Raising your Seed Round — a Playbook for Israeli Entrepreneurs
In my last post, Chapter #10, we talked about what to do when you get a term sheet. In this final chapter of “Raising your Seed Round — a Playbook for Israeli Entrepreneurs” — we will cover the closing process, getting the deal done and hopefully some 7 digit balance in your company’s bank account within a couple of weeks.
Before we begin: Choosing the right term sheet
If you’re fortunate enough to have more than one term sheet to consider (which should always be your aim) your duty as founder and CEO is to try and optimize the deal that the founding team and the company will sign with its first institutional investor. Even if you’ve only received one term sheet, the key question is, how do you weigh the different elements of the deal? When is a good deal “good” enough, and when do you risk burning all your bridges? Let’s try and define the key considerations:
1. Check size
The amount of money you take in your first financing round can impact your company in many different ways:
- Taking a high-bar check brings high-bar expectations, and high bar business milestones
- Taking a much-lower-than-competitors’ check might signal weakness, or hint to the world that your investors know about a hidden flaw in your startup
Most importantly, you need to feel confident that no matter what size check you take, it’s enough to get you to the next funding round, be it seed extension, A round, or cash independence. Yes, bridging is always an option, but if you aim for mediocre achievements to begin with, you will probably not end up doing amazing. Also, investors tend to bridge successful companies, ones that are on the right trajectory but fall a little short in time or in speed, not the companies who met poorly-planned goals and are doing “as expected.”
In his masterpiece “The Founder’s Dilemma,” Professor Noam Wasserman describes the tradeoff founders make when choosing between being “rich” or “king.” He explains that when fundraising, you always have to choose between keeping a smaller portion of a business that is potentially much bigger, or staying in control of a small business that has a capped value.
Breaking this concept down a little more, I’d say some tradeoffs are easier to comprehend (i.e. more money for more dilution), and some are less tangible but are just as important (i.e. investor brand, value add, and founder-investor chemistry). You should be willing to give up more equity in order to work with Sequoia or USVP, or the top investor in your specified domain, or just to work with that specific investor who you learned the most from and felt great talking to through the diligence process.
3. Commercial terms
The key issues that I discussed in Chapter #10 highlight different soft spots with different founding teams. Make sure to prioritize the absolute critical points for yours, as most early stage investors have their “system” in place and will not be willing to make drastic adjustments to more than a few items.
4. Alternative cost
You should always try to evaluate both the likelihood to close and the time until closing, as these might cost you in alternate funding options, missed hires, or failed deadlines with customers. Sizing and evaluating these two factors is a delicate craft, usually mastered by serial entrepreneurs who have raised multiple funding rounds. If this is your first time, my best advice is to find a trusted mentor.
After weighting and scoring the 4 items above, you are likely to find that no term sheet is “best” all around. As investors are usually educated players who are aware of the competitive nature of funding processes, you should be able to try improve certain elements in your top candidate’s term sheet, simply by telling them that you hold other offers that have better terms for certain matters.
At this point, be prepared for several potential answers, and prepare your response in advance to reduce impulsive reactions:
- The investor says “yes” and waits for your reply. This probably means that you have some more room for optimization. I try to never leave a partnership deal where my counterpart feels defeated, so be aware and considerate here before you turn the screw.
- Investor says “yes” or a partial “yes” but calls last offer. If you’re still unhappy with the deal at this point, it means that you did a poor job on prioritizing your item(s) for negotiation. You should consider this to be truly a final offer, one which many investors might also bind with a deadline.
- Investor says “no” and calls last offer. Most investors have a certain “system” in place. If it’s crunch time and you received a definitive “no” on your last request, the chances are good that you’re asking for something outside of their flexibility zone.
- Investor says “no” and takes the offer off the table. While not common, you definitely need to prepare for this option. Before pushing for that extra point for optimization, make sure you’re not taking the negotiation and optimization effort one step too far.
First things first
After signing your term sheet, the first thing you should do is build a game plan across 3 fronts:
- The investor side: calibrate timelines and expectations. Find out when the closing is really due (in practical terms), when the wire is due, and if there are any further significant hurdles you need to overcome.
- The lawyer side: share the aforementioned timelines with your lawyer, and coordinate internal timelines and recurring touch points with them. These will be directly affected by the resources they are allocating for the deal, their current workload, and the expected costs, so be sure to discuss those as well.
- The founders side: set up process expectations with your cofounders, covering both timeline and content. During the coming weeks, you are going to make some hard decisions, a few of which could potentially impact you and your cofounders personally. Make sure you have their blessing to run the process according to your best judgment, and set up an update/discussion mechanism to make sure you are able to process complex and sensitive issues effectively. As the CEO and the one leading the negotiation, if you’re not able to manage your cofounders, then this will be perceived as a negative signal to investors.
After aligning your three main fronts, the next step is to define the work channels between yourself, your lawyer, the investor, the investor’s lawyer and your cofounders. Well-defined processes and channels will create a productive closing process, while mismanaging them will set the stage for a slow, redundant, ineffective, and incoherent process. A piece of great advice that I borrowed from Ben Horowitz’s “The Hard Thing About Hard Things“ is to impose fake deadlines onto the closing process, so as to to push everyone towards a finalization mentality. At this stage of the deal, all sides are genuinely interested in getting it done, so there is little to no risk in drawing those lines in the sand. In the worst case scenario, the deadlines will be extended.
Eyes on the prize
In the next few weeks, you will be faced with hundreds of decisions, some small, some big, some important, and some not. Your main goal throughout this process is to stay focused on things that actually matter, both short and long term, so that you will be able to get the best end result for yourself and your cofounders, as well as for your company. With the help of your counsel, pointing out the key points would also enable you to give away tokens during the process and keep your investor partially satisfied.
How do you define what is really important? Ask yourself the following questions:
- Does it handicap the company for the short or long term?
As much as possible, avoid things like excessive veto rights, uncommon liquidation preferences, named rights, and any other factor that might make the company less attractive or function less effectively in the future .
2. Does it create or enhance misalignment of interests?
As noted in chapter #10, you are now entering a new era in your venture, one in which 3 and potentially 4 legal entities are taking part: Founder, Investor, Company and Board. Every item in the legal documents that creates or enhances a misalignment in interests between these entities is effectively a ticking time bomb with a fuse of unknown length. These cases usually occur around the financial interests of the different parties, and can vary across a wide range of subjects such as ESOP, indemnification, liquidation preferences, and many others. A good way to resolve such conflicts is to always try and stick to the market standard and to the company’s best interest.
3. Does it hurt the founders economically or put them at risk of legal action?
In definitive agreements, you’ll discover tens of clauses and items which have the sole purpose of carving founders out of their equity or economic rights, or so it seems upon first glance. In fact, most of these clauses are standard, and usually refer to extreme cases of misfortune or misconduct. As distressing or uncomfortable as they make you feel, pushing back on most of them will be a complete waste of time. However, it is totally legitimate to try and improve your stand on specific items that you feel are out of line, or are simply sensitive issues for you. Your counsel should be able to prevent you from fighting gravity, for example pushing back on terms that no reasonable investor would accept but we have seen occasions where lawyers try to prove their worth by over negotiating on terms unnecessarily, so be wary of this. We can say that because some of our best friends are lawyers :)
During closing, you’re likely to hear some cliches that never get old:
Our office always does X that way;
I have worked with partners from your firm who agree with my approach;
X,Y and Z were not specified to that extent on the TS;
The TS says exactly that;
When it comes to deal-making, cliches are used when good reasoning and logic are lacking and your claim is based on little ground. Yes, you might pull off such a tactic once or twice, but never on important issues and surely not for long. A good indication of when to give up on an item is if both you and your counsel are struggling to truly justify it for reasons other than “I want it.” The only time when “I want” might be sufficient argument is when you’re negotiating unconventional terms that deviate from the market standard. Also note that second tier VCs may offer you terms that a tier 1 VC would never accept, so don’t over negotiate, just decide on what’s more important to you and most importantly, who you’d rather work with.
To keep cliches to a minimum, make sure that both sides’ legal teams have direct preparation calls before the business guys join the line. That way there will be less need to impress their clients, and more drive to resolve and minimize pending open issues.
What’s actually in it? The main documents
Seed round deal documents are the DNA of the company legal structure, for better or worse. Proper deal documents will make your future rounds quick and effective, requiring only minimal updates, while messy, sloppy, or non-standard documents will make closing and diligence of future rounds a nightmare. So while I highly recommend that you leave the legal work to the professionals, please do your homework and get to know the materials and the mechanisms that are going to have an important role in your company’s future. These include:
- SPA (Share Purchase Agreement). This document defines everything that has to do with the actual sale and purchase of the company’s shares, in a specific agreed price and specific agreed amounts.
- IRA (Investor Rights Agreement). This document defines (wait for it…) the rights of the investors in the company: who is eligible to elect a board member, what type of decisions require the investors’ majority consent, what kind of majority would that be, information rights, and other issues.
- AoA (Articles of Association)/CoI (Certificate of Incorporation). This document goes by different names in Israel and the US, but it always includes some of the most important items in a venture deal: many decision mechanisms, active or passive veto rights, quorum definitions, liquidation preferences, and others. An AoA/CoI is also the most “lasting” document, as it sets some conventions in place. Any future investor looking to change them would have to go through an Article Amendment process, which is never obvious and could consume costly time on future funding rounds. Good AoA/CoIs set the company up for a healthy set of relationships between investors and founders, and among the investors themselves, by applying clear, well defined and fair mechanisms from day one.
- DS (Disclosure Schedule). Disclosure schedules aim to create maximal transparency between the founders and the company, and the investors. They include all the “by the way”s and “just so you know”s that usually pop up during or after diligence. It also places a separation between the investors and the founders regarding legal liability for actions that took place before the investment. Your DS will be reviewed by future investors during diligence, so everything you put in there should have good reason and justification. Drafting the DS is a good time to iron (legally of course) any wrinkles in your historical paper work, get all those required waivers from vendors signed, and basically do some healthy housekeeping in your company’s legal work.
Closing the closing
When there’s more than one investor, you’ll typically use one of two common practices:
- Simultaneous closing. The lead investor represents all the investors in the round, and the deal documents are delivered “as is,” with little to no room for comments or changes. Depending on the inter-investor relationship and the size of each investor’s check, the co-investors might be looped in to the deal documents early, and sometimes they might get the documents signed by the company and the lead investor. Make sure to be on top of these delicate relationships; the last thing you want is to start off with a poisoned relationship or a vengeful investor waiting for payback.
- Deferred closing. The lead investor’s check covers only a portion of the round size (or potential size), and there is no co-investor willing to sign a check at the same time (as in section #1), the lead investor and the company usually agree upon a deferred closing mechanism. This generally lasts for about 90 days, give or take 30. During this time, the round remains semi-open and the founders can calmly find the best fit for the co-investor slot. Deferred closing investment is usually done in the same terms as the rest of the round, but if your company did really great in that short time period, bullish investors will be willing to pay a small premium on the round price (10%-15%) just to get through the door. The execution itself is rather simple; the new co-investor signs a Joinder (that’s the technical legal term) agreement and becomes a party to all the above mentioned deal documents.
It’s lonely at the top
Being a first-time fundraising CEO underscores the hardship of leading a company. To the extreme. During the closing period, you will be forced to take some hard decisions: some may personally impact you and your co-founders, and some may create bad blood with existing or joining investors. With some, you will have one and only one option, and with others you will knowingly hurt the company’s chances for success. With some, you will have zero knowledge or time to decide, and for some you will make a call that is not popular, doesn’t make anyone happy, and is not even optimal, but is still the right call for your company.
At the end of the day, your main objective throughout this process is to close the deal. That said, you are also required to pay attention and identify signals that indicate this may not be the right long term partnership for you and your company. As you go along your founder journey, you want to make sure you have the right partners alongside you. That said, as important as they are, it’s not investors that make or break companies, it’s the founders and the decisions they make. Choosing, negotiating and closing the right investment is one of the earliest defining choices you’ll have to make.