Founders Friendly VCs

It would be expected that Venture Capitals (VCs) when they are defining the terms and conditions of their investments would greatly favor their interests vis-a-vis the Founders.

However, one of the guiding principles of VCs everywhere is to be Founders Friendly. This attitude can be seen for instance in Term Sheets and Investment Agreements. There is a generic disposition for issues that may arise between Founders and Investors to be resolved through consensus. In many instances there is no rule inscribed in the contracts on how to overcome a deadlock. Another example is the absence, in many instances, of a penalty clause in case of breach of contract. In some legal systems such as the Portuguese, the absence of such a clause makes it a great deal more lengthy the legal procedures if the need arises.

In part, this approach stems from the economic environment. In the last years, it has been a sellers market and VCs have adapt accordingly. Additionally, the profusion of successful Founders turned Investors, has helped VCs gain a different perspective towards Founders/Investors relationships.

In the end of the day, however, I believe the major reason for this approach resides in the realization that a VC investment to be successful has to be based in a truly cooperative relationship between Founders and Investors.

Don’t get me wrong, Investors will insist in including protective provisions against down rounds (Anti-dilution clauses) and poor Exits scenarios (liquidation preference clauses). They will also demand a Board position and approval rights in major decisions for the company. In all likelihood there will also be a Good Leaver/Bad Leaver clause to protect against Founders who leave a Startup in the middle of its journey.

Nevertheless, the Investor is also aware that the Founders are the persons better placed to make the Startup a success. Key people may be brought to help complement the Management Team, but to do these recruitments or going a step further and replace the Founders against their will is to condemn the project to failure. Therefore, Investors have to truly partner with Founders in order to keep the different interests aligned and everyone focused in growing the Startup.

In this sense, it doesn’t really make much sense for Investors to overprotect the Investment Agreement. Founders will be managing the company in its day to day operations and in all but a handful of issues, Investors will be just supporting and advising the Founders.

If a stalemate is reached, chances are that forcing the Investors will on the Founders will result poorly, and unless it’s one of those few issues that are vital for the Investor, he will give precedence to the Founders.

Nowadays with the crunch in valuations, the Founders Friendly thesis is being questioned as the market power shifts towards Investors. Although some Investors will be tempted to follow this path, I believe that in the end of the day, Investors and Founders should have a balanced relationship. Founders are not employees of the Investors, but equals in a high risk venture.

And if the project is not a success there is always the Liquidation preference provision to safeguard that whatever money can be salvaged, Investors will be the first to be compensated for their investment.

 

 

What to expect when receiving a Term Sheet

Term Sheets are an important stepping-stone in the relationship between Founders and Investors and constitute a summary of the main matters that once agreed will be drafted in more detail in the Investors and Shareholders Agreement.

Investors draft their Term Sheets according not only with the best practices, but also with their experiences and beliefs, therefore there will be variations in the Term Sheets from one investor to the other.

Content wise, Term Sheets vary also according to the specificities of each project.

Nevertheless, there are core subjects covered in pretty much all Term Sheets: i) Valuation; ii) Investment; iii) Cap Table; iv) Board; v) Liquidation preference; vi) Voting rights; vii) Right of first refusal; viii) Tag-Along; ix) Drag-Along; x) Stock options pool; xi) Management Team; xii) Anti-dilution protection; xiii) Conditions for closing; xiv) Exclusivity; xv) Expiration.

Regarding the differences between Term Sheets, the most obvious one arises from the length of the document. I have seen Term Sheets ranging from one page to ten or more pages. The shortest Term Sheets are more demanding for the Founders, in the sense that they assume that the recipients of the proposal are savvy enough to know the most used technical terms, as well as what is the standard or common practice in these kind of investments. In this light, Term Sheets up to five pages allow the investor to explain a bit more what he intends with each provision, while not overwhelming Founders with too much detail. I believe that especially in Seed Rounds with unexperienced Founders striking the right balance can make a great deal of a difference in the communication of the investment proposal to the Founders.

Another big difference lies in the process. Some Term Sheets are presented as a first proposal to begin a negotiation. Others on the contrary, are handed out as a final offer. In the latter case, the investors, first, discuss with the Founders the main points of the Term Sheet, and then submit their best and final offers.

These different approaches can be troublesome when a Startup is evaluating different proposals, since there is not typically much time to decide between them. The investors that at this point are already making their final offers, also usually set a very short deadline for their proposals to be accepted before expiring, sometimes 2 to 3 days. The rational being not to let the Founders shop around for a better proposal by using one already submitted.

A third kind of difference lies in the clarity of the Term Sheets. Some Term Sheets are more direct and to the point, while others are less clear with hidden issues. It can be argued that the latter ones provide more flexibility by leaving some room for further negotiation. In the end of the day, I believe that issues left in a gray area, will come later on as a surprise for Founders and they have the potential to sour a relationship that should be long term. Founders should also bear in mind all the implications of these hidden issues to make a fair comparison between Term Sheets.

In conclusion, each investor Term Sheet will have its own specificities and it’s the job of the Founders to understand them so as to make a fair comparison. Additionally, and when comparing investment proposals from different investors, Founders should also bear in mind what isn’t said there, namely the added value that each investor can bring to the project, as well as in the case of the lead investor which partner inside the investor will represent it in the startup’s Board of Directors.

This post was originally published in LinkedIn.