Terms, Term Sheets, and Terminal Value
Mark Suster has a great post on calculating valuation and the things that VCs can throw at you to make the deal better for them (I guess I should say us) than it actually looks. Go read it. It's complicated stuff but you should try to wrap your head around it. I've written a bunch about this as has Brad Feld and other VC bloggers have too. The VC world is changing. We are talking about this stuff, explaining it, and discussing it. That's progress.
But here is the thing. Terms and term sheets are a necessary evil of the venture business but most venture returns don't come from terms. They come from terminal values. Meaning the size of the exit. One deal often returns the entire fund. The next three to four deals return it again. The rest of the portfolio might return it again and if you can do 3x gross, you'll raise another fund, and another, and another.
In my talk with John Battelle yesterday at Geo Loco, where I said some controversial and partly tongue in cheek things that were widely reported, I did talk about this. And I wish it was as widely reported as the sound bites. What I said was that there are only a few things that really matter in a venture investment. The first is the amount being raised, the second is the dilution to the entrepreneur and the ownership the investors are buying (largely the same thing), and the third is the relationship between the investor and the entrepreneur. Everything else is pretty much noise.
I do care about and want a plain vanilla one times liquidation preference because I think it is fair. If the company is sold for less than the valuation that we invest at, I think it is fair that the investors get their money back in that scenario. Any multiple of liquidation or participation should be avoided at all costs by both sides. VCs often use those tricks to bridge valuation gaps but I have come to believe you should resolve valuation gaps with compromise or just don't do the deal if the gap is unbridgeable.
I think the VC business is changing in many ways and one good way is that more and more VCs are thinking less about terms and more about terminal values. And that is best for everyone.
We just raised our round last week, and two pieces of advice that I followed helped tremendously:-Finding a great VC is like getting married (with no divorce option), so don’t bicker on the smaller terms or even try to squeeze every penny out of the valuation. When you’re in love, you don’t auction for your wife. Treat this the same way.-Negotiation of terms is part of relationship building.I kept both of these points in mind, and ended up with the best investor out of the lot that we met.Finally, the tips in Nivi’s option pool shuffle post actually works!
Congrats on your funding!
Maybe with the increase in second markets there will options for more divorces – bringing founders and investors back to a better playing field.
I agree with you Fred. That’s why I’ve pushed the Series Seed Documents and was surprised you didn’t like them.
We have a light preferred term sheet I like better
Great post you partially answered my question I put in Mark’s blog.How much of the actual returns are done by the deals that didn’t work??Do you have a guess on that one???I agree completely if you put up cash if the deal sells for that or less cash is cash, everything else is purely potential.But how much extra return could you get by “squeezing” the one’s that didn’t work?? Participating Preferred with a multiple liquidation. Would it be the difference in 3x versus 3.3x??I understand its really an unanswerable question because from your view squeezing the last bit means you won’t get the first two really great tranches…kind of like when you say if I saved 30% on food costs buying cheap food and serving old fish how much more could my restaurant make…answer none, people will stop going.But do you have a SWAG???
1/3 of deals return nothing1/3 of deals return 1-2×1/3 of deals return a lot more, say 3-10xyou can do the math. the top 1/3 provides the vast amount of the returns. it’s probably even more than 80/20
Have to agree it is more 80/20 – or more like 1 in 10 do a lot more, 1 in 10 return investment and 8 in 10 return nothing.
Hey Fred, wIll your interview with John be posted on the web, video or transcript? I hate soundbites. lol
Malcolm — Here are the YouTube versions — if these will do.Part 1: http://bit.ly/asn6f7 Part 2: http://bit.ly/aCGDwHPerhaps, there is a better version out there somewhere?
I really liked mark’s post. Between that and a chapter in Jeff Bussgang’s ‘Mastering the VC Game’, I have learned a great deal about how the term sheet is set up when before it was such a mystery.I strongly endorse a more transparent VC industry. All boats will rise with such an open attitude.
I’m reading the Bussgang book too — more slowly than I’d like. How are you enjoying it?
I was lucky to have a lot of travel time to read when I first got the book. I blew through it pretty quickly. Easy and accessible read that echoed a lot of what’s on the blogosphere but also added a lot to my knowledge.My girlfriend picked it up after me and sped through it as well. She wanted to know more about my interests and has now become engrossed herself.
I appreciate your clear position – its appropriate and fair, and frankly 1x preference should be the standard. Entrepreneurs arguing to eliminate it don’t recognize the risk taken and value provided by the capital; VCs that want more… are probably not the VCs you want as long-term partners. It should apply to angel rounds too; i gave 1x to my angels who were mostly friends and family without them even asking for it. The effect isn’t just for protection at bad exits either; at good-but-not-homerun exits like ours, it served to more appropriate distribute returns based on risk taken between entrepreneur and investors, taking their return from say a 2.5x to a 3+x.
Not sure about this unless it was a participating preferred. If the sale price times the ownership percentage returns more than the preference the preferred’s convert to common and the preference is irrelevant.
What is good for the goose is good for the gander (or something like that). I don’t think VCs take more risk then founders and should not be compensation more. It should be more of a fair partnership (working for the same goal) and if one wins they both win and if one loses they both should lose. Aligning investors more with founders might even ensure more home runs.
Maybe a silly question but have to ask it since it has been raised today…The VC business model is said to take on a LOT of risk by financing entrepreneurs and new innovative business ideas and hence the rationale for big rewards. (Incidentally, both – the entrepreneur and the idea – have been thoroughly scrutinized in every possible way as part of the risk mitigation process.)Can someone please elaborate the risk when a floor to the VC’s loss (liquidation preference) has already been built in?Isn’t this an option where the cost of the option is the opportunity cost (S&P @ historical 7%-8%) of the protected investment? If yes, then we are not talking about a LOT of risk anymore – right? 8% of e.g. $5M (avg.)?Thanks for clarifying…
The most important thing in Mark’s piece to me were that if your potential investors are assholes in the term sheet phase it’s going to be worse when it’s time split proceeds or they’re on your board.A smart lawyer once told me that if a VC has to count on financial engineering for their returns they’re not much of an investor.
Here’s the thing. Term sheets are just shorthand for the terms of a deal – and deals are driven by supply and demand. For a long time there was a real difference between East Coast and est Coast style deals – and terms come into and out of favor. Hopefully, everyone has good lawyers helping them out – with real venture experience – who can very quickly and easily explain all of the intricacies.I agree that simpler is better, and I agree that returns in deals are not particularly determined by terms but dictated by the terminal value.Truthfully, terms can really screw up exits – with lots of differing factors potentially pitting one investor against another – with the founders or team right in the middle.One thing that I have not seen mentioned on too many blogs about the subject is what I call “the buying of management.” It is when, in a later series of financing, a VC wil come in and give a term sheet that has management re-upped with options – but all done pre-money – so that the existing investors bear the dilution. Yet another way to lower the price paid by the new investor. Management then buys off on the deal – as they are suffering no dilution, or even may end up with a larger stake than they started with. I know most blogs talk about ways that VC’s get the better of founders and entrepreneurs – but they do it to each other as well.
i did that “buying off management” trick in the deal we did at Flatiron to invest in Geocities. the existing investors went ballistic. we ended up with a compromise. but we had to do it as the founder had sold half the business in the first round and would have been way too diluted
I’m shocked! If I remember correctly – that probably worked out well for everybody involved.I am certainly a believer that the management team should do well – they are the ones doing the real work. I’m just the peanut gallery – and occasionally the peanut gallery has something useful to add, but they are not on the field playing the game – so incentives for those who are make all the sense in the world.That said, there is something to be said for capital efficiency. If a team has done bad deals in the past – or used far more capital than they originally thought and thus got diluted – I have a hard time generating ton of sympathy – one can only assume that the opportunity that eats up $100M in capital better be much larger than the one that eats up $10M of capital.What is interesting is that I would never ever blame the management team for being “bought off.” They’re doing the hard work, and if they can get a better deal for themselves for doing the same work, god bless em. In general, I would blame the existing investor base for allowing such a thing to happen. If they are not willing to keep investing and want to become free riders with sunk costs – then whatever happens to them happens.
in that specific case, it was not blowing a lot of capital that caused the dilutionthey had simply made a bad deal and sold 50% of the business in the first round for $2mm
Can you provide some links to some of those blogs you mention?
I just closed a round of finance and this was so true. Nail on the head:”The first is the amount being raised, the second is the dilution to the entrepreneur and the ownership the investors are buying (largely the same thing), and the third is the relationship between the investor and the entrepreneur. Everything else is pretty much noise.”
I appreciate your transparency here, Fred. It’s one of the best things about this blog and has served as a major primer into the VC business. I became interested in Angel Investing after reading your blog since 2005 and closed my first investment this spring. Our documents were pretty vanilla and this is based largely on the advice I’ve read in your (and Brad Feld’s and Bijan Sabet’s, etc.) blog. I am convinced with so much dumb money floating around the VC and angel space, integrity and transparency are what will allow investors into the best companies. Many thanks for sharing.
In life, you rarely get what you deserve, you get what you negotiate.Remember to negotiate and never fail to give yourself a chance to get lucky.All the terms of any financial transaction are negotiable, some moreso than others obviously. Asking is not the same as negotiating. Go to the Chester Karass Negotiating Seminar and learn how to operate the machinery. Best money you will ever spend.As my sentiments lie with the entrepreneur, I would only caution that no deal ever “heals” itself and you can damn sure know with virtually absolute confidence that no VC is going to make an equitable adjustment in a liquidation scenario. You will only get what you agree to and sometimes less than that.As you become more successful, it is possible to drive a better bargain as well it should be. This is also why serial entrepreneurs may want to invest their own funds initially to drive valuations higher before resorting to OPM crack.
Just remembered one of your quote and there is your comment. I am one of your fan in fredland.
I wish we took money from a VC with such transparency. As Mark Suster says I will know after 2011 how much we have been screwed ( it is almost the similar situation for him in 1999 … take it or go bankrupt). Some leanings don’t come from text book … we gotta learn the hard-way and i hope the hard-way should not beat me the way JLM tells ” I will put the shoe up his ass and he will smell it in his throat”.
I’m trying to figure out what a company that is limping along looks like, or even an underwater company due to market craziness. It might be painful: some where in there is a fascinating discussion that is important to the question of “how do you get that 1x out without pissing too many people off?”Mark Suster is doing a superb job and opening up the documents so that anyone can manipulate them is really fascinating. Totally amazing way to get an education on the subject.
I’m amazed by Mark’s output. Reading Mark’s and Fred’s post is like attending street school, but online.
mark’s posts are about 3-5x longer than mine. i have no idea where he finds the time
I’m asking myself the same thing. I’m glad for us all he does find it.
I was reading some comments about the future of venture capital and someone mentioned the necessity of a future Venture Diet. What the author meant was that too much money could make the vc industry under-perform, just like eating too much would fatten you and make you unable to move properly. The author also mentioned that the money in vc is not to much, but wrongly distributed, too much in some countries and sectors, very little where it’s needed. There is always one very popular segment that gets funded and there are also the innovation segments, which are the ones that should be mostly considered for funding.
Not sure I agree with money being wrongly distributed – the money is where the money is – a quote:Usually with things, you go where you can find the financing to do it.” – Don Bluth
“I think the VC business is changing in many ways and one good way is that more and more VCs are thinking less about terms and more about terminal values. And that is best for everyone.”Very cool. Also appreciate how you break this down so that it is not too oversimplified for the pros but still makes it accessible to the novices — like me.BTW — enjoyed the interview with Battelle. Sure, my 15 y.o. got a kick out of my sharing that you said Apple is evil, but I did note that you said other things more in keeping with your trademark message. Especially appreciated what you said at the end in response to the last question — too bad not more time for questions. You may need a brand manager before long if you continue to shake things up out there. If anyone is interested, here are the YouTube links to the approx. 17 minute interview — broken up into two short parts.Part 1: http://bit.ly/asn6f7 Part 2: http://bit.ly/aCGDwHFred — it’s remarkable how much you can stir up with relatively few words!
i don’t want to watch those videos. i’m not sure i should have said those things even though i was being honest about how i feel
I posted those links for the community. I’ve been around long enough to know you don’t like to watch yourself on video.You were actually quite brilliant.
Always dig getting the skinny on the VC industry, and boiling deals down into just a few major terms.
Morning Fred, Does somebody edit these comments? Can’t see a question I posted yesterday…Wondering what was ‘wrong?’ Also would it be possible to have your links open in another tab? Thanks –
No editing from what I’ve seen over the years. I have had occasional problems in Firefox with posting questions in Disqus. Mostly because I usually have about 30 tabs open for items I’ll “read later / never.”Long story short, if your comment doesn’t post immediately it’s most likely a browser issue.
Right click on the link and click to open in another tab.
Fred,When you’re desperate for help and are new to entrepreneurship, you will bite at most deals that keep your dream alive. I’ve done this and so have many others. The thing is, there is nowhere to get help in understanding the legalese or financese for newbies except to self teach / trial and error and that is what leads to unfortunate situations. Fred perhaps you could initiate some sort of “club” where seasoned entrepreneurs and newbies could interact to learn from each other – or do the meetups serve that purpose?Dale
nice to see that competition is making the VC industry less opaque.curious:”I do care about and want a plain vanilla one times liquidation preference because I think it is fair. If the company is sold for less than the valuation that we invest at, I think it is fair that the investors get their money back in that scenario.”does this mean you don’t have any participation rights in your deals?
they are rare and getting rarer. one thing i do feel strongly about is if we are coming into a cap table where there is already participation, then there are reasons to get it for ourselves too
“or just don’t do the deal if the gap is unbridgeable” – could not agree more but, as you know with so much money and so few deals – some of you just have to find ways to stay in the game. Love the “juicers” reference.Would also like to point to a comment on the post that stated even if you could get a lawyer to explain some of this to first round founders – that still does not mean that the founders will understand how they get screwed by them, if there are ways around them and if these terms are the norm.I hope that you will, with Mark, dive into some of these fringe terms more – especially given your propensity in hoping that more VCs will work in closer partnership with their portfolios.
I’ve posted comments on other blogs on this before, but here’s a very simple way to get a VC to give you 1x, no participation (point out the following):1 – Participating preferred is bad if you are the first money in (i.e., Series A or Series Seed or whatever you want to call it). You are just subsidizing the returns of the later stage investors if the exit is meaningful (and non-meaningful exits for VCs don’t help the VC raise the next fund – if all you are doing is giving back cost to your LPs (or worse), you will be out of business as a VC). You, as the first money in, are more aligned with the founders than you are with the later-stage investors, and so you want to force a conversion decision at exit among the investor class. The early-stage investor makes money on ownership (i.e., valuation), not liquidation preference, and the money he/she is looking to make is 10x (not 1.5x-3x that the later-stage guy is looking to make). If a later-stage guys comes into a deal and sees full participation, he/she is getting a free ride and are more than happy to take it. No participation results in many exit valuations where the later-stage investor (assuming increasing valuations with each subsequent financing) will only get money back.2 – Giant liquidation preference overhang demotivates the team, and it’s the team in which you’re investing. You’re just setting yourself up for a tough conversation down the road with the team and your co-investors if the deal has been structured as 1x full participation (i.e., no conversion decision for the preferred). You’re then looking at a probable management carveout, which isn’t any fun.3 – Early-stage VCs need deal flow, which means you need to be more like the founders in terms of alignment than like the later-stage investor (goes back to point 1 above). Crappy terms for the founders means you aren’t going to get deal flow. Getting good deals is insanely competitive, especially with the capital efficiency models / angel investors in play, and developing a reputation for being a financial engineer (i.e., PE investor) is a surefire way of killing your dealflow.
I too would like to have my cake AND to eat it too.”If the company is sold for less than the valuation that we invest at, I think it is fair that the investors get their money back in that scenario.”Terms like those might be generous for the Angel and VC as an industry – but low TOLERANCE for risk and a big APPETITE for cake doesn’t make them attractive as a potential partner.In fairness – in a worst case scenario – there isn’t much at risk for the ANGEL or VC partner if they are guaranteed to get all or more than their capital back. Not much of a commitment with those terms except an opportunity cost.
allanlet me paint the scenario i am trying to protect againstlet’s say you convince me to invest $1mm into your company for 10% of thebusinessand then let’s say that you get an offer to sell it for $5mm cashyou take it, you get $4.5mm, i get $500kthat’s not fairand that is what the liquidation preference is designed to protect against
Could you kindly elaborate why this is “not fair?” isn’t that the nature of most, if not all, financial investments? can’t think of another investment that behaves like debt (guaranteed return OF capital) on the downside and equity on the upside…As Allan points out – “there isn’t much at risk for the ANGEL or VC partner if they are guaranteed to get all or more than their capital back.” assuming this is right – why then is the VC business said to be taking on great risk – at an individual investment level?…i understand the risk from the poor success ratios (2.5:10?) of the portfolio as a whole.thank you for clarifying on this already past blog…
it’s not about downside protectionit’s about alignment of interest in a low value salesee my reply to allan
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I’ve been working through valuing our traffic at SkyRank, which primarily consists of ultra high net worth investors and hedge funds. SkyRank is a patented hedge fund rating system I created, and we publish data and ratings on over 11,000 hedge funds worldwide. We’ve attempted to build a subscription model and are now opening the site up for free and my programmer is building a commenting function for our users online. We’ll see where this goes. But, we’ve been approached by some angel investors and we’re working through some valuation questions particularly as they relate to valuing different types of users. I’ve been thinking that unique visitors should be valued based upon purchasing power of the visitors. I recently wrote about this on josephomansky.blogspot.com and would welcome all comments on this topic either here on Fred Wilson’s blog or on mine. Thanks in advance for any feedback.
+1 they deserve 1x and 5% interest. Anything more is BS. It autoskews future funding.