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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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The Challenge of The Ideal First Round Term Sheet

Comments (32)

Suddenly the blogosphere is talking about the need for a standardized first round term sheet.  The latest iteration of this seems to have blossomed when TheFunded Founder Institute released a “Plain Preferred Term Sheet” (developed with WSGR).  According to the article in TechCrunch, the goal is to (a) protect founders and (b) reduce legal fees.  Kudos for yet another shot at this – between all the blog posts that have been written about this over the past few years, term sheets are no longer a mysterious thing to an entrepreneur.

However, let me suggest that the problem is not “the idea first round term sheet.”  We now have a bunch of these – the YCombinator one, the TechStars one, the NVCA model docs, and several from law firms (WSGR did the YCombinator one, Cooley did the TechStars one.)

I think the focus should be on standardizing the docs and having a handful of fill in the blank terms for a first round financing.  I’ve done my share of financings with a set of bullet points in email (I just proposed one today) and I’ve stated that the only things people should care about in the first round financing is (a) valuation and (b) the amount raised.  That said, there will always be a handful of other things to argue about in a first round investment – most notably vesting dynamics, change of control issues, and option pool size (which is really just valuation).  However, you should be able to do this off of a one page checklist that everyone understands.

But let’s get back to the real issue – standardizing the docs.  I read through the protective provisions in TheFunded Founder Institute (TFFI) term sheet and they are a version that leaves a few things out that are important to me.  I like a tighter version.

First is the TFFI version:

“So long as 25% of the aggregate number of Preferred shares issues in the financing are outstanding, consent of at least 50% of the then-outstanding Preferred will be required to (i) alter the certificate of incorporation if it would adversely alter the rights of the Preferred; (ii) change the authorized number of Preferred Stock; (iii) authorize or issue any senior or pari passu security; (iv) approve a merger, asset sale or other corporate reorganization or acquisition; (v) repurchase Common Stock, other than upon termination of a consultant, director or employee; (vi) declare or pay any dividend or distribution on the Preferred Stock or Common Stock; or (vii) liquidate or dissolve.”

Following is the standard we use in all of our financings:

“For so long as any shares of Series A Preferred remain outstanding, consent of the holders of at least a majority of the Series A Preferred shall be required for any action, whether directly or through any merger, recapitalization or similar event, that (i) alters or changes the rights, preferences or privileges of the Series A Preferred, (ii) increases or decreases the authorized number of shares of Common or Preferred Stock, (iii) creates (by reclassification or otherwise) any new class or series of shares having rights, preferences or privileges senior to or on a parity with the Series A Preferred, (iv) results in the redemption or repurchase of any shares of Common Stock (other than pursuant to equity incentive agreements with service providers giving the Company the right to repurchase shares upon the termination of services), (v) results in any merger, other corporate reorganization, sale of control, or any transaction in which all or substantially all of the assets of the Company are sold, (vi) amends or waives any provision of the Company’s Certificate of Incorporation or Bylaws, (vii) increases or decreases the authorized size of the Company’s Board of Directors, (viii) results in the payment or declaration of any dividend on any shares of Common Preferred Stock,  (ix) issues debt in excess of $100,000, (x) makes any voluntary petition for bankruptcy or assignment for the benefit of creditors, or (xi) enters into any exclusive license, lease, sale, distribution or other disposition of its products or intellectual property.”

Details, but important ones.  The protective provisions in the TFFI term sheet include the word “adversely” in section (i) – this is simply “lawsuit bait” if it ever comes to pass as an issue.  I also want a protective provision to disallow increases in Common Stock.  And – given the board size, I want a protective provision that doesn’t allow the board to be increased without my consent.  Finally, I want a protective provision against making an exclusive deal or license for the assets – this is another way of selling the company out from under the investor.

Now, I guess I’ll negotiate on these, but I can’t imagine why anyone would struggle with any of this.  Except for the lawyers.  Remember – we are still in the term sheet – just wait until the lawyers expand this into the actual financing documents.  I’m sure the WSGR lawyers might have a different point of view, as might my lawyers, or any other lawyer that looks at this.  Or, if the WSGR lawyer is on the other side of the deal (representing the VC) he might have an issue with the TFFI version.

Standardizing the deal documents would solve a huge part of this.  Also, if the lawyers acknowledged that they aren’t adding much value at this level (e.g. it’s a simple negotiation and a straightforward thing to document), you could get to a place where lawyers should be able to do this for a low fixed price (say, $10,000).  However, this has to be done at the legal level, or you don’t really solve the fundamental issue.  Sure – you theoretically can streamline the process by starting with a better “form” that has been “pre-negotiated” (e.g. take it or leave it), but until you standardize the legal stuff behind the deal, you are always going to have lawyers armed with word processors redlining things.

I’m not unhappy about the effort to simplify this – quite the opposite – I’m delighted even more people like TheFunded are getting in the mix.  However, I encourage everyone, especially the lawyers, to recognize the value in standardization of the underlying docs (with the appropriate “fill in the blank negotiated terms”).  I’m not sure how to get this to a standard point, but it’s got to be easier than figuring out if universal healthcare is possible and – if so – solving for it.

  • http://www.broderick.org/ Shawn Broderick

    Helpful post, dude. I had exactly this discussion like a dozen times yesterday. We can't forget how incredibly valuable it is to teach the entrepreneurs how to fish. Presumably this would be only the FIRST of many term sheets they're going to need to negotiate.

  • http://www.loupaglia.com Lou Paglia

    Was feeling pretty confident this was going to happen until you brought universal health care up as a proxy. ;)

    • Jay Levitt

      Four words: Venture capital death panels!

      • http://intensedebate.com/people/bfeld Brad Feld

        Egads.  No thanks.

  • Dave Oshinsky

    I'm an attorney, and I am fine acknowledging that the lawyers are not (typically) adding much value at this level, especially when it comes to reviewing and negotiating the deal docs. Where a good lawyer should be adding value, though, is in his or role as a counselor. For entrepreneurs that may be uncomfortable or unfamiliar with institutional financing, the whole process can be pretty intimidating, and the deal docs (full as they often are with time-honored, over-drafted provisions) can be downright soul crushing. The startup's lawyer needs to be there to hand-hold through the process and answer any and all questions (and, hopefully, with more than just a wave of the hand and an "oh, that's all standard language").

    I have done a number of early-stage investment deals where the bulk of my time was spent on the initial document review – that way, I am prepared to quickly answer questions, and quickly understand and efficiently respond to changes and comments. There may not be a ton of value-add there, but it's not a huge amount of time, and I see it as an essential step for proper representation. To the extent that standardized documents help skip that step (or at least shortcut it, so that the initial review is basically a redline to see what has been changed), then yes, there's time and money to be saved.

    I love that this conversation is happening and potentially even bearing fruit – after all, for me, the fun part is not the funding deal but after my clients get funded, when I get to work on their licenses, alliances, development deals and commercial transactions – but I think we need make sure this movement doesn't end up throwing out the lawyers with the bathwater. I would argue that lawyers still need a place at the table, however small…especially on the company side, maybe not so much on the VC side.

    My $0.02, anyway. I'm cool with VC death panels, too, though some of my clients might tell you that's redundant.

    • http://intensedebate.com/people/bfeld Brad Feld

      Dave – all good points.  The highest and best use of an attorney at the seed / first round stage is as an advisor to the entrepreneur.  If the entrepreneur is experienced, the advice is less valuable.  If the entrepreneur is a first timer, the advice can be very valuable.  If the docs were standardized, it’d be even clearer where the value is!

      • Dave Oshinsky

        I agree. Though there are plenty of "experienced" entrepreneurs more than happy to expose the limits of that alleged experience. And just as lawyers need to take an active role in managing client expectations, I think it's important for clients to control their lawyers and make clear what issues are and are not priorities. Definitely a two way street – too many lawyers don't keep their clients adequately in the loop, and too many clients are afraid to insist that counsel controls costs, notifies them at certain budget thresholds, etc.

  • PhilSugar

    I think the key is understanding the percentage of the deal….and that's super important.

    I understand that for a $20M round a $10k legal bill is irrelevant compared to how much money the company is going to end up spending on toilet mints.

    But when you are talking about a sub $500k round or a sub $100k round….you can't have a bill over $10k.

    One of my best one liners was when a lawyer yelled at me……"I would expect this kind of language in a car dealership!!!"

    I asked him what he drove? "WHAT?" What do you drive????? "What kind of question is that!!"

    Have you looked at the size of this contract???? You brought it up….what do you drive????

    Silence…..

  • http://intensedebate.com/people/bfeld Brad Feld

    Awesome one liner!  Just awesome.

  • http://intensedebate.com/people/david_ulevi3244 David Ulevitch

    Lawyers are not highly incentivized to streamline their work and create standard docs for use. Not to mention that these term-sheets, while called "ideal first round term sheets" are really only ideal for naive first-time entrepreneurs.

    Call me bitter, but I just don't see this happening, and frankly, I don't see the value. First-round deals are already fairly straightforward when the angels haven't screwed up the cap table. And when they have, these docs won't save you.

    • http://intensedebate.com/people/bfeld Brad Feld

      I agree that the value of this standardization is largely for first time entrepreneurs.  But – there are plenty of them and they keep being created (or creating themselves).  Plus, I know plenty of experienced entrepreneurs that don’t really want to think about this stuff much at the Series A level – they just want to get on with things.

  • http://www.liebermanlaw.com Saul Lieberman

    I am not sure that you can standardize the documents to the point that you have "only a handful of fill in the blank terms for a first round financing." (Witness your difference of opinion with TFFI.)

    I have a more modest proposal: parties can agree to start with a "standard" form that is really only a "starter" form. That alone can be useful — even if the parties make changes beyond filling in the blanks. Everyone knows the content of the starter form and can focus on the changes only.

    In a previous life doing office leases in NY, there was a "Blumberg form" that was used for smaller deals. I guess it started as a "standard" form and evolved into a "starter" form. Even though law firms developed their own "standard riders" to that form (to add their own particular preferences as well address changes in law, etc.), it was better than reading and commenting on an entirely new lease agreement — for a small deal. But the same form was used for many years (and may still be used today).

    • http://intensedebate.com/people/bfeld Brad Feld

      I actually think this is conceptually easy to standardize but very difficult in practice.  All we need is for the major law firms that cater to VC-backed companies to get together and standardize the docs.  You could probably accomplish this with WSGR, Cooley, and Gunderson.  Once they’ve agreed, they can work to get all their colleagues to agree.  Then they’d have to live with both sides of the deal and the corresponding nuances.

      The challenge is getting WSGR, Cooley, and Gunderson in a room together to work on this particular effort.

      • http://intensedebate.com/people/Yokum Yokum

        I'm late on commenting, but as the author of the TheFunded Founder Institute term sheet, I'd volunteer as the WSGR rep to be locked in a room with folks from other firms. I'm not sure if creating "NVCA"-lite documents is the answer. It may require a completely different approach to these concepts — such as creating the Creative Commons-style human readable version of a term sheet with standard legalese that corresponds to the human readable version. Just talking out loud …

        • http://intensedebate.com/people/bfeld Brad Feld

          Thanks for volunteering.  I actually think a standard “legal” version should be able to work – I think the key is to link the term sheet to a set of underlying docs that everyone agrees is a standard contract.  Then – no changing the underlying docs, except fill in the blanks.  One can dream.

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  • http://intensedebate.com/people/mbsolon Mark Solon

    I think this is one of your best posts Brad. Everyone's getting in a lather about this. There's a happy medium out there and we're moving towards it. I think the key point here is a "starting point". There will often be a reason to tweak the boilerplate. I've seen dozens of these. Maybe someone on the founding team has a reputation for bailing early and you want to address that through the option vesting. Perhaps it's a participating preferred that's capped so that an early exit if necessary is palatable to everyone. Like so many other things in life there's no "one size fits all" here but I'm glad that our peers are recognizing that it's about making this easier on the entrepreneur, especially the first timers. They've got enough to worry about…

  • http://intensedebate.com/people/PhilSugar PhilSugar

    As soon as I see the word "tweak" or "start" with I see the "full employment act" of lawyers being invoked.

    My lawyer has to make a change otherwise I'll think what am I paying for and then the opposing lawyer of course can't have the stigma of looking weak by just accepting the changes, and so on and so on. (I'm convinced once you pass the bar there is a secret ceremony where this is taught)

    There are many deals where the terms are fixed and you don't "tweak" that are larger than first round deals. Big expensive car leases, purchases of database software from Microsoft or Oracle, computer purchases, lines of credit, etc.

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