One of the things that venture capitalist Bill Gurley touched on in his epic post was the terms of deals. One thing that I always admire is really clean term sheets. I value them-and never try to be in a deal with a lot of terms.
It’s critical for all parties to a deal to understand the terms of the deal. Some entrepreneurs and VCs will try to put in tricky terms that are “interpreted” down the road.
Brad Feld wrote a book I suggest reading. Last January, Gurley alluded to problems with terms when he said capitalization tables in later stage deals are set in concrete.
Here is Gurley’s primary concern: Privately-held companies that raise lots of funding at higher and higher valuations eventually build up tons of liquidation preferences. For the jargon-challenged, liquidation preferences are inserted into venture funding deals to ensure that the VC gets paid first (and how much) if the company is sold (i.e., generates liquidity). If a company is sold at a massive valuation increase, then it’s largely academic, as everyone gets rich. But if the company is sold at a price below where it last raised money, it could leave a bunch of people out in the cold, including employees who were largely compensated with stock options.
“The cap chart begins to calcify a bit, which eventually can be problematic,” Gurley explains. “Hiring new employees, particularly senior management, becomes tough because they worry about getting stuck beneath a huge liquidation preference stack. Some of these deals have so many [anti-dilution terms] that the cap table becomes almost concrete. If the valuation goes down significantly, it will sink them.”
Don’t make terms a problem in an early stage term sheet. I really dislike aggressive liquidation preferences, dividends, and other terms that get in the way. Terms are often put into the deal to try and de-risk it.
At early stages of startup life it’s all risk. If they are uncomfortable with the risk and terms make them more comfortable maybe they shouldn’t be taking it.