Raising your Seed Round — a Playbook for Israeli Entrepreneurs
After discussing how much to raise in Chapter #1, the various sources of funding in Chapter #2, VC organizational structure in Chapter #3, securing face-to-face Partner meetings in Chapter #4, guidance on how to prepare for these meetings in Chapter #5, meeting dynamics in Chapter #6, due diligence process factors in Chapter #7 and the the due diligence process in Chapter #8 and Chapter #9, In Chapter #10 we will be covering the in and outs of the funding process’ holy grail — the Term Sheet.
Term sheets come in different shapes and sizes. Some VCs pull them out at the end of a successful partner meeting, some submit them in “Take it or leave it” mode, and some set a 48–72 hour expiration date to it. Most VCs, however, try to calibrate expectations on the main commercial aspects during the investment process, and use the first draft handed to the founders as a framework, with certain flexibilities.
In this chapter , we will explain what a term sheet actually is, how to prepare one, and what to expect from one; review the main elements of the document; discuss where you should and where you can negotiate; and try to explain in non-lawyerish language the meaning and impact of the term sheet’s many different elements.
What is a term sheet?
A term sheet is an outline of the deal your company is being offered. Investors issue term sheets to calibrate expectations regarding the main aspects of the deal, and make sure both parties are aligned before deploying more costly resources on drafting definitive agreements (a.k.a. “the closing”).
As exciting as getting (let alone signing) a term sheet is, it is critical to note that it is a non-binding legal document (other than specific elements in it we will discuss later) which means that legally, both sides can pull out up to the very last minute of the closing. Such cases are relatively rare, so you should be wary of any investor with a reputation for this practice.
Bring in the suits
They say there are only three real lawyer jokes in the world, because all the others are true stories. However, using a good, deal-making lawyer is a key factor in getting your term sheet signed quickly, effectively, and fairly. As the seed round is likely to be your first equity round, it is also the round in which the company’s Articles will be drafted, the different investor and founder rights and restrictions will be set, and many other long-lasting elements inked into formal company documents. You can rest assured that your prospective investor is going to hire a top lawyer to make sure their interests are protected and that the majority of the 50–50 cases end up in their favor. Don’t put yourself and your company in an inherent deficit by saving a little money on a lower-tier lawyer.
Three’s a crowd
Term sheets tend to surface a hard truth, usually not present to founders until that point: from this point forward, you are entering a three-sided legal (and professional) relationship between the founders (you), the company (maybe also you?) and the investors (probably not you). Each of these three entities has its own incentives, goals, rights, and restrictions — and it is important to understand the delicacy and note the balance of these as early as possible.
As founders, you might find yourself wearing three different hats — founder (shareholder), CEO, and director — with each hat bearing different duties and considerations. Your prospective investor will also usually be wearing both the investor (shareholder) and the director hats, sometimes leading them to vote differently as a director (prioritizing the company’s interest) and as an investor (prioritizing the shareholder’s interest).
A classic example of this is an early, low-ticket exit — a first-time founding CEO holding 25% of the company shares would think hard before saying no to a $20 million acquisition offer, while an investor looking to return 3x on their $100 million fund would be very disappointed with such an outcome. Wearing their director hats, the CEO might claim that the company had tripled its value within a couple of months and approve the acquisition, while the investor might claim that only a small portion of the potential value had been captured so far and push to reject.
There are no easy answers here, but a recommended practice is that all parties agree to make the company’s interest their #1 priority and acknowledge that #2 and #3 might clash in certain scenarios.
Divide and conquer
One of the best practices I recommend is to have a preparation talk with your (top-tier, deal-maker) lawyer about the key objectives for you, and how you prefer to split the work between the two of you. Being a first-time founder, you are likely to be less experienced in such processes than your lawyer, and you should definitely use your lawyer’s experience and knowledge, while maintaining the driver’s seat; not every question or decision should go through you, not every point is critical. Moreover, you’re not likely to have good answers for each and every point your prospective investor or their lawyer would come up with.
Put your lawyer in front of the investor’s legal team with some agreed liberty, and make sure to deeply review and re-review the term sheet with them before and during the process — to make sure you understand what is crucial for you, and not less important, what is not — and can be used as a bargaining chip in your negotiations.
The common ground for almost all investors is that they hate being a sucker. In this first equity round, every right you give your investors beyond standard conventions will set an undesirable precedent for next round investors (so if a $1.5 million investor cashes in on his high demands, then the $15 million investor will expect even more). To avoid this slippery slope, avoid any custom items in your deal — meaning named rights, Israeli shtick, oversized boards and any other uncommon and unacceptable terms. If in doubt, take a look at the US VC market standards.
Key elements in a term sheet
- Round size: Is there a fixed number or a base with an upper limit?
- Investors: Who are the known investors? What are the criteria for any deferred investors? And how much is each planning to deploy?
- Pre- or post-money valuation: If the round size is fixed, there shouldn’t be a difference. But if it is defined as a range, then post-money would benefit the investors and pre-money would benefit the founders.
- ESOP goal: Startup employee options are professionally referred to as ESOP. Each investor wants the company to be able to attract talent and be able to compete over the best employees, so it needs the company to be able to offer those candidates significant equity — preferably without diluting anyone around the table. The ESOP goal in a term sheet defines what portion of the company’s shares would be allocated to employee options *after* the round is complete, and derives the number of shares that would be dedicated for this purpose *before* the round.
- Price per share (PPS): You get this number by dividing the pre-money valuation by the total fully diluted number of shares — *just before* the round — assuming that all notes, SAFEs, and employee options (yes, including the newly allocated ESOP) were converted to common shares.
Investor ABC, would invest $1 million in Company XYZ in a $1.5 million round based on a pre-money valuation of $3 million. The remaining $0.5 million would be invested by investors acceptable by both the founders and the investor, in a deferred closing, within 90 days of the closing. The PPS would be calculated based on the pre-money valuation divided by the total fully diluted number of shares, including a reservation of 10% of the company’s shares post-round for ESOP.
This section is pretty straightforward — it defines the size and structure of the board. A seed-stage company’s board shouldn’t be too much of a headache, but rather a thinking and measuring tool at the CEO and the founders’ disposal. It is also helpful to set governance displicine, which you’ll hopefully need when you raise your subsequent funding rounds and bring in new board members. To keep it simple, you should try and minimize both the size of the board and the courtesy gestures you are handing out. Remember (see the above Poisoned Apples section): every future investor will (rightfully) demand the same…or more.
The board will be composed of three directors: two nominated by the founders and one nominated by the lead investor.
Even though investors are all into this game for a significant return, they still need to hedge and protect their investment in the less fortunate yet very likely outcome of a low-ticket acquisition. This isn’t relevant if the company burns, as no one gets anything in that event.
When VCs invest in a startup, they get preferred shares and liquidation preferences is the mechanism that actually defines what that means:
Who gets money first? Usually, the last investor in takes the first money out and so on. Last in line are the common/ordinary shareholders, usually the founders and employees.
How much money do they get? Two factors define this: the multiplier on PPS and the interest rate (if any).
Participation mechanism: There are two main methods: “Non Participating” is the fair and most common method, meaning that if investors got their money back first, they do not get a piece of what is left for distribution after all the preferred shareholders get their cut. “Participating” (a.k.a. “Double Dipping”) is the more aggressive approach that means that after all preferred shareholders get their cut, they also get a proportional cut of what is left for distribution.
Each preferred shareholder will get a 1x non-participating return on each preferred share, with 6% yearly interest compounded annually.
Protective provisions (veto rights)
Protective provisions give the investors the right to veto certain actions by the company, even if these actions were approved by the board and are aimed to help those investors protect their position in the company and keep a healthy balance between company, shareholder and founder interests above. These rights do not give the investors any active, enforcing rights, but only passive veto rights — mainly on different variations of the three elements: (a) the issuance of new shares (to prevent non-agreed dilution); (b) changing the rights of the share class; and © changing the nature of the company’s business or making extreme business decisions that will dramatically impact it.
Now you might be asking: If I can’t issue any new shares without approval, then how can I raise my next round? The veto rights are usually balanced by a Qualified Financing threshold — meaning an agreed definition of what would be a future financing offer that the current investors can’t veto — and it usually refers to a minimal round size and pre-money valuation that investors, shareholders and founders should be satisfied with.
Without consent from the majority of the preferred seed shareholders, the company will not: deviate from the budget by more than 20%; issue new shares; decide on liquidation, IPO, shutdown; change the main business of the company; or change the board composition.
Reverse vesting (repurchase)
By definition, early stage investors are investing primarily in teams. As such, they expect the founding team to stay in the company for a long, meaningful period. Investors also need to be able to somehow get the company back on track in the unfortunate case that one or more of the founders end up leaving early on. Reverse vesting means that if you leave the company early on, a portion of your founder shares is returned to the company pool. The factors that define that portion are: (a) time period (usually four years); and (b) vesting mechanism (this could be yearly, quarterly, or monthly — customary terms define the first year as a “cliff,” meaning during that year your shares don’t vest gradually, but as a single block at the end of that year, and gradual vesting begins on a monthly/quarterly basis over the remaining time period).
100% of the founder’s shares will be subject to a repurchase right, over a period of four years, with a one year cliff for 25% and the remaining 75% vesting monthly over a 36-month period.
No sale, co-sale, right of first refusal (ROFR)
As mentioned above, founder shares are a sensitive point for investors. If a founder sells all their shares, it’s both a negative signal on the company (i.e. the founder doesn’t believe in it) and it creates an unhealthy disincentivized founder situation. To mitigate those risks, term sheets usually include three mechanisms:
- No sale — a set of limitations on when, how much, and how fast a founder can sell their shares;
- Co-sale — this gives the investors the right to “piggyback” any transaction in which a founder is selling their shares, and force the buyer to also buy a proportional portion of the investor’s shares;
- Right of first refusal — this gives the investors the right to match any offer the founder gets for their shares.
Founders will not sell any of their shares three years from closing; after that, they can sell up to a total of 30% of their shares, and not more than 10% each year.
This last part of the term sheet is optional and case pending. In some deals, investors like to mitigate some of the risks they are seeing by conditioning the closing on a variety of elements. These may include: getting IP clearance for former workplace or academic institute; getting the additional portion of the round committed; signing a key employee or advisor; clearing separation from a spun-off entity, and so on. As a founder, you need to make sure the closing conditions make sense to you and most importantly that you are highly confident you can meet them. A scenario where you have a signed term sheet but failed to close the round because you didn’t meet agreed upon closing conditions might make it extremely challenging to find an alternative investor, which would be devastating to a young startup.
Closing conditions: The company will find a co-investor committed for no less than $1 million; the founder will get an IP clearance from the Hebrew University regarding his PhD research.
No shop is the *only* legally binding aspect of a term sheet, and basically it means that during an agreed timeframe which is dedicated to finalizing the deal (“the closing”), the founder can’t shop around for other investors to take the deal, or offer better terms.
No real example here… Think wisely before you sign, and conduct business in good faith after you do.
There’s a lot to digest for what is typically a simple and short document but, understanding each party’s interests and the implications of each key term will put you in a strong position to successfully securing your investment partner at the start of your journey. In the next chapter, I will cover how to negotiate the term sheet to close the deal and also how to manage the process where you’ve been fortunate enough to have received multiple term sheets. Stay tuned for the final chapter next week!
To get notified when we publish chapter #11, subscribe to our newsletter. If you missed chapter #1, #2, #3, #4, #5, #6, #7, #8, or #9 you can find them here, here, here, here, here, here, here, here and here.