How to negotiate a term sheet Video Lecture | How to Start-Up your own Company (Video Course) - Entrepreneurship

hey everybody welcome to startup basics
I'm your host Jason Calacanis you know
me this weekend startups to launch for
us with all that stuff and I am here my
good friend Todd carpenter and Rachel
profit they are attorneys at Wilson
Sonsini wsg are and you guys run the San
Francisco like hip cool startup factory
not the you know in the valley office
yes we are the co heads of the soma
office some ways we have a great office
in spirit hour as well where our MA and
some where litigators
you know those guys are situated right
who do a fantastic job as well but right
yes where that office people are like
what's going on with that hip office
down there like the other like the
people who work in the big like you know
tower like want to go work down there
and be in the cool office is I like a
point of contention they like their
views actually they're like alright well
listen we are going through all the
important questions that people have to
answer our startups and you have to have
a great attorney obviously and you have
to you know basically just understand
the details of this and one of the
biggest things is how to negotiate a
term sheet I've been on both sides of
this many times so who should initiate
the term sheet and how should that work
because that is something that I think
especially just 10 years ago nobody had
ever seen a term sheet and when one
entrepreneur got a term sheet they
wouldn't even show it to another
entrepreneur that was like could even
could I show it to you that was kind of
like you didn't do that you wouldn't
even show it term sheet to somebody else
now they're all over the web and you
know people are explaining them but who
should initiate the term sheet do you
think it's today in 2014 this is
probably one of the most exciting parts
of our job because this is sort of when
an entrepreneur is most validated in
their sort of steps to date right all
the trials and tribulations I got them
there and usually that overzealous phone
call is if someone's really excited send
us a term sheet we then sort of counsel
them that most likely the terms are
gonna come from the investor who's
really excited and they should wait
patiently and maybe talk with the
investor about what they're expecting
but it's pretty rare I think
preneur to serve up a term sheet if
there especially if they're first-time
entrepreneurs okay and then what should
you be looking for in the term sheet and
what is the purpose of the term sure
because it's back for a minute one thing
I think that is changing and I think
that's why you say this usually the case
is there's the advent of things like
angel list and you have syndicates of
angels yeah and it is changing the whole
ecosystem and you're part of all of that
yeah and oftentimes because there are a
disparate group of angels investing now
its more common certainly than it was 10
years ago where the entrepreneur would
actually be in the right to serve up a
term sheet because there's no one else
stepping up to take the lead so I think
generally it's still the case that
especially if it's a larger
institutional VC firm they will present
the term sheet of course yeah but if
it's you know if it's a seed round or
you know a large group of equipment a
party around sometimes an investor's
putting in you know on average 75 carry
right there is nobody doing the term
sheet so then does it fall to the
entrepreneur make one it says yeah and
as in that that's an interesting
situation that we run into a fair amount
because you know what do you present to
them you want to be reasonable but you
know let's protect the company and the
entrepreneurs to the extent that we can
and just people in those situations even
read it or these angels just all put
their 75 yeah yeah but not even like
check it it depends who the entrepreneur
is and what the idea is right because
sometimes like you said these these
party rounds they're people just want in
yeah they're they're kind of like just
tell me where to sign and send the money
but we do try to you know counsel folks
that there should be some sort of set
bit of terms and opportunity to discuss
with their counsel if they need it and
and it's it's pretty standardized right
we're what what are the standard you
know five items in a term sheet that
really matter
mm-hmm do you think like I think it
depends on what security you're selling
is it a no deal which there's very few
terms there or is it an equity deal yes
let's start with a note what are the key
you know sort of concepts of a note so I
think the key factors in a note term
sheet obviously how much you're gonna
raise people will be interested in that
interest rate although no one really you
know it's there but as long as it's in
the range of reasonable nobody gets to
it what's reasonable typically you know
it's gone down with the Fed rate being
lower so it used to I used to think it
would be six to eight now I think it's
more three to six so the idea is when I
convert this loan into equity if it took
a year and I put a hundred thousand in
and I got 6% I'm gonna get a hundred and
six thousand dollars worth of the stock
that's right that's right
so that's how they should think about it
so you're getting this tiny small
benefit as an angel investor for giving
the money right as a note and it's one
of the key attributes of a loan Ram and
that's kind of what makes a loan alone
that is the maturity date so if you
didn't have it it couldn't be considered
a loan is that right like technically if
you don't have well actually if you
don't charge a high enough rate there
are tax implications there's an ik you
did write that the IRS will apply so you
know we'll have people say well this is
friends and family I want to do zero
yeah you really can't write if it's
characterized as a loan and that gets
into some tricky accounting and tax like
we said in other episodes of startup
basics like why even trigger something
just go with what the standard is at
three four five percent whatever yeah
move on but that's not really that
important yeah so you've got that what's
really important to them is probably the
conversion discount and the valuation
cap which we see almost uniformly now
don't you it's yeah not not two years
ago but now it's red mainstream so the
cap is this is the highest valuation I
will be converted to equity Adam exactly
and then the discount is or how to
discount to whatever the round is but
which one actually gets triggered if one
is higher than the other how does that
work because that's a very confusing
part I think for a lot of people I think
this is to help insulate the investors
from a major homerun on the company side
right so if if you put your valuation
cap at ten million bucks and then the
company ends up again swinging for the
fences and has a series a at a twenty
five million dollar pre-write you aren't
going to be diluted down your seventy
five thousand hundred thousand dollars
it's still worth something right and
it's so you're gonna get you know the
ten million dollar cap in that example
right versus you know you end up raising
an eight million dollar and you're gonna
probably do the discount instead got it
but you usually have the protection of
it's the lesser of the two exactly right
so it's in favor of the investors
anguish taking this huge risk by backing
the come
with a line mm-hmm now what happens when
two years go by because the terms tend
to be two years 18 months 10 suits from
I mean so certain institutions can't
have longer than a year but I think I
think typically it's one to two years
one to three answers I just had this
happen where we were asked to do an
extension yep convertible and I was like
whoa why would we do that right like
let's convert it and they're like well
there's a deal coming or something like
that so explain that what what is the
fear that people have with convertibles
expiring because people have said in the
past like what happens if all these
convertibles happen in the market
crashes or tanks like I said a valid
concern and yeah I mean I think it is a
valid concern I think that's one of the
reasons that that convertible equity
instrument entered the market is because
people have referred to colloquially
these convertible notes is ticking time
bombs because in theory your investors
could call your notes and potentially
run the company into bankruptcy that's
worst-case scenario right and that's why
it's good to do business with investors
that understand the ecosystem and when
you get a request to extend a note I bet
you usually extend the note yeah well I
kind of pushed the entrence like well
why don't we just price the round so why
wouldn't they do that because it seems
like it's in favor of the company to
push it out another year and we still
get interest but I was like what's to
convert why wouldn't somebody convert
the cost well the entrepreneur probably
doesn't want to because they aren't
doing that well right then right in all
likelihood if it was fair point if they
have not raised qualified financing to
cause the trigger to convert then
they're sideways
yeah they're probably not doing well and
they want the extra runway so that they
can raise an up round and convert at a
higher valuation right it's gonna be
Oceana against themselves technically if
they went to you and said what do you
think I should convert that right they
might write want an outside person to
come in and put a higher valuation on
but you will see in some notes people
addressing that up front that if we hit
the maturity date and there has not been
a qualified financing then the note will
convert at a predetermined rate ah with
that rate be the cap or lower than the
cap I guess it depends yeah I'd say most
often it's the cap and it's a fallback
to common stock but it's a voluntary
conversion
so the the lender can say fine I let's
just get rid of the note I'll take
equity and you can move on with your
company and sometimes they even pre
negotiate you know a series of preferred
stock that into like a you know series a
a I think Y Combinator and occasionally
puts that in there yeah so that's what
this new safe document is from YC Y
Combinator the accelerator right II
called safe doc safe is if you're
similar to the capital contribution
agreement you and I have done some deals
on that before it's very similar to that
it's just kind of the next iteration of
it so it's a hybrid debt equity
instrument where it doesn't have a
maturity date or interest and it will
convert into a future round of preferred
stock
now these convertible notes of these get
instruments why do people do those above
pricing around I mean that's like a
common question and I literally just was
in a meeting this afternoon where the
people who are doing the startup said do
you want us to price the round we do
want to do an ode and I said you know I
I leave that up to you I'm comfortable
with either but I just thought to myself
it's five six seven years ago people
were screaming up and down don't do
convertibles don't do convertibles it
was like foreboding and now it's the
standard I mean I think there's a
variety of reasons I think it's usually
cheaper and quicker to raise convertible
notes there's a lot of less terms and we
haven't talked about the equity terms
yet but there's far less terms to sort
of think about negotiate and draft into
documents and also it does kick the
valuation can down the road right I mean
yes there's a cap in there but that
doesn't necessarily mean that that's
what your new round is gonna be and to
Todd's point from earlier there is a
world in which you just kind of want to
put a pain and evaluation discussion and
build a product and get it you know
proved and then go raise money based on
that success yeah and so why were people
so against these convertible notes and
why do you think the industry has
changed
I think people have changed their tune
and are more accepting of them because
they've built in these terms is that
that protect them from the downsides
that they were really worried about like
them runaway valuation you know you
would have these companies that someone
would invest you know a hundred thousand
dollars an angel would invest a hundred
thousand dollars and then
the company would get into one of these
fantastic accelerator programs and on
demo day they would get a you know forty
million dollar pre-money valuation
before developing a product right and
suddenly the guy that took the biggest
risk at the hundred thousand dollar
investment you know his percentage of
the company's so very low right I mean
he's not properly compensated for his
risk if he just gets a 20 percent
discount that's exactly what happened
with I think the first one if I'm
history serves me correct was technorati
I don't want you to speak to it but
there was a whole Technorati
brouhaha because all these people I
think Marc Andreessen and a bunch of
other people had put money in and they
converted everybody at 30 million which
was spectacular and people were incensed
and people were pissed in the valley
about this I don't remember that but it
does seem like people have changed and
the device has gotten better okay let's
talk about what's okay to do with the
term Shane what's not because I recently
had a situation where somebody got an
inside around the existing investor gave
a term sheet to the founder and said
don't drop it and they didn't shop it
and their competitor was like how the
same performance got a shock their term
sheet and literally got a four-time
valuation which put me as an angel
investor through the roof about this
like I went crazy on the VC firm that
did this like should I put their lawyer
at the roof - I'm not gonna be involved
in suing anybody ever but I will never
do business with you again is what I
told this other VC firm and I'm at war
with them right now over this when
should you shop and not shop and what is
the etiquette around this and how do you
communicate that as an entrepreneur do
you think my own my theory is any
insight lead round should be shocked not
wiser because you're conflicted right
you're already an investor in the
company theoretically you're sitting on
the board you don't have as much of an
incentive to put a high premium from the
company because that's necessarily gonna
mean it's gonna cost you more to invest
more and it's gonna be you know
potentially more diluted to in a
different way right so I think then it's
also just good practice right because
again let's be mindful what we're doing
here which is trying to build an
enterprise it's a growth enterprise it's
gonna maximize value for stockholders if
you're are sort of on that right
trajectory and you're sort of doing
these are the inside deals I mean
I know you're not gonna be involved in
suing people but there's plenty of other
folks that would be and do see ya like
because I had other people tell me you
know that's probably actionable if they
ain't told the founder to not shop it
and then I got on the phone with it like
we didn't say that I was like well the
founder told me you did it and they're
like are you gonna blog it are you gonna
tweet it I was like norms we're talking
about on my show with a bunch I'm not
gonna ever say it I'll never bring it up
in terms of the names of people but I
just don't know if I could be in
business with you ever you know other VC
firm so well I will say yeah I'll come
to this theoretical parties somewhat
defense and say that it is quite
standard in a term sheet to have a no
shop provision okay but that's once it's
signed
so once you've negotiated and generally
what will happen is the entrepreneur
will do the quote shopping before they
sign any term sheet and so they should
go to a market check and make sure that
they're getting the right deals they
should be bringing them they shouldn't
feel bad about that yeah everybody
expects that yeah the walk up and down
you know Sand Hill Road that's that
store that you should be doing that in
order to make sure that you're getting
the best outcome for everyone involved
you rigueur by the way for people don't
know is French for don't be stupid
no actually happens when you sign that
term sheet so what are you actually
agreeing to that's that's a very good
point and so there if you look at any
term sheet at well written term sheet at
least there should be a provision either
at the beginning or it's usually Bank
banging or ins and it will say this is a
non-binding term sheet except for a
couple of provisions which are usually
confidentiality no shop and sometimes
fees and expenses
god I'm and those are binding agreements
between the parties so the company and
the investor and the key from the
investor's perspective is like look I've
committed to this I've put in a lot of
time and effort um I've spent legal
dollars to negotiate and sign a term
sheet let's get this deal done and
frankly 98 percent of venture capital
deals that get to that stage do get done
because people work together
collaboratively and and that's kind of
the name what's the two percent when did
the two percent not get done if
something really unknown comes out so a
big diligence
there's an IP infringement problem or a
problem or just something that was just
an unknown at the time that they entered
into the contract and they just don't
want to invest on those terms and so in
that case the VC says to the founder
it's it's non-binding so yes it's you
know they just usually walk away and say
you know thanks if you can address this
problem you can find a workaround happy
to talk again but it's not the deal that
I thought it was investing now what
happens when it expires because I've
been in this situation as well where I'm
trying to close the deal now we're at
day 31 mm-hmm and I'm getting close to
closing but hey I'm no longer it's no
longer binding to people file extensions
if they don't file extension would you
be out of school to go talk to another
person have you seen that happen
probably less common for that to be a
major worry in a fan of financing
context versus an M&A deal but I think
the idea once we sign it is we're all
going to negotiate in good faith and
work to get to the outcome and at odds
point like it's extraordinarily unusual
for deals not to close it would be you
know not a not advice we'd give which is
oh you have another party that's gonna
give you a higher valuation just slow
roll the docs and wait till this to
explain right you should probably have a
really important really poor taste right
and you would you keep bringing up good
faith and so I think this is a really
important point to talk about which is
you have a long career and so they and a
lot of times young entrepreneurs maybe
lose sight of the fact that like hey you
gonna be here for decades probably if
you do it right and a very small
ecosystem in a very small ecosystem and
I can tell you there were things I did
earlier in my career that were
aggressive or you know I've been known
to be a little blonde and like sometimes
like they were like hey you wrote this
thing back in 1999 or 2000 do they bring
it up with me 15 years later you gotta
be careful about this right absolutely
even if it's just one company you gotta
think about the path to an exit these
days it's getting longer and longer so
even if you are relatively on the
conservative side and say it's gonna be
five to seven years you're gonna be a
partnering with these people for that's
a long time you don't wanna leave a bad
taste in anybody's mouth when you're
doing these negotiations right so let's
talk about that who tells Sequoia or
Bill girly at benchmark when they get
that term sheet from like rule Bell
or some major person and they say yeah I
would like a couple million more dollars
or I want you know do they have their
attorney do that or how would you advise
you know I found who says like this term
shoots a little too low and I got a
higher one but I want to go with the
lower one cuz I like that firm better so
like the dinky like VC firm nobody's
heard of his outfitting Sequoia or
benchmark or Excel or you know
Chema that social capital party I'm like
can you come up to this level how do you
negotiate that and do you have your
attorney do that or do you do that
probably ends on the person right I mean
we both have played that role sometimes
we can counsel them in the background
and give them sort of the insight and
the data points to go back and talk to
them because I think sometimes the
introduction of lawyers overly
complicates things
yeah but in other times they said look
I've kind of made it as far as we can
make it and I need you to deal with them
or deal with their counsel and I think
it's really an entrepreneurial
preference so if we were on the phone
right now and I'm like counsel for Chema
Thor something like you would call
counsel for a month or you would call to
mouth and just say what like Jason would
like another two million dollars I think
the reality is look it's a deal that's
got a lot of interest and you're the
preferred partner you clearly are gonna
add more value they you know all the
other nice things you want to hear right
that's got to be accompanied by but the
price to get there is going to cost a
little bit and maybe you don't have to
get all the way to the competing bid
because again they want you to be there
but right but you're gonna have to get
closer otherwise no again we've got it
take them
theoretically the better deal on the
table yeah so that sounds very nice
actually the way you said price you have
to go back to the entrepreneur say
listen that's the best price yeah and as
a point we're going to talk about
earlier which is you don't always have
to take the highest valuation in fact
I've had clients turned down someone who
throws in this outrageous bid just to
get the deal because you need to pick
the best partner I mean I have to Todd's
point I mean you're going to be
effectively married to these people
until the end of time for your company
and it's very difficult to get out so
you really want it the best partner for
the long game that's happened to be so
many times like both sides and now how
do I deal with that as an angel I need
some free advice here from Dennis
because I let's face it like if people
think I'm investing it kind of validates
a little bit I'm not making a big deal
out of myself but I'm more
ten best angel investors out there
probably objectively today so if I say
I'm going to invest in something it kind
of pushes the price up invalidate so
what what should i do because i'm not
doing term sheets or binding anybody
anything how do I protect myself or how
do I have that conversation but you
probably should be if you are pricing
rounds in setting terms for going back
to the party round discussion we had
before I think you would be doing
yourself and the entrepreneur a favor
and having these things be organized and
and within those terms you could very
clearly state the things that you want
for your protections I mean you may want
a board seat on some of these companies
you know but I think communicating those
expectations up front and making sure
that you and the entrepreneur are on the
same page and then that brings everyone
else in the line around you exploding
term sheet is that still common like you
have 48 hours this time this people
still serve them up but I advise clients
it like if that's really the case then
this is probably not the partner you
want to work with if if someone's not
gonna give you the time that you need in
order to understand the terms and be
comfortable with them I really think
that the key here is getting engaging
with a partner that's going to be a good
long-term business partner right and
someone that won't allow you to digest
things properly and is trying to overly
pressure you you know sometimes you're
in a situation where that's your only
option and then you can't do much about
it but if you have other options I think
you should explore them and make sure
that your do the best VC's do that so
you see the best VC is give these
exploding term sheets or is that
something about like the more desperate
VCS there's usually an end time periods
didn't want this offer out there right
over to ax t right because god forbid
three weeks later they get assigned they
already replaced the deal right in their
pipeline but usually I mean there's a
week to think about it and I toss points
about on I mean they need to talk to
their advisors or you know I'm sure you
do advise a lot of startups and they
want your opinion is this what you're
seeing in the market it was a reasonable
amount absolutely that's probably a week
I and most good VC is if if people are
still negotiating in good faith are
happy to push that out it's really as
Rachel said so that you don't have a
document floating out there that's
accepted in your way further
down the line than you anticipated and
then you're somehow bound to do a deal
or you feel obligated yeah so Wow well
this is like I think this is one of
those issues term sheets and negotiating
them and all these deals that we could
talk about for an hour but we have to
stop at a certain point this is a
tremendous amount of information Thank
You rachelandtodd and we'll see you next
time on star to basics thank you