Terms Outrank Valuation

The Core Insight

In 1957 American Research and Development put 70,000 dollars into Digital Equipment Corporation. At the 1968 public offering the stake was worth over 355 million dollars, more than 5,000 times the money in.

The 70,000 dollars bought 78 percent of the company, on a 90,000 dollar post-money valuation. Both halves of a venture deal sit in that line. A price was set, and 78 percent was control.

Brad Feld and Jason Mendelson run Foundry Group, and Mendelson helped draft the NVCA model documents. A term sheet carries two things that matter, economics and control. Economics is the money you take out in a sale. Control is the set of vetoes over what happens before it.

Most founders treat a term sheet as a price negotiation and spend their strongest hours on the pre-money number. Feld and Mendelson argue the option pool, the liquidation preference, and the board decide more of the outcome. An investor digging in on a term that touches neither economics nor control is posturing. That tells you what they will be like on your board.

The Framework

Founders and employees hold common stock. Investors buy preferred stock, and the preferred carries the rights. Preferred converts to common at the holder's election, and never back.

Every term worth your attention sits in one of two buckets.

• Price, which splits into the pre-money number and the option pool hidden inside it.
• The liquidation preference, meaning the multiple paid first and whether the investor also shares the rest.
• Vesting and acceleration, which set what the founders and the team keep.
• Antidilution, which reprices old shares when a later round prices lower.
• The board, which approves the budget and hires and fires the chief executive.
• Protective provisions, the list of company actions the preferred can veto.

The rest of the document is long and mostly settled. Registration rights fill the most pages and change the least.

Fund size sets what the investor across the table can say yes to. A micro VC usually runs less than 15 million dollars. Seed funds go up to 150 million dollars and rarely invest past a Series A. Early stage funds run 100 million to 300 million dollars. Mid stage and growth funds run 200 million dollars to 1 billion dollars.

Fees and carry explain the pressure. A 2 percent fee on a 100 million dollar fund pays 2 million dollars a year, whatever happens. Carry is the profit share after the capital returns, usually 20 percent. A 100 million dollar fund returning 300 million dollars pays 40 million dollars of carry. A fund buys new companies for about five years and lives about ten.

Key Ideas

Pre-Money and Post-Money Are Five Points Apart

The pre-money valuation is what the investor values the company at before the money goes in. The post-money is the pre-money plus the investment. Raise 2 million dollars at a 6 million dollar pre-money, and the post-money is 8 million dollars and the investor owns 25 percent.

The trap sits in the bare word valuation. An investor offering 5 million dollars at a valuation of 20 million dollars usually means post-money. That is a 15 million dollar pre-money and 25 percent. The founder hears a 20 million dollar pre-money, which is 20 percent of a 25 million dollar post-money. The words match and the ownership differs by five points.

The fix is one sentence: say that you assume the investor means pre-money. The denominator is fully diluted, which counts every option and the unissued pool.

The Option Pool Is a Price Cut Wearing a Governance Label

The authors say the option pool moves valuation more than the liquidation preference does. Take a 5 million dollar investment at a 20 million dollar pre-money. The unissued pool is 10 percent and the investors want 20 percent. The extra 10 percent comes out of the pre-money, so the effective pre-money is 18 million dollars.

A second case shows who pays. A 2 million dollar financing at a 10 million dollar post-money gives new investors 20 percent. The term sheet requires a 20 percent pool after the round. The cap table lands at 20 percent investors, 60 percent old shareholders, and 20 percent pool. Rolling over the existing 10 percent pool instead gives 20, 70 and 10. The investors own 20 percent either way, and the old shareholders carry the whole difference.

Three responses exist, and all three are price. Push the pool to 15 percent. Accept 20 percent and ask for a 22 million dollar pre-money. Or put the increase post-money. The weapon in that conversation is an option budget: every hire to the next financing, and the grant each one takes.

Typical early stage pools land between 10 and 20 percent. Unissued options vanish at an exit. Own 1.0 percent of the company, watch a 10 percent pool go ungranted, and you own 1.11 percent.

Participation Decides Who Gets Paid at a Small Exit

The liquidation preference has two parts: the multiple and participation. A one times preference is the standard, and in 2001 investors pushed multiples as high as ten times. Participation decides whether the investor takes the preference and then shares the rest.

A company raises 5 million dollars at a 10 million dollar pre-money, so the Series A owns 33 percent. At a sale of 5 million dollars the preferred takes the whole amount under every structure. That is the overhang.

At 15 million dollars the structures separate. One times with no participation pays 5 million dollars to the preferred and 10 million dollars to the common. Two times with no participation pays 10 million and 5 million, halving the common. One times participating pays 5 million plus a third of the remaining 10 million, so 8.3 million dollars against 6.7 million dollars.

At 100 million dollars they converge. Both nonparticipating cases convert and take 33 million dollars. The participating investor takes 5 million plus 33 percent of the remaining 95 million, so 36.35 million dollars. A three times cap of 15 million dollars is passed, so a capped investor converts and matches the rest.

The damage shows on a big stack and a middling exit. A company raises 50 million dollars, the investors own 60 percent, and it sells for 100 million dollars. One times with no participation returns 60 million dollars. Two times takes all 100 million dollars and the common gets nothing. One times participating takes 80 million dollars.

Participation costs the most at low and middle outcomes and fades at high ones. The other term that pays in a bad case is antidilution. A full ratchet reprices the earlier round down to the new price, even on a single cheap share. Weighted average, the common form, weighs the size of the cheap issuance. Broad-based or narrow-based turns on which shares go in that denominator, and the authors treat antidilution as a term to shrink rather than remove.

Vesting and Acceleration Price the Team

Standard vesting runs four years with a one-year cliff. A quarter vests on the first anniversary and the rest monthly over three years. At eighteen months you hold 37.5 percent, which is 18 months of 48. Unvested stock is reabsorbed by every remaining holder, which the book calls reverse dilution.

Single trigger acceleration vests on a merger. Double trigger needs two events: the acquisition, and the acquirer firing the employee. Double trigger is much more common in venture-backed deals, and the authors recommend it with one year of extra vesting. Foundry Group writes its own version at thirteen months.

An acquirer who cannot rely on unvested equity builds a management retention pool into the deal. That money comes out of the price paid to shareholders.

The Board Is Where Control Lives

The board is the most powerful part of a company's structure, and it almost always holds the power to fire the chief executive. Early boards run to three: the founder and chief executive, the investor, and an outside member. A five-person board adds a second founder and a second investor.

The authors say investors do not want to control boards, and use protective provisions instead. Those are vetoes over specific company actions.

• Without investor consent the company cannot change the terms of the preferred or authorize more stock.
• It cannot issue stock senior to the preferred, or buy back common shares.
• It cannot sell itself, change the charter or bylaws, or change the size of the board.
• It cannot pay a dividend, borrow more than 100,000 dollars, or declare bankruptcy.

Two details decide what those vetoes cost later. Fight to have all series of preferred vote as one class, because a separate Series B vote creates a second blocker. Then read the consent percentage. A threshold of 90 percent instead of 50.1 percent hands control to a new investor holding 10.1 percent of the round.

The authors refuse the word material inside these provisions, because nobody agrees what it means. Specificity is the cheaper choice.

A Valuation Cap Becomes the Ceiling on Your Next Round

Convertible debt is a loan. Raise 500,000 dollars with a 20 percent discount. Six months later a lead prices a 1 million dollar Series A at one dollar a share. The round totals 1.5 million dollars. The new investors take 1,000,000 shares and the note holders take 625,000 shares at 80 cents.

Discounts run 10 to 30 percent, with 20 percent the most common, and interest runs 5 to 12 percent. The cap is the expensive half. An angel puts in 100,000 dollars expecting a pre-money of 2 to 4 million dollars. Nine months later the term sheet arrives at a 20 million dollar pre-money, and a 20 percent discount converts him at 16 million. With a 4 million dollar cap, any valuation up to 5 million dollars gives him the discount, and the cap applies above that.

Investors read the cap as your price and negotiate from it, so a strong seed cap becomes a weak Series A. Never accept both a discount and warrants on the same note.

A company that raises convertible debt is insolvent by definition, because its debt exceeds its assets. Directors can then owe duties to creditors, and some states impose personal liability during insolvency.

A decade ago the legal gap between a seed round and a note was 50,000 dollars, and today it is under 10,000. What drives notes now is the wish to avoid setting a valuation.

Practical Applications

Say the pre-money line back before anything else, and get the answer in writing. Then ask where the option pool sits and how large it must be at closing.

Build the option budget before the first meeting. List every hire to the next financing and the grant each takes, then size the pool from that list. A pool of 15 percent defended with names beats 20 percent accepted on habit.

Model the exit table before you sign. Compute what the common receives at the post-money valuation and at half of it, under the exact preference on the page. Structures that look alike at a good outcome separate at a mediocre one.

Run a real process, because competing term sheets are the only true advantage you hold. Allow three to six months and drive the firms into the same window. Settle the easy points first and leave valuation last. Bound the no-shop at 45 to 60 days.

Who This Is For

Founders raising a first priced round get the most from this. So does anyone holding a signed note, and any operator about to take a board seat.

Read it knowing who wrote it. Feld and Mendelson are venture capitalists describing their own instrument, and the model term sheet in the appendix is Foundry Group's own. The terms they call fair are the terms they offer. Market terms also move with the funding cycle. Multiples above one times appeared in 2001, and pay-to-play spread after the dot-com bust. The fourth edition is from 2019, and no book replaces a lawyer reading your document.

Skip the crowdfunding, venture debt, and investment banker chapters until you need that thing. Skip registration rights, which the authors treat as a page nobody must negotiate.

The Decision

Take the term sheet you hold, or the one you expect, and spend an hour on four lines.

• Find whether the headline valuation is pre-money or post-money, and where the option pool sits.
• Compute what the common stock receives at the post-money valuation and at half of it.
• Write down who elects each board seat and which company actions need investor consent.
• On a note, name the cap and the price it sets for the round that follows.

Each of those has an answer already written into the document. A founder who negotiates only the price accepts all four unread.

Whatever you cannot answer is a term someone else decided for you.