights, and structuring/securities options such as SAFEs, convertible notes, common stock and preferred-common, to name just a few.
     
  2. Thoroughly investigate your financial suitor. Said differently, diligence should be a two-way exercise for both the entrepreneur and investor. Hard as it may be, take the time to critically assess your prospective investor's track-record, reputation (especially amongst other entrepreneurs, but also venture capitalists and lawyers), and capacity to add-value beyond the marginal dollar. And where necessary, find the fortitude to say 'no'. After all, taking in outside capital is akin to marriage—it is challenging even when the parties are well-suited, hell when they aren't, and soul crushing if it comes to divorce.
     
  3. Don't over-weight mindshare on valuation as it is a double edge sword—on the one hand a strong valuation implies external validation, bragging rights, PR fodder and the beginnings of paper wealth; but on the other it can become a trap of your own making, raising the performance bar for successfully raising a subsequent round. That said, go ahead...obsess a little, but maintain balance and perspective – benchmark against other companies, understand the economic/market cycle you are in, be honest about attainable growth prospects en route to a fair number.
     
  4. Get experienced advice—arm yourself with a great lawyer, a strong and supportive advisory board, and let their experience guide you through your process.

In the world of startups, there can be no substitute for the 'school of hard knocks'. Armed with even the best research, advisers and smarts in the world, you must eventually step in the ring and take your licks.

Read more of "As VC Funding Cools Beware Bad Term Sheets."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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