Now switch the preferred shares to common shares and eliminate all liquidation preferences and you'd have something closer to a fair term sheet template.
No young start-up should ever agree to preferred shares or any liquidity preferences. This is the next great battle for founders to win over venture investors. To push that risk back onto the investors where it should be instead of allowing the investors to unduly offload even more of their risk onto the founders and early employees.
Liquidity preferences should have never become common with start-ups, they should be quite rare. There is no more important territory for founders to be focused on taking back from venture capitalists than that. Liquidity preferences are a routine source of screwing over the founders and early employees. YC could do something tremendous for founders by fighting on their behalf to put that shifted risk back where it should be: with the investor; the founders and employees already shoulder enough risk as it is.
2) This is a 1x non-participating liquidation preference.
Plenty of folks sign term sheets with MUCH WORSE preferences. Participating 1.5x etc.
This preference simply says, investor gets their money back if invested on a preferred basis during Series A.
That's where the real problems often come, participating preferred at 1x+. This is not one of those term sheets.
3) Fair is what is available in the market that is not misleading. A 1x nonparticipating preference is much more logical than many other approaches, so is easier to understand. And yes, if you take 20M from a Series A funder and sell for $22M, you are basically going to get $0.
There's no such thing as "standard". "This is a standard contract" is something lawyers say to get you to agree to things you may not have otherwise agreed to.
I'm not saying this flippantly. I've negotiated many contracts over the decades and I've heard "this is standard" dozens of times, but it's always negotiable.
Note, I'm not saying the agreement presented is fair or not. That's situational. Just that "it's standard" is irrelevant.
Which is why "standard" isn't an especially useful term; the better term is "market" --- what similar deals, negotiated repeatedly by people with similar leverage, have settled out to. These terms seem somewhat better for founders than market (but YCA might have unusually strong startups).
If you've negotiated many term sheets for Series A with not even a 1x nonparticipating liquidation preference - impressive.
That said, also illogical, why are these investors doing a preferred investment vs common if they don't have a preference?
The only people I've run into who can negotiate nonsense contracts are folks playing with other folks money (family etc). I will say I stay far away from those types of folks. Often crazy, and often have enough money to pursue their flights of fancy, including ungrounded legal theories, a good long distance.
Preferred investment can generate a yield and/or can take priority over some but not all other equity. I’m not saying it’s a good deal...just trying to answer your question.
Not sure why the downvotes. The reality is preferences are what poisons employee equity grants and is what ends up surprising people when startups end in any way other than spectacular success.
It’s unrealistic to do away with the common/preferred split, but protecting founders and perhaps some key employees as well as banning any kind of participating preferences or ratchets is a good place to start.
Participating preferences are bogus - obviously, as are > 1x in most cases.
This term sheet is nonparticipating 1x. Despite the first comment in this chain, this is actually a very reasonable approach, and preferred stockholder is always going to have a preference - or there would be no point in being preferred.
I agree, I don't expect any shift against preferred shares (although I'll always advocate that direction). I do think ground can be reclaimed on the liquidity preferences. That particular area in VC today is so frequently egregious I don't think it would be very difficult to rapidly improve it.
Yeah excessive preferences do exactly this. But it's not the preference mechanism as much as what the preference does in relation to business value. Assuming liquidation preferences are 1x, what it means is that the company needs to build value that is well in excess of the amount that's been raised. The reason people end up surprised is that the amount raised is not always transparent, nor is the value of the business.
How does a VC deal without at least a 1x liquidation preference work? The founders have taken $X from investors and control the board. What prevents them from selling the company and pocketing their share of $X? In what way is a 1X liquidation preference unfair?
Well, selling the company for the post-money valuation will give the investors their $X back. The thing that the liquidation preference works is preventing certain types of control fraud.
For example, if the founders take $1M in funding on a $2M post-money valuation, then end up losing $1M to excessive payroll costs to insiders and sell the remnants of the company for the pre-money valuation, the investors are out half their money without a liquidation preference. In short, the liquidation preference means that any losses come out of founder equity first, rather than the new cash infused in the business. This is important because the founders control the company and can choose to take courses of action that impoverish the company at their personal benefit.
Right, that's an example of the scenario I was referring to and why I pointed out that in the scenario we're talking about the founders retain control of the board.
The broader point is that investors should eat the same dog food as the founders and early employees, including when it comes to common shares and no liquidity preferences. The fairness point you asked about includes removing preferred shares, you're splitting it as though I was only talking narrowly about an issue of a 1x preference. I fundamentally disagree with start-up investors receiving preferred shares as a norm.
I think YC should take the lead in trying to strip liquidity preferences from the industry. They should become non-standard in most term sheets. Ideally they advocate up the chain further by leveraging their considerable influence to water down or eliminate liquidity preference whenever possible. YC has been a founder-friendly venture firm from the beginning, I believe one of the best pro-founder fights for them to pick is to work toward ending the standardization of liquidity preferences. It's currently backwards, liquidity preferences should be rare.
I can't tell what you're saying here. You say I'm focusing too narrowly on the 1x preference, but then go on to say you disagree with preferences at all. I asked: how does a VC deal with no contractual investor protection work? You could be giving up $X in exchange for contractual rights to only $X/5 in a sale that occurred the next day. That's not a moral problem, it's a math problem, right?
Query whether this needle can't be threaded by allowing the board to waive liquidation preferences, so long as the investor board member(s) approve. I agree with you that a certain level of investor protection is needed to prevent fraud (obviously there's the threat of a lawsuit for breach of fiduciary duty, but there are many reasons why that would not be a reasonable substitute for a liquidation preference).
The question I have is when the founders have acted in good faith and the company goes downhill, should the founders bear all the downside risk there?
I can see someone saying yes - if the company goes south, everyone should get the money they invested as shareholders back. But that's a different argument.
An additional question I'd ask - is some method of waiving liquidation preferences by the board (again, including the investor board member) a good idea from the perspective of aligning incentives?
Let's say the company has seen a downturn where there are two options at play: a sale at a value that would give the founders nothing, after the liquidation preference is exercised OR a risky (but legally defensible) Hail Mary business plan to bring the company back from the brink.
If the founders get nothing out of the sale, aren't they incentivized to choose the Hail Mary option? (Obviously there are other opportunity costs for the founders.) If the liquidation preference could be waived by the board, then that would give the founders an incentive to approve an "efficient" sale.
Note: I am suggesting the idea of the board approving the waiver, as opposed to the preferred shareholders, so that the waiver applied across the board to all preferred shareholders. And the investor board member would have to vote in the best interests of the company when voting in the role as a board member, as opposed to in their own self interest, which they do as a preferred shareholder.
All that being said, I don't think liquidation preferences are the place to focus on making "standard" term sheets more company friendly. I could write a lot about that...
This term sheet is a fair distillation of fairly standard terms. I think what adventured is looking for is something that moves the Overton Window as to what's "standard." I don't think YC was purporting to play that role here.
With organizations like the NVCA playing such a pivotal role in the terms of VC financings, I think it is critically important that thought be given on the founder side towards advocating more founder-friendly "standards."
Liquidity preferences are also critical in allowing companies to grant employee stock options at valuations substantially below what the Series A investors pay. If liquidity preference disappear, the IRS will likely take a much closer look at low strike prices on options.
I'm a founder and have never been an investor. I feel there are many things that could be improved, but I don't feel that moving investors to preferred is one of them.
My sense is that investors take a risk and that preferred protects them from a lot of downside of that risk. If they didn't have that protection, they'd need to do way way more work to protect against the risk, making it harder for startups to get/close their funding rounds.
Also, since investors price the risk in, you'd end up having to give investors more upside in the success case, which is a thing I'd personally prefer not to do.
What do you think are the upsides of investors having common stock only?
I think you already answered that question in your post. There would be incrementally more proceeds for the founders and employees in an exit that is flat or below the postmoney valuation of the Series A round. But as you also noted, this stuff doesn't exist in isolation - pull one lever and it results in other changes. In this case, that outcome would probably change how the investors think about the risk-reward and may depress the valuation itself, especially if it's relatively high.
> There would be incrementally more proceeds for the founders and employees in an exit that is flat or below the postmoney valuation of the Series A round
Right, I understand the outcome, but why do we want to do that.? What problem is solved by this? I'm trying to extract the benefits so that we can weigh them against the downsides.
I think it just comes down to risk preferences. If you optimize for a higher valuation and give the investor downside protection for that, then you own more of the business and therefore more of the upside. If you choose to better optimize for the downside by taking away investor downside protection, you may end up with a lower valuation, lower ownership of the company and lower upside.
Ya... Preference means higher valuations means more cash. So employees can get less diluted (upside), higher salary (downside), and bigger team (derisking=both). Removing will lose those.
Removing preference may seem like it more strongly aligns existing team during critical events... But that'd get priced in to the above, say by 80% based on today's preferred vs common. Ouch!
Todays push to 1x participating vs higher in older days is great. I do agree about misalignment during some critical events..
I'm not sure why you framed this as an us-vs-them fight.
Hypothetically, each investor has some internal valuation for your startup, and is willing to take <x> risk. Giving those investors preferred shares reduces that risk, which means you can theoretically get more money while giving up less of the company. Obviously you trade that for the downsides of having preferred shareholders, but that's a choice for the founders.
The venture capitalists in implementing liquidity preferences as a commonality defined it as an us-vs-them fight. It's an aggressive risk shift onto people - the founders and employees - that are far more vulnerable in the start-up building process than the very wealthy capital class that makes up most of the VC world and its institutional money.
Overwhelmingly the VCs are not your pals. They are there to make money, you should deal with them accordingly. In the best case scenario they're business partners, that's it. They don't feel bad about liquidity preferences and how that benefits them. Founders should never feel bad about fighting for the best terms they can get, the VCs will do exactly the same thing when they can - it's a core part of their job.
I would take the premise a step further actually. Potential early employees should always avoid joining start-ups that have liquidity preferences that could meaningfully negatively impact their own outcome (the worse the potential impact, the greater the aversion should be). When the liquidity preference hatchet comes down, the non-founder employees typically get smashed particularly hard.
Another great way to kill off liquidity preferences, is to create a competitive incentive related to employees and starve liquidity preference start-ups of talent. Start-ups should begin touting the lack of onerous liquidity preferences as a notable recruiting point re compensation packages.
> The venture capitalists in implementing liquidity preferences as a commonality defined it as an us-vs-them fight.
... You'd have to support that argument, because it is not evident.
This is a mutual agreement between two informed parties. You don't have to take those terms, and you are free to offer them more common stock as a risk substitute. I also don't understand why you invoked class warfare here, which really undermines any credibility to your argument.
> This is a mutual agreement between two informed parties.
YC has put so much effort into founder education over the years precisely because that frequently has tended to not be the case. Quite the opposite.
I'm not sure what you're defining as informed here (mutually responsible for understanding what is being signed, sure), however I would point to knowledgeable as the more important term. The problem continues to frequently be that founders and early employees are nowhere near as mutually knowledgeable as their counterpoints in the VC world, who are elite professionals at these deals and do them for a living.
There's a great statement above by @mnemotronic that summarizes the routine imbalance between the two sides: "I'm a software guy. Most of that sheet is a foreign language to me."
I can sympathize, I've been dealing with VCs since the late 1990s and the terms/legal side is still an immense chore.
> I also don't understand why you invoked class warfare here, which really undermines any credibility to your argument.
No it doesn't, because it's not invoking class warfare, it's making a point about the typically dramatic financial condition and personal risk imbalance between the two sides (the personal damage absorbed if things go south). Founders and early employees can easily see their lives ruined if a venture fails, it's a not uncommon outcome, HN sees such stories posted regularly.
Upvoting the parent. The comment is worthwhile and merits discussion. Should not have been downvoted.
The comment that this is a way of reducing investor risk and may yield a higher valuation is well-taken. But founders should not agree to it, because their risk is far, far, far higher than that of the investors.
A founder gets one shot, or maybe two or three shots, in their lifetime. An investor gets many shots across a diversified portfolio. A founder puts their career and their financial future across in this one basket. They put their sanity and their personal happiness in this basket. An investor puts nothing but a small portion of their, or more frequently other people's, wealth in this basket.
Making it less likely that a founder will get a payoff is just stupid. A founder should do everything they can to reduce their risk, even at the cost of a lower valuation.
And remove/edit the vesting schedule. A vesting schedule of this sort may be reasonable for YC, but is unreasonable in some other cases. Many founds have already invested their life savings (and more) and years of work without pay. They should not lose their existing shares.
If it's essentially a growth round labelled as an A you can normally negotiate the vesting schedule, but if you're at a standard Series A point, then it's unlikely you'll be able to change it unless you're a super hot deal.
It'll likely take 7+ years from a Series A to an exit, if a founder leaves straight after funding and keeps all their equity, that's hugely demoralizing to the rest of the founders. They'll have to do the work to generate the value of the business over the next decade and end up with exactly the same rewards as the founder who left. It's the kind of thing that kills businesses.
From an investor perspective, an investor is unlikely to want to invest if the founders aren't committing to stick with the business.
You can make arguments like this in negotiations and sometimes they can work. It just depends. As I mentioned elsewhere, this was meant to be more descriptive than prescriptive. Founder vesting/re-vesting is often a negotiation point in a Series A term sheet and the outcomes are varied and fact-dependent enough that it's tough to say that there's a standard here.
The vesting schedule line has 2 sections, 1 for founders (which is bracketed, i.e., needs negotiation) and 1 for other employees.
The rank and file get a standard 4-year, monthly vest, 1 year cliff. The founders presumably get something very different. Existing employees are an unknown.
I didn't see a vesting schedule indicated for founders, only for regular employees. The spot for the founder vesting schedule was blank brackets indicating a negotiation with no default.
(I just read the inline version, not the downloadable Word version.)
Bad preferences happen when Founders are overoptimistic or focused on optics (like a postmoney of $1.00B). Even the standard 1x/nonparticipating reflects a mismatch in optimism. Few founders would accept the valuations that would come with an all-common investment, so it's rarely discussed.
Yes employees suffer along with the founders when bad preferences are chosen. But that's still the founders fault, not the investor.
You're arguing against something I didn't make a point of. I never said it was the investor's fault that the founder signs a bad term sheet. Investors will generally pursue the best terms they can get, founders should do the same.
My obvious point is that founders and employees should conspire whenever possible - acting in their shared interest - to eliminate investor-favorable liquidity preferences as a common part of start-up term sheets.
If the startup isn't going to agree to preferred shares, they're not going to get funded. If the startup is wildly successful, the preference won't matter anyway.
No young start-up should ever agree to preferred shares or any liquidity preferences. This is the next great battle for founders to win over venture investors. To push that risk back onto the investors where it should be instead of allowing the investors to unduly offload even more of their risk onto the founders and early employees.
Liquidity preferences should have never become common with start-ups, they should be quite rare. There is no more important territory for founders to be focused on taking back from venture capitalists than that. Liquidity preferences are a routine source of screwing over the founders and early employees. YC could do something tremendous for founders by fighting on their behalf to put that shifted risk back where it should be: with the investor; the founders and employees already shoulder enough risk as it is.