10. The Term Sheet (Brad Feld)

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Brad Feld joins Nick on The Full Ratchet to discuss the Term Sheet including:

Economic Terms:

  1. Valuationbrad_feld_term_sheet
  2. Liquidation preference:  preference and participation
  3. Pay-to-play
  4. Vesting
  5. Employee pool and/or the option pool
  6. Anti-dilution

Control Terms:

  1. Board of Directors & Board Observers
  2. Protective Provisions
  3. Drag-Along Agreement
  4. Conversion

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Guest Links:

The Term Sheet


Key Takeaways:

1- Preference and Participation

First we talked about preference… ie. Preferred shares vs. common shares. While preferred shares are still equity and are not senior to debt, they are senior to common stock. So, in the event that shareholders are paid out, those with preferred shares will receive their capital first. The standard in the industry is a 1x liquidation preference… which means that in the event of liquidation, the preferred shareholders can choose their liquidation multiple, often 1x the original purchase price, in lieu of their equity percentage and prior to any other payouts.

So Brad, walked us through the following example… and this is a simple example where we do not have to consider participation, b/c there was no participation.

Preferred, No Participation… three different exit values:

1x Liquidation Preference, no participation:
$10M has been raised over the life of the business
Through fundraising, 50% of the total equity is distributed to investors in the form of preferred stock, for that $10M
Upon a sale of the business, the investors have a choice. They can either take 1x their original investment amount of $10M (ie. the Original Purchase Price), or they can take 50%, their equity position, of the liquidation value (ie. The Current Price)

if company sells for $14M… the investors will receive $10M (b/c they had the choice between $10M or $7M)
In this example, the remaining common stock holders, employees and founders, end up with $4M

For this example the break-even liquidation amount is $20M, where the investor gets the same cash return of $10M whether they choose the original purchase price value or the 50% of the sale price.

If we assume a much higher exit price is $100M, then they will choose their 50% equity distribution and receive $50M.

  Scenario 1 Scenario 2 Scenario 3
Preferred or Common: Preferred Preferred Preferred
Preference multiple: 1x 1x 1x
Participation: None None None
$M Raised (Series A): 10 10 10
Series A post-money valuation: 20 20 20
Investor Equity % (Series A): 50% 50% 50%
Sale Price: 14 20 100
$M paid out to preferred shareholders: 10 10 50
$M paid out to common shareholders: 4 10 50


Preferred, Yes Participation… three different exit values:

Now let’s look at a Participating scenario.
Remember with Participation you get your investment dollars back first, then you get 50% of what’s left.

So in the $14M sale price example, the investors will get their money back (ie. $10M) plus they get 50% of what remains (ie. $4M), for a total cash return to investors of $12M. Employees and founders and up with $2M.

In the $20M sale price example, investors get their $10M + 50% of the remaining 10, for a total of $15M. Common stockholders in this scenario will get $5M.

And with a $100M sale price, investors get their $10M, + 50% * the remaining 90M. So $45 + 10 = $55M. The common shareholders get $45M.

  Scenario 1 Scenario 2 Scenario 3
Preferred or Common: Preferred Preferred Preferred
Preference multiple: 1x 1x 1x
Participation: Yes Yes Yes
$M Raised (Series A): 10 10 10
Series A post-money valuation: 20 20 20
Investor Equity % (Series A): 50% 50% 50%
Sale Price: 14 20 100
$M paid out to preferred shareholders: 12 15 55
$M paid out to common shareholders: 2 5 45


Participation Cap (if the cap multiple is exceeded, then participation does not apply):

The last example I wanted to review is with Capped Participation. Recall that when the simple, non-participating, return to investors exceeds the cap, then participation does not apply. When the simple, non-participating, return is less than the cap, then participation does apply.

So, in the first scenario, at a sale price of $14M, the simple, non-participating return to investors was $10M. So if we assume a cap of 3x, that is less than 3x their original investment of $10M, so participation does apply and the payout to investors is the $12M from the participation example.

In scenario two, at a sale price of $20M, again the simple return of $10M is less than 3x of the original investment of $10M, so participation applies and the payout to investors is the $15M from the participation example.

And finally, at a sale price of $100M, the simple return of $50M does excced 3x the original investment of $10M, so participation does not apply, and the investors receive the payout of $50M from the non-participating example.

  Scenario 1 Scenario 2 Scenario 3
Cap Amount: 3x 3x 3x
Cap Exceeded? No No Yes
$M paid out to preferred shareholders: 12 15 50
$M paid out to common shareholders: 2 5 50


And these are the straightforward examples… remember that Brad mentioned stacked participation as well in scenarios where their are multiple rounds of investment with stacked preferences.

2- Vesting

Recall that Brad discussed founder vesting and how that is seen as investor friendly, but often it can be more important for dynamics between co-founders than it is between the investor and the founder. He has seen multiple situations where a founder leaves and retains his/her equity position… then the remaining founders have to continue working to build the company and receive no greater % of the business than the founder that departed. This can be a very difficult situation and can be very de-motivating for entrepreneurs.

3- Conversion

As Brad outlayed, there may be situations where a strategic acquirer offers $100/share for common stock and $1/share for preferred. This is one of the few cases where it’s more advantageous or the investors to convert to common for a better financial payout… and you will find that conversion is nearly always included in a term sheet, just in case, particularly with a preference.


Tip of the Week:  Great Risk Merits Great Reward

Below is the “Tip of the Week” transcript from the Podcast Episode 10: The Term Sheet feat. Brad Feld Upon an investment, an angel investor can receive either Preferred Stock or Common Stock. The key thing to note in Brad's overview, is that the Preferred Shareholders can choose to be paid their liquidation preference, prior to the common shareholders. So just b/c you have 20% equity in a company, if it's common stock, you may not get 20% of the proceeds. While Brad, mentioned that a 1x liquidation preference is standard, I have received term sheets, from entrepreneurs that already had a lead investor, that include 2x and 3x liquidation preference. There are also a number of other rights that are often secured through preferred stock. For example, pro-rata rights, that we discussed last week. Also information rights, rights of first refusal, co-sale rights, anti-dilution... while we haven't covered all these items, it becomes clear that preferred stock is a way to protect and support one's investment. On top of that, as we touched on, if later stage investors negotiate for participation, then they will get their original investment, or some multiple of their original amount, back before the common shareholders equity percentage is applied to the remaining capital. I recently had an opportunity to invest in a very exciting startup in Chicago called Scholastica. It is run by some University of Chicago alums that have a vision to re-invent the publishing industry... and, I believe, that have a real good shot of doing just that. After running them through my evaluation process, they scored very high, and it was a GO. Unfortunately, (more…)Read More...


Nick:               Today we have Brad Feld with us. He’s cofounder of Foundary Group and also his great blog called Feld Thoughts over at Feld.com .Brad thanks so much for joining us today.

Brad:               My pleasure.

Nick:               So before we jump into the topic can you walk us through your background and how you got into the venture business?

Brad:               Sure I started a company in the late 1980’s when I was in Boulder oh no sorry I was in Boston and I was actually in school at the time; as a self-funded business that I ran for 7 years. With a partner we grew it to a couple million dollars in revenue and then sold it to a public company in 1993.

I exquisite that public company for a couple of years. During that period of time I made about 40 Angel investments in real estate tech companies with some amount of money that I made from the deal. So between ’94 and ’96 I made a bunch of investments which were effectively in that companies at the time we weren’t we were calling them software companies.

That evolved in me accidentally ending up co-founding a venture capital firm with some guys from Soft Bank. I was one of the affiliates. I was doing Angel investments but also working with this group form Softbank on some of their investments along with a couple of other people who were affiliates which included  Fred Wilson who now is a partner at Union Square Ventures and Rich Levendof  who is a partner at Avalon  Ventures. Both whom are good friends. And we’ve continued to invest together.

So you know I woke up one day and was part of a venture capital firm that ended up being called Mobile Century Capital and we had a very successful funds and we raised in 1997, we raised a much larger fund in 1999 which was a disaster.

And then we raised even larger fund in 2000 which has ended up doing mediocre.  But you know sort of accidentally stumbled into being a VC versus a deliberate path

Nick:               That original software company. Did you guys do a fundraise?

Brad:               No. the company was called Feld Technologies. It was named after my dad, sort of tongue in cheek. We had 10 shares of stock. There were 3 owners. We invested $10 in the company. I got 6 shares of stock, my partner Dave got 3 and my Dad got 1.

And when we sold the company we still had 10 shares of stock outstanding fortunately they’re worth a lot more than a dollar at the time. But we never raised any money we just boot strapped the business. It turns out that we did effectively raise $20,000 from a credited line that my dad personally guaranteed.

It really wasn’t used very intelligently. So we started the business, we hired some people. The first month we lost 7 or $8,000. The next month we lost $10,000. And we very quickly realized we couldn’t keep doing that so we fired all the people so it was just my partner Dave and I. And from that point forward over the 7 years we made a profit. Sometimes we made a dollar, sometimes we made $100,000 profit the month but we always focused on making profit and cash flow for that month.

Nick:               Well good. So today we’re talking about the Term Sheet. I’m very excited to dive in and cover a lot of material. And I’ve teed up on the major elements in the intro.

So let’s start out with the economics of the Term Sheet. First one is Price. An episode was recently launched on Valuation where I interviewed Jeffrey Carter of High Park Angels. So we won’t spend a ton of time on valuation today. But can you start us out on a primer on valuation and highlight some of the factors that impact valuation?

Brad:               Sure. And I’ve written about this extensively in the book I wrote Venture Deals.

Nick:               Yup

Brad:               With my partner Jason Mandelson. And we really believe that there’s especially in early stage investment there’s really only two things to focus on which are economics and control. And interestingly I think people focus on price as the primary major driver of economics but it’s only part of it.

If you think about price per share or if you think about valuation; you know people say, “what’s the valuation of your business?” the very first thing you have to understand is whether they’re talking about the pre-money valuation or the post-money valuation.

Nick:               Sure.

Brad:               And I would say that classic problem especially for first time entrepreneur is the entrepreneur is generally talking pre-money and the investors are generally talking post-money. So understanding that the difference between those two can be quite significant, right. A million dollar investment on a $3 million post-money valuation is 33% of the company by one over three. And the million dollar investment on a $3 million pre-money valuation is only 25% or one over four.

So price is a piece. The option pool that exists is a piece of this economics in the price essentially whether the option pool is pre-money or post-money. So does the investor ask you to allocate 10% or 20% of the company for unissued options to future employees?

So let’s take the 10% number against the $4 million post. That’s essentially $400,000 of value that gets put into the valuation pushes the pre-money valuation down by that much. Obviously if it comes after the deal then it’s just additive and the new investor and everybody else takes the incremental dilution of additional points.

Another thing that plays into economics is liquidation preference and the nature of the liquidation preference. So if you have a liquidation preference that’s what’s called non-participating it means that your investors got in a downside case. They have the choice of either getting their money back or converting into shares and getting a percentage ownership of the company. And in the upside case they take the shares but in the downside case they might take their money back. In a participating preferred stock structure, what that means the investor gets their money back and then gets their percentage of the company.

So it’s extra juice on top of a deal which you know can have prematurely impact on the outcome and who gets what depending on how much money is raised and how they preference. So generally focusing on price per share as the only metric is often losery.

Nick:               Yeah and I wanted to get into that economic term of liquidation a little bit. Can you give us an example that illustrates both preference and participation?

Brad:               Sure. So let’s say you’ve raised; let’s use some decent size numbers but not enormous ones. Let’s say you’ve raised over the life of the business $10 million. And let’s say that that $10 million that you’ve raised owns 50% of the company and the other 50% is owned by the founders and employees.

If it’s a simple liquidation preference then the investors have the choice of getting a $10 million or 50% of the company. So in a case where you sold the company for less than $10 million investors take the $10 million and the founders will get nothing. If you sold the company for $14 million, the investors would have the choice of taking $10 million or 50% of the 14 which is 7 so they take the $10 million.

So your sort of breakeven point would be a $20 million deal. If you sold the company for $50 million investors would take 50% of it or $25 million and the founders will get $25 million. That’s the non-participating scenario.

Nick:               Got it.

Brad:               In the participating scenario the investors get their $10 million back first and then get 50% of the company. So remember the breakeven point the last time was $20 million right, that’s the point of difference. Anything above $10 million the investor’s gonna take 50%

Nick:               Yup.

Brad:               And everybody else gets 50% in the participating case. Let’s go back to that $14 million situation right, where the investor would take their 10 and so 10 would go to the investor and 4 in that case would go to the founders and employees.

In a participating preferred structure, the first 10 million goes to the investor. So the investors get 10 and then they get 50% of whatever is left so that _____ so in that case; 12 would go to the investors and 2 would go to everybody else. In the $20 million case, 10 would go to the investors and then you would split the remaining 10 fifty-fifty. So 5 would go to the investor so they’d end up with 15 and employees and founders will end up with 5.

If you got to a $100 million exit, 10 million still goes to the investors. So they get their 10 million and then you split the remaining 90 fifty-fifty so 45 would go to founders and employees and in total 55 would go to the investors. So at high valuations that preference matters less and less. I should say high valuations relative to the amount of preference it matters less and less. But it still matters. But at low valuations or mid-case valuations it can have a very significant impact.

Now there is a notion of; I’m giving you both ends of the spectrum, a preference that does not participate and a preference that fully participates.

There is another structure which is that you can have a preference that participate up to a percent return or up to a multiple return. So let’s just say participate until you’ve gotten 3 times your money back .So if you sell the company for more than 3 times your money, more than 3 x’s there is no preference.

Nick:               Okay. So cap on participation.

Brad:               Correct. And so in a $100 million exit it would be the investor is getting more than 3 times their $10 million. So they would simply get 50 million and you know their 50 percent which is a 5x and entrepreneurs and the founders will get 50 million or 5x.

So you can have lots of different flavors of these preference. In addition to make it even more complicated as you raise additional investment, each of your series of stock might have different preference of characteristics.

So one of the things we try to do as early stage investors and we really encourage all early stage investors to do it, is to not have a participating preferred structure early on. Because usually the terms that you have early get inherited as the company grows.

So if you’re a small investor let’s say you’re a part of a million dollar round. And then the company ultimate raises 20 or $30 million. The amount of return you get from that participation is dwarfed by the later investor’s participation and in a  lot of cases as an early investor it’s in your interest not to have participation anywhere in that stack.

And so by not having in the beginning you set a trend. Think a lot of investors don’t think it through especially in the early stages to what the real implication and outcome is.

Nick:               Got it. So you can get these stack participation situations where all the later investors are first ones on the stack to get paid out their participating amount.

Brad:               That’s right and again you know as the amount of preference increases, the amount off the top increases so the returns for the earlier investors correspondingly decreases.

Nick:               Well I’m gonna take these examples that Brad gave us today and I’ll include those in the true notes with the number so that if you want to circle back you can do that.

Okay let’s move on to Pay to play. Can you talk about Pro-rata rates and what people pay per vision is; and can you explain why this is particularly bad for Angela and or early stage friends and family investors?

Brad:               Sure. Well there’s 2 very different things. Pro-rata rate right I would say is a good thing but the pay to play is a bad thing.

Nick:               Why is that?

Brad:               What a pro-rata rate is it means that in future rounds you have a right to invest the amount of money in that round to maintain your ownership percentage. Now the calculation for pro-rata depending on how it’s ordered can be a little sloppy. But the general way to think about it is if you’ve invested in a company and you own 1% of the company, in the next round whatever the financing is you have the right to invest the amount of money so that you still have 1% of the company.

That’s the simplest way to think about it.

Nick:               Yeah I actually wrote a blog post on that last week so.

Brad:               Okay good, so the idea of having pro-rata rights for an early-stage investor who wants to invest throughout the life of the company and maintain their percent ownership is a good thing for them. And for the entrepreneur probably is an easy thing to give the investors. You’d like your investors to keep investing if they’d like to have a chance to invest.

Nick:               Yup.

Brad:               There are some Angel investors that are seed investors. When I invest as an Angel I explicitly don’t care about my pro-rata right because I don’t continue to invest in the company. I make my investment as an Angel and I essentially reserve 100% of the money I invested so if I make a 25,000 investment I have another 25,000 in my portfolio allocated for that company.

And there are certain cases where I’ll put that money in, the company hasn’t made enough quite enough progress to hit the next round but I’m happy with what they’re doing. I have some additional capital that I can give ’em. But generally speaking once they’ve raised the next round once I’m investing as an angel which versus as an institutional VC I only make that investment that first time. That’s been part of my strategy.

So I think understanding what your Angel Investor strategy is in terms of pro-rata maters.

Now when you start talking about Pay to Play you’re actually dealing with a different situation. So Pay to Play is the line which basically says if you don’t invest in this round you will lose something. And the typical thing that people lose when they don’t invest in a future round under a Pay or Play provision is they lose their preference.

So let’s go back to the case where you’re an Angel investor in a company. You’ve invested whatever number 25; $50,000 as a part of a million dollar round. And you do it as a simple preferred stock. So you don’t have a participate it’s just a simple preference in and as a result you’ve got $25,000 liquidation preference for your $25,000 investment.

That; let’s say that there’s a Pay to Play provision in that financing. The next round that happens you have to write your check for whatever tour pro-rata is or you’ll lose your preference and your stock will be converted to common stock. That’s a simple situation.

Now there’s lots of nuances around that. The nuances can include for example an investor introducing you know in later rounds a Pay to Play provision. You often see this happens in situation where companies are distressed.

So it’s a classic form of a later stage investor. Or you know even a venture capital investor introducing a term because the company’s struggling. And to try to motivate the early-investors to write a check so the company can raise more money. So they’re kind of opposite sides of the 2 things.

In general if you’re an Angel investor who uses the strategy which I use which is not to follow on in future rounds, you don’t like Pay to Play because once a Pay to Play happens you have to keep writing checks. The reason I don’t care about my pro-rata is that most people that introduce a pay to play or do any sort of a down round on a company almost by definition extend pro-rata rights even if you don’t have it because you’re trying to raise as much money as you can from the existing investors.

And in some cases if I like the company, you know I’ll participate in that later round and continue to play. But those terms actually really muddy the water in terms of the dynamics.

Nick:               Interesting; so on one side we got pro-rata which is a right to invest and press a winner and the other side you’ve got pay to play which is a requirement to invest or you lose some sort of provision or opportunity.

Brad:               Exactly; correct.

Nick:               Good deal. Next item is Vesting. What do you find is the standard regarding a vesting provision in a deal and why is it important for investors and entrepreneurs to set up a fair vesting situation?

Brad:               Yes the default vesting position which has been going on since I started making investments in the mid 90’s was that stock for founders as well as employees that’s so for 4 years and that vesting typically happens either monthly or quarterly, sometimes annually but usually quarterly or monthly.

And there’s often something called a cliff or a one year cliff which means until you’re there for a year you don’t get anything but after a year you get a full year. So your first sort of vesting point is that full year. Occasionally you’ll see different things with founders than the broad employee base that you’re hiring.

So founders sometimes will have the additional chunk of their equity already invested. So let’s say you’ve been working at the company for; there’re are 3 of you and your cofounders and you’ve been at it for a year or two before you go raise money. When you go raise money, you know you get a year’s credit on your vesting schedule so one out of 4 years is vested and the rest of the 3 years is vested. Over the next 3 years you see that structure sometimes.

You’ll also see what’s called acceleration on changing the control. The most common is double-trigger acceleration which means that if the company gets acquired and you’re terminated within some period of time you get some acceleration. And that acceleration could range from a year to all of your stock.

Sometimes you see what’s called single-trigger acceleration which is that when the company gets acquired before the deal closes, you’re at the point where the deal close you get full acceleration on all of your stock or if you have single-trigger that’s a year you got a year of acceleration.

So those are the nuances that you see. I have really come to believe over thousands of deals that acceleration, sorry that vesting actually is more important in terms of dynamics between the founders than between the founders and investors.

And I’ve run into this over and over again where founders when they start the company they say we’re gonna be here forever. We’re working forever together we’re never-ever-ever gonna split up and you know 6 months or a year or 18 months in one of the founders leaves.

And it could be because they get fired. But you know they get fired by the other founders; it could be that they decide that they want to go do something else; it could be something in their life changes; it could be something unrelated to the business. It could be that they’re just tired bored of the business and it really sucks if you don vesting in that situation if you’re one of the remaining founders.

So let’s assume that there was no vesting and these 3 founders at year end one of the 3 founders leaves. Just leaves, like you know I put my year in I’m outta here so I decided on moving somewhere. I’m moving to New Zealand and you guys are on your own.

Nick:               (Chuckles)

Brad:               The other 2 founders are working their butts off right for the same stock and it’s just not fair. There’s really no good way to get that stock back from the founder or some portion of stock back from the founder and sure they may have salaries and things like that. But the real economic value is that equity.

So vesting gives you a mechanism so that if somebody leaves or is forced out to at least have you know a real conversation negotiation about what they get. And it’s interesting how it works both directions. For entrepreneurs who have a really good relationship and sort of have established clearly with each other the rules of engagements often times complexing and interesting things happen.

We had an investment in a company where one of the co-founders after 2 years and change decided to leave and he didn’t ask for more vesting. He actually turned around and gave some of the stock back to the company because he didn’t feel like he’d earned it. And he  did it as you know in exchange for his severance and it wasn’t a big severance like it was 3 months or it was 6 months.

He said look I’ll give this much equity if you give me 3 months of salary that’ll make my life a little bit easier. And that was a really generous on his part. I’ve had the other end of the spectrum where you have founders who literally; three, I’m thinking of 3 who literally sat across the table form me and said we will never, we cannot have vesting we will be working together forever.

And I was in vesting in a company that had already been around for 2 or 3 years and at some point I stop fighting with them. I’m like guys do you know I think you’re gonna regret this but I’m gonna, I want to make this investment and you know okay. And sure enough about you know a year and change later, 2 of the founders fired one of the founders.

Nick:               Wow

Brad:               But you know he got all his equity and then about a year later one of the founders decided that he was gonna disengage from the company. He stayed on the board but he wasn’t working for the company fulltime anymore. And then the company got bought for a lot of money.

And it was a situation where the remaining founder who was really leading the charge and was CEO struggled a lot because every, you know whether he should keep the business or whether he should sell it, because every incremental dollar value he was splitting he was getting one third because his other 2 cofounders were getting two-thirds of it even though they weren’t the ones anymore that were working for the company.

And so at the point the price got big enough his view was you know, let’s sell this and move on. It was okay, you know we’re all happy but you know it wasn’t; if I think about the value allocation for the 3 founders for what they created independently of my ownership; as an investor the allocation wasn’t appropriate.

The last comment on this is a lot of entrepreneurs think that vesting is a way for VC’s to screw it up. And you know I would suggest that I’m sure there’s plenty of that behavior in the world so I won’t argue with that but in general what the vesting does is it essentially creates a commitment that’s a long-term commitment and the way to have the conversation about that long-term commitment if things are not going well.

And I think that it’s important to investors when they’re investing capital in a company, money in a company to be able to have that conversation. It’s very uncomfortable if you can’t. Because going into every relationship assuming things are fine and always going to be good is probably the wrong approach.

Now the full side of it is now if you approach every relationship assuming it’s going to be all up well you shouldn’t go into the relationship in the first place.

Nick:               That’s (laughs)

Brad:               You assume it’s gonna be good but you want to have some mechanisms in case there are problems and vesting I think is a very balanced and fair one.

Nick:               Yeah it’s always an odd conversation. The example that you illustrated here and then in the book in each situation where a founder leaves and they carry their 15 or 20% around with them and everyone else has to work to get them their payout. It’s a, it’s not a good situation, so.

Awright Brad you also mentioned the employment option pool in your book. What is it? What is the standard amount and can you give us a simple example to show how it works?

Brad:               Yeah so I think most, certainly most Angel and venture bank companies and most tech startups but also many other types of have this notion that you want employees to have ownership of the business. And the most tax efficient and structurally efficient way to do that is to create what is called an option pool.

And what the option pool is, is an amount of the company, some percentage of the company that exists so that you can grant options to employees. Those options represent a certain percentage of the company. And you got a certain number of options. They get diluted just like everybody else so overtime as you raise more money the absolute number of shares and the absolute number of options you have will stay the same but the percent ownership will decrease as you raise more money; hopefully corresponding with the value of that would increase.

The reason that there’re options instead of share is that if you granted share to your employees you’d have to pay tax on this illiquid thing called a share that you gave them. And that they’d actually have to pay cash tax on it and you and they might or might not get anything for it depending on the option and structure but you know generally you don’t have to pay tax.

So you just hold the option and if the company’s worthless then it doesn’t matter. You know you have the option it didn’t work. But if the company becomes successful then you get the value of that option at the time. At early-stage companies generally the size of the option pool; the unallocated option pool ranges from 10 to 20%. So a lot of times when you do a financing your new investors will ask you to create an option pool as part of the financing that could be as much as 20%. I mentioned this earlier in the sort of vet, you know economics calculation.

Let’s use a $10 million post-money valuation ’cause it’s easier to do the math off of it. Let’s assume that an investor is investing $3 million in your company at a $10 million post-money valuation. So if that’s the investment you would assume they’re getting 30% of the company but the pre-money valuation is $7 million and as the founders you are splitting up 70% of the company.

However if the investor then says but I also want a 20% employee option pool on it, unallocated option pool built in to the pre-money you know in advance of the deal; then effectively $3 million is buying 30%of the company just like before. 20% of the company is being allocated to this option pool which has not been issued yet and the remaining 50% is what the founders get.

So in that case essentially the 20% is coming out of the pockets of the founders in terms of if the investor didn’t focus on that but you still needed 20% of the equity in the employee pool after the fact then it would come in after the $10 million.

So your post money effectively would become $12 million and you know your investors would get diluted proportionally. So their 30% would go down by 20% so they’d end up with effectively 24% of the company. And they’d be contributing 4 of the 20 points. And 16 of the 20 points would come from the founders so they would go down from 70% to 54%.

So the dilution still hits you but it just hits you in a different way. The size of that option pool ­­­­­________ negotiation. I like to say that you should just be realistic about what you’re gonna use. I mean most early stage companies is you’re hiring people at 10% option pool you know as a reasonable number to start with. But if you really have 3 people and you raise a lot of money having a 20% option pool might be more appropriate.

You can always create more options when you use them up so you know there’s a little bit of yeah it doesn’t matter to get it exactly right and it really comes back down to this notion of economics because the more of it that’s built in to the deal or pre-money that less of the new dilution is absorbed by the new investors.

Nick:               Do you ever find situations where it’s split? Half of the option pool is at the pre and half is at the post or is it usually one or the other?

Brad:               Sure. Sure. And in that scenarios what I would say is look; you know, if I was in an argument with somebody about the 20% and they’re like well let’s split 10% pre and 10% post. And you know let’s assume I didn’t care what valuation I was getting was fine. I say you know what, yeah let’s just do 10% in the option pool and you know if we need more options we’ll just grab them and we’ll both be diluted.  Or I might say I  tell you what let’s just put 15% in the option pool and leave it at that in the future if we need  more options we’ll create more options.

Nick:               Got it.

So the final economic term I want to discuss is anti-dilution. How does this protect investors? What are the 2 most common varieties? And what advice do you have for minimizing the impact and/or making sure that they never come into play?

Brad1:            Yeah so. Anti-dilution is a term that means, in the future if you raise around at a lower valuation or a lower price or share than this round I the investor get some extra shares to make up the difference. That’s what anti-dilution means.

There are 2 types of anti-dilution. There’s what’s called weighted average anti-dilution; and then there’s full ratchet. Weighted average anti-dilution is typical and benign. I think it’s a very down the middle term it’s very fair to everybody involved, you know when it comes into play it rarely amounts to a particular big number.

Often times when there’s a financing depending on the configuration of financing that’s actually waved by the investors if it’s not a material of amount but it does afford some downside protection if there’s lower financing rounds in the future.

So my advice to entrepreneurs is, weighted average anti-dilution don’t worry about it.

Full ratchet anti-dilution is much more severe. And it means if   there is a round at some future date at a lower price per share the current round is automatically adjusted to that price per share. So you know if you raise money right now at a $10 million valuation and then a year later you raise more money on $5 million valuation. The money that’s raised on $10 million valuation is effectively re-priced so that it looks like that investment went into a $5 million value.

I really encourage entrepreneurs never to accept a Full ratchet and to work very, very hard especially early in the life of a company not to have that term in there. Again at the beginning it really may not matter all that much. It may matter some but it certainly may not matter all that much but it certainly matters a lot if it get inherited down the road. And it’s a good indication that you don’t particularly have good balance with your investors.

You know with full ratchet the investors obviously have a motivation to increase the value of the company that’s why they’re investors but they also have this incredibly protective downside mechanism that you know so if the valuation decreases some, well their old investment looks like it got invested than new lowered (00:28:15)

With weighted average you know they pick up a little bit of additional equity, it feels good. It’s much more in the zone of it’s not gonna to materially effect so beware of full ratchet, don’t worry too much about weighted average.

Nick:               (chuckles) yeah my friends in town give me a hard time cause I chose the full ratchet for the name of the show and

Brad:               (chuckles)

Nick:               That is not a promotion for Full Ratchet, so it was merely because it’s a catchy term.

Oh alright. Let’s move on to the control term side. So we talked about economic terms let’s switch gears here and let’s start with the board of directors. How is a board selected? And what is the standard make up of an early stage board?

Brad:               Well you know a lot of early stage companies don’t have a formal board. If they have a formal board you know it’s just 1 or 2 of the founders and I think that’s a mistake. I wrote an entire book on this as well. It’s a book called, Startup Boards and in that book I talk a lot about the value of a board especially at the early stages.

I think typically post, you know seed round and Angel round, you’ll often see a small board you know maybe 3 people, 2 are the founders and one of the investors. By the time you get to a venture round you often have a 5-person board. You know that’s usually the CEO and one of the other founders, 2 investors and then an outside person that both sides pick typically although sometimes it can be that the investor gets to pick it and sometimes it can be that the founders get to pick that outside board member.

As the company grows over time you often see that drift up to 7 people and the configuration there is usually VC heavy. So you typically have you know 3 or 4 vc’s on the board now depending on how much money you’ve raised and you know your goal at that point should be to have VC’s swap their seats for outside directors especially if you’re on a path to going public.

I would say that the other things that’s useful here to recognize there’s value to being in an odd number in sort of the default, but vast majority if times you don’t actually have a contentious voting dynamic the board has to deal with. You can have some voting dynamics that the investors are dealing with so the control provision in the actual financing documents and someone has more impact than a board vote.

I think people like to be an odd number because it feels a little more comfortable if you end up you know if you end up with controversy or confrontation but you can, you know for early an stage or private company if you end up on that situation on the board anyway, whether you have an even number of directors or odd number of directors you got issues that are gonna be pretty deep issues that you have to work through.

Nick:               There are different thoughts on the board observer; recently we made an investment in a company out here in Chicago and we got a board observer seat. Can you talk on what that is and sort of the counter positions?

Brad:               Sure a board observer is somebody who gets to sit and participate in a board meeting but isn’t a formal member of the board. You know observer rights vary. You can have observer rights that look like you’re a full participating member at the table in terms of the conversation, and then you can have observer rights that basically say you can sit in the room but you can’t say anything.

Many vc firms bring and wire things in so that they can bring an observer, you know a junior partner in the firm to the board meeting. Other you know associates, other firms to the board meeting. Other firms like ours at Foundry Group we don’t have any associates or junior people so we don’t care one way or the other about having observer rights. We just have a board seat.  Sometimes you have founders who are not on the board but get observer rights as part of a financing or transition off the board. So a lot of times you might have a situation where you’ve got 2 or 3 founders on the board and through the financing one of them leaves the board which you know you give them observer rights so they can still come to the board meeting. That’s a formal right. A lot of times they still have the informal right to come but you know if they have the informal right and for some reason they’re not wanted in the boardroom they can get kicked out. So the observer dynamic sometimes is helpful there.

And then you know last is well observers are, you know have rights to be part of the board meeting. There is a closed session of the board where you kick the observers out of the room typically. So if you have a contentious situation with one or more observers what you do is you as a board you literally just go into close session and the observer can’t observer or participate.

I personally am not a huge fan of observers. I used to at my previous VC we always had observer rights and people already, always came to the board meetings and they would usually you know partner and somebody else the board meeting. I really have grown weary of that. A lot of time strategic investors get observer rights instead of board seeds; later stage investors get observer rights instead of board seeds; firms that invest get a board seat and an observer right.

And when all of a sudden you’re sitting in a room and there’s 20 people in the boardroom, management plus you know 6 or 7. I’d say 5 to 7 board member plus 5 to 7 observers it’s a mess.

Nick:               Yeah.

Brad:               That’s way too many people and you can’t have a real conversation and you can’t be really effective about what you’re talking about. The other thing that I’ve come to struggle with is there really are 2 kinds of observers. There’s the observers who are observers; they’re observing. And then there’s observers too, even though they’re an observer they believe they’re a full member of the board.

And for whatever reason I d’s say that there’s a lot of tone deafness around this with VC’s as well as with Angels who don’t really have a good understanding of how a board should function. And suddenly you’re in a room and you’ve got the right to be in the room but you don’t really understand why you’re in the room or what you’re doing. And so you can have some pretty negative effects on the dynamics of the conversation. Especially, you know when everything is going fine it doesn’t matter but when things are not going fine being really thoughtful and really precise about how you approach things starts to matter a lot.

Nick:               Next control term is Protective Provisions. What are the main things that a VC is trying to protect against with these provisions and how can they be helpful for the entrepreneur?

Brad:               Sure. I mean the biggest ones are pretty straightforward. A VC does not want the entrepreneur to change the structure and nature of the VC’s equity without the VC’s permission.

A big part of the protective provision is all around the fact that you have to get the investor, I shouldn’t say VC, it’s investor plus Angel too.  You have to get the investor’s consent to make any structural changes in their equity. You have to get their consent to issue new shares. You have to get their consent to create a new class of stock as a result of financing.

Then there’s some things around basic operation. You have to get their consent if you raise more than a certain amount of debt. It’s a company that’s growing very rapidly. Sometimes you have to get their consent to spend over a certain amount of money with one vendor. You might to have to get their consent to be able to change the size of the board. Stuff like that.

So these are these provisions where the investors explicitly; forget about the board, forget about management structure of the company;  the investors explicitly wants veto rights is one way to think about it and affirmation right is probably a more powerful way to think about it right. You have to get their consent to be able to do these things.

You know with protective provisions there’s you know 10 or so that are pretty standard mostly the ones I just described. And in the book we talk, you know Venture Deals we talk about what you can or can’t push back on and what you can be worried about and situations why.

You can find some investors who put a whole bunch of strange control provisions or protective provisions that make it look like they have operating control of the company. And for a venture backed or an angel backed business I don’t think that those are generally very appropriate. I mean you see private equity firms that are majority owners and companies who own the companies anyway so they get those rights by default.

But sometimes you see some angel investors came from that kind of environment who are often heavy handed in terms of the protective provisions that they want. Personally I think the simple way to describe it is protective provisions exist so the investor can’t get arbitrarily. And you know as long as they’re balanced as long as everybody knows what they have to ask for consent to do there rarely an issue.

And in the downside case where there is an issue sometimes it becomes a point of negotiation. But in an upside case it’s generally just good hygiene.

Nick:               So I haven’t been doing this long enough to see how these things play out but what happens if the entrepreneurs violate a protective provision.

Brad:               Well you know;

Nick:               Or anything in the term sheet for that matter.

Brad:               Sure. I mean you know you have a formal, legal contract right and so

Nick:               It probably doesn’t help to spend a ton a time of court which is part of the reason I asked

Brad:               Well of course you know, but it depends on how egregious it is and what happens. And you know one of the ticking time bombs that an entrepreneur doesn’t want and the investor doesn’t want either is you violate a provision nobody does anything about it, the company becomes wildly successful. And then on the back of the company being wildly successful all of a sudden one or the other party points back at a provision that was violated and said I should get some more money.

So it’s memorializing the rules so that there’s clear rules of engagement. And a lot of companies violating one of the protective provisions depending again on the control dynamics, you know as a firing offence. I mean I’ve seen CEO’s being fired for you know violating a protective provision; most of the time it’s a safeguard right.

You know the raising debt is a good example. If you’ve got a company it’s pretty hard for a company to raise any meaningful amount of debt without support from its investors, right (chuckles)

Nick:               (laughs)

Brad:               So protective provision exists it’s probably not gonna be something you can do anyway. It’s pretty hard for a company to raise any meaningful amount of capital without consent from the existing investors because the new investors are going to want the consent of the old investors.

However you could definitely create fraudulent situations or situations where founder is trying to you know, “I don’t have a protective provision and so I’m going to have my friend over here invest in the company at a very low price and dilute everybody and then turnaround and re-grant me a whole bunch of equity. And that effectively dilutes my investors.

Well if there is no protective provision theoretically you can do something like that. In the case of protective provision for equity that is being issued you know on lower price or less terms than the equity you’d have to get the consent so it wouldn’t be a valid equity issuance without the consents.

So I can’t think of over the 20 years I’ve been doing this that I’ve ever been in litigation because of this. But there have certainly been cases where having a protective provision has forced difficult conversation and real negotiation between investors and entrepreneurs to sit down and work through their issues.

Nick:               Next let’s cover the drag along agreement provision. What ability does this provide to a subset of investors? You mentioned a majority of each class and majority of all shares in your book. What’s the difference between theses 2 most common situations?

Brad:               I’ll try to keep this one simple. A drag along is a situation where it gives a set of people the ability to drag along other shareholders in a particular voting context. And a lot of times the drag along provision is the one that you want for either specific shareholders who are non-participants or founders who have left.

So you know in a situation where somebody is no longer a part of the company but you want to be able to effectively vote their shares. I would say drag along often is a pretty healthy fight but when an investor wants to introduce it. It’s often something that gets introduced into a separation agreement. So when somebody leaves the company you know in exchange for whatever they get as part of the separation agreement a drag along on there is sure to get introduced

Nick:               Got it. The final control term is conversion. Why would an investor require the ability to convert preferred shares to common?

Brad:               Depends on the structure of the preferred share in general. I would say that than this is a hygiene chart by explicitly says the investor has the control over whether they convert into common or not. And you know investors are gonna to convert into common in the situation where it’s in their financial interest right.

So we described a lot earlier. You know participation and that sort of thing. If the company gets bought and being a common shareholder is going to be more advantageous than being a preferred shareholder you want that right.

An example there could be you could definitely see a scenario where an investor would offer or sorry an entrepreneur might offer $100 a share for the common and a dollar a share for the preferred in the absence of having the ability to convert the investor would be kind of screwed; but at the end the investor has the ability to convert which they always do. And then the investor can say well just convert to common and I’ll take my $100 a share. Right.

Nick:               Yeah.

Brad:               So it’s sort of a ; it closes a way for there to be this sort of okay I have a different class of stock and so somebody is buying different things from different people.

Nick:               Got it. So let’s wrap up last question of the day. If you had to elevator pitch or some up your approach or philosophy to investing how would you describe it?

Brad:               Well I wrote a post. I wrote several versions of the same post. The most recent one was one I titled Your Word Should Meet Your Actions. I think one of the biggest struggles in entrepreneurship and investing is you tend to have a lot of people on either side who have a view and say certain things but then don’t back it up with the actual actions.

They’re either inconsistent or they’re not clear or in some cases it just full of beep and I really believe it’s important to be, we use the phrase internally with our partnership, brutally honest but kind. So we’re very direct to each other but we do in a kind way. We try not to be ambiguous, we try not to let anything linger and when we invest I think it’s the same kind of thing. We try not to let anything linger, it doesn’t do anybody any good for something to be in my head if I think it’s relevant and important so. Try to be direct and always try to have our words meet our actions.

Nick:               Alright his twitter handle is at Bfeld, the feld dot blog where he has over 30 posts on term sheets, its feld dot com. Of course the VC site is foundary group dot com. I highly encourage you pick up the venture deals book as well as any of his others on the series of startups. Brad thanks so much for the time and for helping all of us over the years with your transparency.

Brad:               Totally Nick.