Guest blogger, Ivan Gaviria today walks us through 5 terms founders should focus on when navigating their first term sheet:

Ivan is a partner at Gunderson Dettmer’s Silicon Valley office, practicing in the Corporate and Securities Group. He has extensive experience working with startup and emerging growth companies through their entire lifecycle as well as representing venture capital, private equity and other investors. For more great resources, we recommend checking our these docs on DocStoc and VentureHacks.

The Series A Term Sheet: 5 Terms Founders Should Focus On

It turns out that a typical Series A Term Sheet for a private company venture capital financing can be as much as 4,000 words long. Given that for many people 140 characters is plenty these days, that is a lot of verbiage for even the most detail-oriented founder.

To try and make it easier to separate the “boilerplate” from the stuff that really matters, I’ve summarized below what I think are some of the terms that a founder needs to drill down on.

Everyone in the tech business is on information overload; the trick is to apply your limited bandwidth in the right places. Of course, as a lawyer, I would never suggest you skim the fine print. My point is that even after your lawyer, the entrepreneurs in your network, your mentors and whomever else you trust have read the fine print and given you their opinion, there are some key provisions that you have to understand and have your own opinion on.

The following comments are done in the order that the points generally appear in a Series A Term Sheet (and I’m skipping valuation on the theory that if you need math help from your lawyer you’re already in trouble):

Option Pool.

Sometimes tucked into a paragraph on “capitalization,” term sheets will generally define price per share as being based on a pre-money valuation of $X and a cap table that includes a “post-financing option pool of Y%.”

The idea is that if the pre-financing option pool isn’t deemed big enough, the investors worry about being diluted shortly after their investment by a pool increase. Accordingly, the desired pool size is factored into the negotiated valuation such that the founders and other pre-financing stockholders bear the dilution. Certainly you wouldn’t expect a new investor to jump into a company with no option pool and accept inevitable and instant dilution. Nor should founders adopt a giant pool and forever protect investors from dilution that is expected in a growing and healthy company.

The key is being thoughtful about finding the right middle ground – how robust is the team at the time of the investment? Is it an industry or region where equity is more or less important a driver of recruiting/retention? Is the hiring plan tailored to the operating plan? Does the team know up front that a major hire will be needed (e.g., is it obvious that the founder group is missing a CEO), etc.

Spending some time on these issues and coming up with an option pool budget helps you have a reasoned approach to pool size. If you can’t tie the pool discussion to the business plan, then it’s just an extension of the valuation discussion and, for the founder, a less effective way of addressing the issue.

Dividends.

There are generally two schools of thought on dividends – (1) they basically should never be declared in an early stage company and any retained earnings should be used for growth and (2) there should be an annual dividend that at least guarantees some modest return. A hybrid favored by some East Coast investors has dividends accumulate from the time the stock is purchased but provides for them to be paid only upon an exit event.

From a founder’s perspective, the second approach can have a real impact on economics. A typical dividend of that type might be 6 to 8% accruing annually – add that up over several rounds of financing and several years to an exit and it can be a major spiff on top of the liquidation preference. So from a term sheet standpoint, you better know what you’re getting!

School (1) generally includes the phrase “when, as and if declared” – the magic words to say there is no mandatory dividend – only a dividend preference for the Preferred if the Board declares a dividend. School (2) will say “cumulative” or “mandatory” and generally have more extensive verbiage around the accrual period, whether they are paid in cash or stock, and whether they are paid regularly or only at exit.

If you’re not sure what you’ve got you need to ask. And always be cognizant that a later investor will want the same terms so an innocent looking 5% on a $750K seed round could be a big deal down the road.

Liquidation Preference.

The basic concept of a liquidation preference is pretty simple – if you liquidate the company, the preferred stock gets money back before the common stock.

But, in the world of venture financings, a sale of the company or its assets is always deemed “a liquidation.” So we’re not just talking about preference over assets when something craters, this is also about how you divide the money when the company gets sold. Who gets their money first when there isn’t enough to go around and how fairly is it shared when there is lots to go around. The problem is that there are half a dozen ways to structure preferences and several of them have multiple names in the lingo – 1X/no participation; “double dip preferred,” “fully participating,” “participating preferred with a cap,” preference multiples with no participation, etc.

In later stages of investment, you also have to deal with “intramural” issues among investor over whether senior preferred should get paid ahead of junior preferred, etc. It’s a bit much to try and review in detail here, but suffice it to say that these provisions are THE major drivers of economics in an M&A exit, and you need to take care to understand exactly what is being proposed and the economic impact at various valuations.

Board Composition.

Virtually all venture capital financings require that the Company reserve one or more seats on the Board of Directors for the investor(s).

Following a Series A financing, a fairly common structure is an odd numbered board (to avoid deadlock) with an independent director as the “tiebreaker” between the directors designated by holders of preferred stock (the investors) and those designated by the holders of common stock (the founders).

In syndicated rounds with multiple investors, 5 is a very typical post-Series A board consisting of 2 investor seats, 2 common seats and an independent. For smaller rounds with a single investor, one might see a 3 person board with 1 investor seat, 1 common seat and an independent. One subtlety to be aware of from the founder perspective is whether a “common” seat is hard wired to the “then serving CEO.” The term sheet typically phrases this as something like this: “Holders of a majority of the Common Stock shall be entitled to elect _____ member(s), one of whom shall be the Company’s CEO.”

In other words, if the founder is no longer the CEO and is replaced, the board seat goes with the office – which can tilt the balance of a board away from the original founder group. Of course the pros and cons of that approach will often depend on the individual circumstances of any particular team or deal; what’s important for purposes of the term sheet is to understand the issue so you can make a knowledgeable decision. Similarly, the choice of the “independent director” can make a huge difference in the tilt of a Board and the choice should be made with care.

For more perspective on Board composition issues, see the following post at Venturehacks.

Founder Vesting.

Often the Series A term sheet will be used to negotiate founder vesting as part of the overall terms and conditions of the financing. With few notable exceptions, the primary value in a typical start up company is in the people and, not surprisingly, investors want to make sure those key people stick around.

As with everything in this business the basic concept is simple – stock owned by the founders is made subject to a repurchase right, exercisable by the Company if the founder quits or is terminated. The repurchase right “lapses” on a negotiated vesting schedule so that fewer and fewer shares are “at risk” over time.

Again, though, the devil is in the details. What percentage of the founders’ shares will be subject to the repurchase right? Over how many years? Will the vesting accelerate if there is a sale of the company? What about acceleration if the founder is terminated without cause? What sorts of things should constitute cause?

It’s a topic on which several hundred words could be written just walking through the lingo – “good reason,” “double trigger versus single trigger,” “constructive termination,” etc. So let me make just two high level points.

First, this is an area where founders often get their first taste of being a bit conflicted. From an individual perspective, a founder might wish to be as aggressive as the market will bear on vesting schedule, acceleration terms and other founder protections.

As a co-founder or CEO, however, one also has to consider the founder/co-founder dynamic as much as the founders/investors dynamic. I’ve often seen co-founders set up aggressively pro-founder vesting terms only to have a team member break up the band and walk away with a lot more equity than the remaining team would have liked. As a related second point, this is an area where it pays to try and strategize a few moves ahead to build consistency into equity terms on the team. Having a patchwork of different deals can create odd incentives or hurt morale if, as a result of different acceleration terms for example, a deal will produce widely different economics for employees at similar levels. In any event, a founder going into a Series A term sheet negotiation should understand his or her existing stock terms and exactly how the term sheet proposes to alter or amend those terms.

Some Final Disclaimers

Having said all of that, I will make a few final disclaimers. First, this entire discussion assumes a company on its first round of professional financing from a VC or angel investor accustomed to working with startups.

Occasionally startups will have an early engagement with a commercial or strategic partner that yields a financing and those deals can vary greatly from what we generally refer to as “market” terms from a venture capital investor. Also as alluded to above, there are additional degrees of complexity as you layer in additional rounds at different valuations. Reasonable VC’s and founders may of course have legitimate disagreements about how to balance these terms, the important thing is to be as informed and self reliant on the key terms as you can be.

Lastly, thanks to the team at Under the Radar for providing this forum and for all they do to support the startup ecosystem.