Standard term sheets and what you need to know about them

by Simon Murdoch

I was a panelist at the UK Business Angel Association conference this week. One of the earlier panelists said he wished there was a standard for early stage term sheets. Well there is.

Saul Klein arranged a short series of excellent meetings in 2010–2011 called SeedSummit and I attended. The attendees were about 50 European early stage investors both VCs and experienced angel investors. One of the topics raised was that we needed a standard for term sheets like the NVCA’s equivalent in the US.

So later in 2011, SeedSummit published two standard term sheets one called a General Termsheet more suited to early stage VCs and another as an Angel Termsheet.

When we launched our first fund at Episode 1 back in late 2013, we used SeedSummit’s General Termsheet as our starting point for creating the Episode 1 standard term sheet. We made a few changes described here and have tweaked it a little over the two and a bit years we’ve been investing. I’m very happy with it now. I think it is a very fair balance given the interests of the investors and the interests of the entrepreneurs.

In a later post, I will explain the specific terms most first time entrepreneurs find challenging and why they are there in the standards.

For now though, here’s what we changed from the SeedSummit term sheet:

Liquidation preference

We picked the first option for non participating preference — much fairer on entrepreneurs. The alternative is a participating preference, often called double dipping by entrepreneurs. (For more details on this see next post)

Anti-dilution

VCs are usually nervous about the valuations entrepreneurs think their businesses are worth. At the early stage we invest, there is no basis for valuations which an accountant would understand — there are no profits, and revenues are usually tiny so there’s no sensible multiple which can stack up to valuations in the £ millions. The valuations are all based on hope of where the company can get to in the long run — can we make 10x from here? Anti-dilution is a way of saying to entrepreneurs: £Xm — are you sure?

We have chosen the most benign version of anti-dilution for entrepreneurs (apart from having none) called the broad based weighted average. It would take a whole blog post to explain just this one point and there is no better place to start than the excellent description of the three forms of anti-dilution by Nic Brisbourne.

Founder vesting

Founder vesting is there to make you really really want to work full time in the company for at least 3 years after investment because we are investing in what you and your team are going to do in the future, not what the company is today. So although you own your shares today, you will lose some of the economic value of them if you leave. “Vesting” is the technical term meaning that over time more of the value of your shares is yours to keep, whatever the future holds.

On the SeedSummit terms founders have to stick around for one year to get any vesting (and will usually have 3 or 6 month notice periods so that makes them very nervous). Then the vesting is straight line per month over 2 more years.

Episode 1’s standard for founder vesting has 28% already vested on the day we invest and then 2% per month for 36 months, so also fully vested over 3 years. We recognise that founders have already done a lot of work on the idea and the business by the time we invest and a risk of losing all their shares, however small, feels unfair to them and us, and we think is hard to sell to entrepreneurs. In a handful of cases where founders have been working a long time on the business or perhaps had vesting terms from a previous round, these numbers may also be negotiable.

Good leaver / Bad leaver

If a founder leaves within 3 years, different things happen to the vested shares for good leavers vs bad leavers. SeedSummit is silent about what defines a Bad Leaver though.

At Episode 1, we again wanted to be entrepreneur friendly so a Bad Leaver is a only founder who:

  • resigns — we just don’t want you to do that for at least 3 years
  • is fairly dismissed for Cause. Cause has a definition in English law and effectively means guilty of fraud or very serious misconduct
  • breaches the Investment Agreement in material and a way which can’t be remedied — very rare
  • is made bankrupt. This may seem a bit mean but is sensible because the value of the shares would otherwise disappear to a bankrupt’s creditors and the company could really do with those unvested shares to help incentivise a replacement for the founder.

A Good Leaver is anyone who is not a Bad Leaver.

Founders often worry that they will be sacked by their VC. In practice this is really very hard to do, but even if it was possible, note that founder would be considered a Good Leaver.

Equalisation of Terms

For most trade exits, the buyer wants to incentivise management to stick around and ensure the business continues to grow revenues and profits. Investors get very antsy at an exit if they feel the management and buyer are conspiring to divert a big part of the exit price into management incentives for after the exit. SeedSummit’s clause on equalisation of terms is an attempt to ensure that is not possible.

We just deleted this term in full. Firstly we found that it was just too hard to explain to early stage entrepreneurs who almost always have never experienced an exit and fear this term is some form of deception by the investor.

Secondly in my experience through multiple trade sales, the equalisation clause would be really difficult to enforce — the management incentives post deal are an important part of the details of the negotiation. Both management and selling investors usually have to approve the deal, so in practise you work out a fair deal.

Summary

So overall Episode 1’s term sheet is better for entrepreneurs than the SeedSummit standard in at least these 5 ways.

We do though find that entrepreneurs still find some of the terms challenging to accept and explaining those terms will be the subject of my next post — coming soon.

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