Edu: Term Sheet Pitfalls – Don’t Turn Your Cap Table Into a Crap Table

Yaniv: They're basically trying to lower the valuation without it looking that way, right? They're getting twice as many shares for the same amount of money. They're basically coming in at half the valuation. And so it's a bit of a little trick.

 Hey, I'm Yaniv.

Jessy: And I'm Jessy.

Yaniv: Welcome back, Jessy. Last week you and I talked about investor comms, how as a founder you should be communicating to your investors post capital raise. Today we're going to go deep on another topic, which you also had a really great LinkedIn post about.

You do have a habit of writing these great LinkedIn posts where you go pretty deep on a topic and we thought, let's dive in and add even more context on another one of them, which is things founders should watch out for. On term sheets these days, there are some new things coming on term sheets that haven't appeared. since before the hype of 2020 and 2021. So a lot of investors are saying things for the first time. A lot of founders are saying things for the first time. so we are here to talk you through these different terms and what they mean and what most importantly to watch out for.

Jessy: Yeah, for Sure. Happy to.

Yaniv: Okay, so we've got a few here. let's start at the top, which is warrants,

Jessy: So, a warrant is basically something that gives the investor a right, but not an obligation to buy additional shares in your company at a set price. Normally that price is set below.

What would be the market price? maybe add a discount to the market price or it's set at the price of that day of the warrant being done. So warrants sometimes have conditions attached to be able to kind of unlock that warrant. it could look like a corporate VC getting a warrant for additional shares at today's price.

If, for example, that corporate goes ahead and executes on a partnership that unlocks a lot of additional revenue for that company. So it's almost giving that corporate a Cara incentive to do the hard work of executing on a partnership because there's this additional upside that they get to realize through their equity holding, by this warrant becoming a lot more valuable than it would be if they don't execute on that partnership.

sometimes you also see though, Non-strategic investors. So not corporate investors, just, pure play angel investors or VC investors wanting a warrant, just as part of the deal. without having to do anything or, simply just by being a kind of value adding investor, they get this warrant for additional equity sometime down the.

That's maybe something worth, watching out for, or at least giving quite a lot of thought to. It is probably a non-standard in vc and it rewards that investor, disproportionately for simply being a normal investor in a way that you would expect all investors to be.

And creates what we call cap table risk because accepting a warrant from one investor, particularly a minority investor, can put the other investors on guard. And a lot of investors can be reluctant to sign up to materially different terms in the same round. So having a early investor come on board that says, oh, I'll only invest if I get this warrant.

Just underline that and know that there are risks and trade-offs associated with accepting those terms.

Yaniv: Yeah, the way I finally understood what warrants are is that they're basically stock options. when you offer employees, employees stock options, you're giving the right, but not the obligation to buy shares at a given price. And that's, what a stock option is. a warrant is the investor equivalent of that.

And like you say, they are used in certain scenarios. you know, circular, we take on a. Debt, investment because of our asset requirements. And I actually think Warren's are most common when you're taking on debt type investments, right? these debt investors, they don't have the same risk profile as equity investors.

So they don't want to buy any equity, right? They're lending you money and you have your, normal repayment terms. But because they're still taking a, a bit of a bigger risk, rather than jacking up the interest, even more, in a sense, part of the interest payment is taken in this optionality, right?

They're saying, okay, we're taking a little bet on you. you give us some warrants and if you're really successful, partly as a result of the debt that we gave you, we take an equity position in your company at, this price. and that. Pretty standard. So if, you're raising debt, you wanna make sure that the warrants are not egregious and then it becomes a question of like how much is a reasonable amount of warrants.

But you will probably be facing warrants, for equity investors. Like you said, it's kind of weird and I don't really understand why you would want that. So

Jessy: Yes.

Yaniv: Definitely a bit more of a yellow flag there.

Jessy: I think for debt investors it also aligns incentives in a way that could be quite powerful. So if they've just provided your debt, then you could argue that their primary incentive is to get you to spend that money that you could spend on growth, on paying back debt. Which might really be at the expense of the company overall and certainly of the people who hold equity in that company.

So actually giving them exposure to equity upside kind of mitigates against that incentive a little bit and makes them more supportive of you spending on growth as well as debt.

Yaniv: Again, because people tend to be more familiar with employee stock options, you really wanna think of it the same way, which is why do you give your employees stock options? under what circumstances do you wanna create those same incentives for investors? Those circumstances exist, then it's a reasonable place to do it, otherwise you shouldn't.

Okay. Next topic is Tranched funding, which used to be quite popular, especially in smaller markets, went away and it's maybe making a small comeback. So tell us about that and why it's a bit of a flag.

Jessy: Yeah, so tranched funding is basically when I say, look, I'll invest a million dollars on these terms on a 10 million valuation, but I'm going to why you. 300 K now, and then I'm gonna why are you another 300 K when you achieved this milestone and the rest when you achieved that milestone? so in a way you can advertise that you raised a million dollar round, but you actually can't necessarily count on the entirety of that funding coming through, unless you achieve these two things along the way.

The reason that it's something for founders to be wary of is that things don't always. Go the way you think it's going to go. some things might be your control some things might not be, and also there might be times where it actually makes a lot of sense to pivot. what is a, metric that you're going after at any given time?

For example, when the market conditions changed and stopped valuing growth as much and started valuing core profitability more, it might have made a lot of sense to actually take the accelerator. Off the pedal when it came to growing the business and focus on really profitable growth, and shoring up unit economics.

So having these conditions baked into your receipt of the funding just limits your ability as a founding team or CEO to steer that ship as you ought to. and it really can leave you in the lurch if for whatever reason, you're not able to meet those conditions, leaving you high and dry.

When that investor doesn't wire the subsequent tranches of funding.

Yaniv: Yeah, so tranche funding is the investment equivalent of micromanagement, but even worse than that, this is micromanagement. That all happens in advance, right? Like you agree on these terms. It's like, imagine you have a micromanaging manager and you sit down in January and they're telling you all the different things that you need to do all year, and you're basically locked into that.

It's actually the same reason I don't like, most performance based, bonus schemes. completely different topic, but, I know it's quite common to give senior execs like, oh, you know, we're gonna give you some KPIs and then we'll bonus you against that. And guess what? Same problem. We've locked people into an incentive structure that forces them to pursue a certain course of action, even if in the circumstances it is no longer the best course of action.

So it's a bad way. It's a low trust, low value way of managing a relationship. And to me it's a sign of an investor who doesn't understand the game they're playing, right? Which is really taking calculated bets on founders and teams, rather than trying to control how those outcomes are achieved.

Jessy: Agreed. I like the analogy.

Yaniv: So, liquidation preferences. Now these ones are common and they're not always bad. but let's talk about what they are and when you need to start worrying about seeing them on your term sheet.

Jessy: So a liquidation preference. Is when an investor automatically gets more than the money that they put in, as long as the company, liquidates or achieves liquidity for more than the quantum that they invested.

And look there. one times liquidation preference, which is I guess, the standard case or maybe the default case. And then you can have 1.52, probably up to four. I I haven't seen anything above four. but I have actually seen everything in between. So for example, if you invest a hundred million at a three times liquidation preference that means if the company exits four, 500 million, you would get to pull 300 million out of the business.

Anyone else who also had liquidation preferences? they're at the top of that . Preference stack would also get to pull that much out. And what it often results in is the common shareholders, which is what founders and employees are automatically on. they actually walk away with nothing in the business, even if they achieve, what on paper looks like a good exit because the investors in that stack with Preference shares get to pull a lot more out,

Yaniv: That's right. So liquidation preferences, as you say, Jesse, they're a way of investors locking in kind of a minimum return in that kind of medium, Exit scenario. It's like, you haven't gone to zero, but you've had a kind of crappy outcome. The investors are like, look, I took the risk. I need to get a certain amount of money out before anyone else gets made whole.

And so a one x liquidation preference, I think, which is very common, is just saying, Hey, like if I put in a million dollars and my stake is worth less than a million dollars when there's an exit, I still get my million dollars back. That seems pretty reasonable. And then, two three x is basically saying, I expect a certain return in this kind of mediocre outcome.

So I think, like you said, the higher the liquidation preference, the more you need to consider whether this is fair and reasonable and whether it creates the right incentive structures. it can be necessary when you're in a lot of trouble and you're raising a bit of a hail Mary round, and this is a bit of a yellow flag, but sometimes this is a yellow flag.

Where both the founders and the investors are in on it. I think I've seen sometimes liquidation preferences used as a way of getting a higher headline valuation, right? it's like, okay, I wanna be able to say we've raised a valuation of a hundred million dollars. The investor agrees to do it, but they're saying, okay, I'm taking a bit more risk on the size of my return because I'm valuing you so highly, so I'm gonna get liquidation preferences to make up for it.

Now the other thing, I don't think that I've seen it make that much of a comeback, but, the type of liquidation preferences we've been talking about are called non participating liquidation preferences, which is basically saying, you Either get your million dollars back, or if it turns out your share is worth 2 million, you get 2 million. So it's the greater of the two. but then you've got participating liquidation preferences, which are a whole different ballgame. So, Jesse, tell us about those and why they can be a bit icky.

Jessy: So look, we don't see these kinds of terms in early stage investing. normally there's not enough of the pie to fire over to put in, participating preferences. But what it broadly means is that you kind of get to double dip. so after that, say two x liquidation preference has been paid out and there's still money left on the table, that investor who holds that preference gets to once again take part in the continual division of what's remaining.

Yaniv: Yeah, that's right. It's exactly the double dip. It's like instead of getting the greater of those two, like the 1 million or the 2 million, you're like, I'll take my 1 million off the table, and now I'm still in line for that 2 million. and it's just kind of, I don't know. As a founder, I find it a bit gross. I can't imagine a scenario in which that's really a good faith. Equity structure, although I'm sure there are some edge cases where it makes sense. definitely, like you say, Jesse, it's probably not one that you'll, see, but if you do, I would run in the other direction if at all possible.

So the next one that we wanted to talk about was investors who are looking for a bit more They want sweat equity to act as advisors or, something like that to say, well, we're value add and so we should be compensated for that value add with even more equity. now what are your thoughts on that type of condition?

Jessy: Yeah. So I think sometimes this looks like an investor saying, I'm gonna invest a hundred K and I'm gonna be helpful and you're going to give me 200 k of equity at today's value for that. the reason I would call it out is that there's just a pretty large host of VC funds, early stage VC funds, accelerators and angel investors who see that as completely non-standard and who, would expect themselves to add a lot of value in sweat for their companies without asking for more equity than they've invested.

So I think the ones that are asking for square equity and trying to kind of pass that off as something. Normal and fair are probably less sophisticated. like not that engaged with the ecosystem and up to date on the standard practices. or they're betting on the fact that you are not particularly engaged with the startup ecosystem and they can kind of get one over you as a result of your ignorance.

So I think probably not right to give up loads of your business to, somebody who invests but then also wants extra cream on top. I think it just telegraphs, slight bad faith from them.

Yaniv: there's an element of, It's just the convention. It's like investors help and they don't charge for that help. so like you said, it's, non-standard, but I think, depending on the size of the sweat equity that is being granted And, like you said, Jesse, it's, generally not good faith what effectively the investor is trying to do.

 Is they're basically trying to lower the valuation without it looking that way, right? They're getting twice as many shares for the same amount of money. they're basically coming in at half the valuation. and so it's, a bit of a tricky little trick.

I think there's one exception, whether it's sweat equity or something else. And, you know, I've done this just once or twice myself, which is if you're a small time angel investor, you've written in a very small check, so you're not a significant equity holder, and then you're asked for help that goes above and beyond just being, you know, generally helpful as an investor.

Then I've sometimes said yes, but I will need to. Charge for that service. And that can be, as a contractor or for sweat equity. I think that's acceptable. But again, you don't want to be exploitative. And I think that's the line. I think VCs should very rarely be expecting this type of compensation.

Jessy: Yeah, Agreed with that.

Yaniv: Okay. So this isn't something to watch out for Exactly. But over the past few years, Especially at the early stages and creeping into later stages, we've had safe notes replace the traditional so-called priced round as a very common way of raising money. So we thought, we'd just talked briefly, I guess, about what a safe note is, and what to watch out for when you are raising on safes.

Jessy: So a Safe Note stands for a simple agreement for future equity. Normally, safe notes are used because they're simple, they're well understood. There's legal templates for lots of different geographies under safe notes, and it just allows an investor to put in, money to around, against something quite proforma, without having to do all of the legal. Involved in a price round. So they're often quicker. They don't require both sides to, get significant legal advice. and it's technically an unpriced round, so it doesn't necessarily require someone to set the valuation.

Now, typically the valuation does get set in some way through a cap and discount mechanism. So a cap on a safe note is, the maximum at which this note will convert into equity. And the discount is, discount on how much that safe holder would get on a future valuation. So, for example, if there was a safe that had a $5 million cap and that startup goes and raises at a 10 million valuation, that safe note holder would have their cap convert as if the valuation was just $5 million dollars instead of 10 million dollars. Or if there's, for example, a 20% discount and that startup went and raised at a 10 million valuation, that safe note holder would get those shares at a 20% discount to that valuation.

Yaniv:  Like you said, they're technically unpriced. I think there's this interesting thing where safe Notes have perhaps deviated from their original intention and some of the propaganda for them, which is like, oh, it's too early to set evaluation. So raise a safe note.

In practice, I very rarely seen an uncapped safe. And in fact, I would consider it a red flag at this point. So generally you do set valuation and the mechanism for that valuation is simply the cap. Now, what actually makes safes appealing these days is that they just have a lot less paperwork, what happens is when you're a safe holder, you don't technically hold equity in the company, right? It's called a simple agreement for future equity. So you have a contract to get equity in the company based on some future event. Until then you know, you have that contract, but you don't have the equity itself.

It means you don't have to constitute a board, you don't need to have a, shareholder's agreement. And you know, it's just nice and easy.

Jessy: Yeah.

Yaniv: And in that sense, it's considered founder friendly and generally founders like them because they're less effort. and they give their investors fewer rights less control.

So in that sense they are founder friendly and what you'll find is, founders pushing the safes as far as they can go. but eventually you get to evaluation to a size of round where the investors are like, no, we, we wanna actually hold equity in this company. And that's when it ends.

I think that's generally the case that safes are founder friendly, but there are still a couple of little things to watch out for. You can have what's called a post money safe or a pre-money safe. and that simply determines how you value. Equity. when that conversion takes place, because like I said, eventually you raise a price round and then all those safes turn into shares at that capped value.

And the question is, does the value of that cap include all of the equity that's going to be issued or does it exclude that? and more and more now, you see what's called a post money safe, where all the money that you've raised in safes goes towards the valuation, of the company in the cap. so let's say you've raised money at a $10 million post money cap, and you've raised a total of $5 million using that, well, that actually means you only own half the shares in the company, right?

Because 5 million is with the founders and the other 5 million gets split across the safe holders. and so that's completely reasonable. But the thing is, because safe, so easy to raise, you can get in trouble. If you raise too many safes with a, post money cap, you can eat away a lot more equity than you realize.

And because it doesn't sort of show up in an obvious way on your cap table, it's something to watch out for.

Jessy: And I think it's particularly worth watching out for in this current environment because when you are modeling out how much dilution you're taking, let's say you raise 2 million on a $10 million post money safe, and you are like, cool, I've given up 20% of my business at pre-seed. That's fine.

That's, within the benchmarks. And then you go and raise more at seed, maybe on another safe, you give up another 20%. maybe you've moved the valuation up. So it's 20 million at that point. But let's say, things change. You don't find product market fit at quite the time you thought you would, or market conditions drastically change.

And to get any funding away for a Series A, that investor actually comes in and prices that series A at 10 million. Now you've raised to rounds that are both discounting from what the next price round is. So suddenly, instead of giving away 20% at. S Pree and seed and then series A like you thought, because the valuation of the price round is lower than the cap.

The way that that cascades through the discounts might actually mean that by Series A, when all the safes convert, you've given up 80% of your company, which is probably not within the benchmarks of what a lot of investors, in series B and onwards think. So don't just model out the best case scenario.

Everything goes to plan. I raise well in excess of my cap. also think about not putting yourself in a bind. If for whatever reason you can't actually raise it above your car,

Yaniv: Like I was saying before, you do effectively set a valuation, on your round, but it's called a cap for a reason. Like you said, Jesse, is, a maximum valuation, but there is no minimum valuation. And so that's where it gets scary. It's, actually a type of anti-dilution for the investors, if you think of it that way.

And so yes, when you start getting into the world of down rounds, you can find yourself kind of wiped out by a dilution if you're not careful.

Jessy: The thing about a price round is that investors then are in it with you, if there's a down round, they would get pushed down their holdings in the business, alongside your, common shares. Whereas if they're holding a safe, they actually just convert that safe at a proportionately lower valuation.

So sometimes it is actually worth doing a price round to clean up all the safes, get everyone, fully aligned, fully shareholders in the business, alongside you rather than.

Yaniv: So one thing we just thought, we talked very briefly in passing, when we were talking about safes, is the, grandly named most favored nation status, because that's recently been introduced into why Combinators standard deal and why C were actually the inventers of the safe.

So they're still very much have a, kind of thought leadership, and so we're seeing it become a bit more popular.

So what is the MFN status?

Jessy: Yeah. So most favorite nation normally it comes in a side letter. and it just means that whatever you negotiate with another investor, in this round, I'll get that as well. So suppose some other investor goes and negotiates better conversion terms. or a better maturity date, or they negotiate a better car, better discount.

When all of the safes convert, I will get what they get. and look, we do put it in our safe agreements because we think that it aligns incentives. It means that I can go and fearlessly introduce you to all of the other angel investors, all of the other VC funds that you want me to, without worrying that one of them is going to do a better deal with you that I'm not also privy to.

So if they manage to negotiate a better cap or a better discount, then I will get that too. And it just aligns incentives in that way, even at the safe note holder.

Yaniv: So just, stops earlier investors from being screwed by later investors. And ultimately, I'm inclined to agree with you. That's in everyone's best interest, including the founders, because it's just gonna create a lot of acrimony if, you try to pull something like that. Anyway, okay. So those are all the things to. watch out for on term sheets. I do think, Jessy, I, I'd say, to every one of these rules, there are many exceptions, this is general guidance and, you know, ultimately when you are raising capital for your business, the circumstances are always unique.

They might be only a little bit different. They might be quite different. And all of these terms, there are times when it is reasonable to take them, but know that they are somewhat non-standard and that they can have some serious negative consequences down the line. So what we're trying to say here is go in with your eyes open and understand what's normal and what might be a little bit unusual.

Jessy: And I think I'd encourage founders to think of the fundraising process, including the setting and acceptance of terms, as a negotiation. All of these terms are levers within that negotiation. For example, if you want a higher valuation, somebody might ask for liquidation preferences, and it might actually serve you to have that high headline figure; maybe you think it's really important for hiring. So be the own judge of what you're trading off, but just be clear-eyed about what these trade-offs are and hopefully we've done a little bit to eliminate that here.

Yaniv: Absolutely. I think it'll be very helpful for a lot of people right now staring at term sheets for the first time and wondering what all these things are and, whether they're reasonable.

 That brings us to the end of our time. Jessy, thanks so much for being really generous with your time. I think it was a, fantastic discussion. As always, I hope to have you on again in the

Jessy: Yeah, thanks for having me. And if you are an early stage founder and you are actively fundraising or you're thinking about starting fundraising, we are actively investing through all of 2023. So, do feel free to hit us up. You can check out the after work website, after work.vc, or get in touch with me over.

Yaniv: I just wanted to thank everyone who has already honored the startup podcast packed. As a reminder, if you are listening to more than one or two episodes of this podcast and you are getting value from it, You've signed up to a deal and the deal is we would like you to rate review and follow. Our podcast on your favorite podcast app. We'd love you to follow us on YouTube, and we would also appreciate a shout out on social media, LinkedIn, or wherever you have your audience. for those who have already done the pact. it makes such a huge difference and helps more people find us. So a big thank you to all of you.