tej dhawan's random musings

Category: Funding

The critical elements of a term sheet

The “Term sheet” carries an air of mystery and intrigue in the entrepreneurial community. Founders are either nervous or giddy about them, want to get one and celebrate its arrival. Investors are eager to sign them (while tending to wait for a lead investor to generate them).
Working with startups and angels in my community gives me a perspective on term sheets.  Since the landscape that governs capital here is markedly different than that in VC hotspots, I’m sharing the elements I see ignored/problematic/contentious, here, in Des Moines, Iowa.
Disclaimer: Getting introduced to Brad Feld’s Venture Deals, following a number of blogs, and ultimately digging through dozens (hundreds now?) of term sheets, I feel like the 4-10 page document is boiled down to a few critical elements that trip up entrepreneurs and angel investors alike. I am not a VC, nor do I represent a fund, so the motivators behind VC decisions are still largely remote to me.
Oh, and also – I am not a securities attorney – use this as a starting point in your journey on term sheet education but seek competent advice at the time you begin working with these documents.
What is a term sheet?

When an entrepreneur chooses to accelerate the journey of building or scaling a business with outside capital, the term sheet is a formal document that outlines the summary terms of exchanging a portion of the company (equity) for cash from an investor (investment). Though filled with legalese about a variety of important topics, it sets the initial terms of engagement, specifically through core elements that would fit on a napkin.
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The elements boil down to three simple drivers –  economic, team and control. Drivers that control the money aspects of the transaction, those detailing the people building the company, and how the power will be shared once the investment is initiated, respectively.
Economics (equity, valuation…)
Though it should come later, this is frequently the starting point of a negotiation.  A placeholder for the amount the two parties think a company is worth, valuation is a key point of the negotiation. Of course, like any parent, the entrepreneur values their company higher than the dispassionate observer. Similarly, the investor tries to justify the entrepreneur’s assessment or comes up with their own yardstick for evaluation. The mid-western investor rarely puts down a $1M or higher value on a company that has no product, no real customers, and an incomplete team. Ideas alone seem to rarely receive outside funding, and when they do, the term sheets are skewed toward a great deal of control in the investor’s hands for significant share of equity.
What’s an entrepreneur to do?  If the desire is to raise local money and not travel nationwide pitching to investors, then appealing to the local investors motivators is key. Those motivators, at this point in time, are product, revenue, and team:

  • Product – a company needs a minimum viable product (MVP) that demonstrates the founding team’s vision. It must be usable, demonstrable, available on the relevant platform (web, mobile, physical goods etc.), and one or more customers be able to speak to its viability and use.
  • Customers – Revenue comes from customers, so this is important. The history of a product’s sale to an unrelated customer — one with whom the entrepreneur didn’t have an established relationship –is important. Customers provide external validation of an idea and are key to an investor’s ability to preview a product’s market viability.
  • Team – a complete team is generally a pre-requisite for a company raising funds and must include founder (with a concrete role – not just title) marketing, product development, and ability to execute. These people and roles will change over time, so, a complete team needs to reveal the people who fill to roles to adequately guide the minimum viable company to the market where their products are sold, licensed, and used by real customers.
  • Exit – there will be discussion, however premature it may seem, about the liquidity or liquidation event. It could be brief, or a full buy-sell analysis, but there will be one. READ THIS CAREFULLY, especially the section related to liquidation preference that establishes rights to the funds received at a liquidity/sale event.

Team
Though the term sheet will have a signor on behalf of the company, the team does not need titles like CEO, CTO, COO, etc. At this stage, there really isn’t a true CEO or CTO – but rather founders, builders, designers and hackers. The first developer on a team will very likely NOT be the CTO of the fully baked company — the skill sets for the two are vastly different. Similarly, the founder will very likely be replaced as the CEO over the venture-backed lifetime of the company. The team, therefore, needs to be able to present a diversity of opinion that will lead the company to grow, but show a unified front through consensus building.
Rented CEOs and other titles are a let down – angel investors invest in passionate founders, and founders who have given up critical equity for a part-time CEO in early stages of building a product can actually hurt themselves. So, for the purposes of showing off the MVP and raising capital, founders (not a bunch of rented suited professional CEOs) should demonstrate their wares .  Business attorneys do a far better job negotiating terms.
Control
Once money and equity exchange hands, those providing the money will often desire control over the operation of the company in material areas. These terms change the daily behavior of the company and its founders, and must be negotiated early and clearly. If legalese in the documents is not understood, clarify – it’s a lot easier to do before the deal is done than after.  Any attorney worth their salt understands that the legalese in the documents is a necessary evil, and can summarize the entire document in a page of plain English. That page is worth its weight in gold for us mere mortals.  Key elements of control include such things as

  • Information rights – this gives the investor a right to receive regular (quarterly or otherwise) updates from the company that summarizes financials without divulging too much information that may be proprietary. Though angel investors have significant insight into a company and operate like many insiders, this right is still necessary to document and usually a requirement for an angel investment.
  • Founders salaries – investors know that the first influx of cash can alter the incentives and behavior in a company, including such major items as founder compensation as well as minor items like benefits. Thus, term sheets may dictate how much or if the founder can give themselves a raise.
  • New stock/dilution – investors understand there will be dilution during successive raises but want to have a say in when/how much/rules surrounding such raises. Expect a clause allowing the angel investor to participate in future rounds to maintain their ownership percentage, participate in sale of stock by the founder, and advance warning about upcoming events that can cause dilution.
  • Board Seat  – though many investors would love to be on the board for their new portfolio company, angel investors in particular, frequently decide against it and choose to serve instead as informal advisers, rainmakers, network connectors, and  supporters. Still, a paragraph or two will be dedicated to this element.

In closing, remember, a term sheet is not the final definitive document that guarantees an investment. It is simply the first formal document used to begin the conversation. Treat it with care.
 
Additional Resources
Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist
Ideal First Round Terms, Chris Dixon on cdixon.org

Clubbing the Patent Trolls

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Image courtesy CEA (Consumer Electronics Association – ce.org)


I just wrapped up a very full day meeting in Washington with several Senators and their staff on the issues surrounding patent reform.  This day was coordinated by the Application Developers Alliance, an advocacy group I connected with in December around the time of the House vote on the Innovation Act (House Bill 3309). 
Before I go further, political correctness stalwarts as well as trolls themselves are calling for the name trolls be dropped and Patent Assertion Entities (PAEs) be used instead. I will use the term troll instead… it is not only the industry standard name, it also labels these entities accurately.
Imagine receiving a letter like –

Dear CEO – you owe us $1000 per employee at your company for each networked scanner that emails scanned documents and one or more of your employees potentially uses that feature.
or
Dear Kevin – we noticed that when you picked up groceries for your mom and sister during your recent shopping trip, and delivered them on your way home, you violated our patent on efficient routing for purposes of grocery delivery between retailer and one or more consumers. You owe us $1200 per delivery point for this violation.

Does either sound ridiculous? Yet, one is real and the other… well… the other could become real.  In the case of the former ‘letter’, a trolling entity has divided the US into territories where patent attorneys are actively sending demand letters to businesses using scanner to email function. Each letter demands the $1000 compensation. It has ticked off enough complaints and confusion in the business world that state attorneys generals have been called into action.
In a remarkable move, 42 Attorneys General have urged Congress to take action and to provide the Attorneys General to utilize the powers granted to them in assisting the citizens in their states and territories. This letter generated significant buzz during our visit and was largely being seen as a positive action toward patent reform.
Fast forward back to today – and what brought me here to DC. Meetings today covered members of the press, a dozen senators, a number of legislative staffers from senators’ offices, and two representatives from national VC firms – Brad Burnham of Union Square Ventures and Jason Mendelson of the Foundry Group.
Trolls aren’t a headache JUST for large technology firms. They are beginning to affect everyday businesses through measures that can best be described as extortion. Send vague letters to businesses large and small claiming that the business is infringing on a patent. Given them a short window to respond with payment or the penalty will go up. If the business chooses to litigate, the ‘fines’ will go higher and potentially private and personal information extracted through discovery of the company’s systems, mobile devices, phones, etc. This is a national problem that affects all of us and household names in my own state – Kum & Go, Bettrlife, Kinze Manufacturing,Iowa Bankers Association, HyVee and more have gone on record documenting their problems with trolls.
It was good to have two very large VC firms and a relatively small angel group represented in DC by our group of three. As Iowans we have an unusually significant sway – whether it is in the first in nation status in the caucuses to having two very senior senators who are respected universally. Senator Grassley’s position as a ranking member of the Judiciary committee makes him particularly powerful in this realm. Those who have read this know that I’ve spoken with him and his staff in the past about immigration issues and found him receptive – even though party politics (and the 2012) election rocked that boat past his control.
Patent reform has taken the form of a 325-91 support in approving the House bill (H.R. 3309) in December 2013.  The bill, also called the Innovation Act, immediately received support from the White House . The companion Senate bill (S.1720) was introduced in December and is currently being studied by the Judiciary committee while other bills make their way around the Senate. Our direct request today was for the Senate to move forward toward passage of patent reform in the senate that can pave the way to conference that will resolve the difference between the House and Senate bills before the President can sign it into law.
The key provisions we asked for are –

  1. Clear identification of who is suing (who has the financial interest in the claim)
  2. Clear identification of why the claim is being brought – specifically which portion of the company’s patent is being infringed
  3. Clear identification of how the infringement happened – specifically what did the infringer do wrong
  4. A fee-shifting provision (about who pays what)
  5. Potential for pre-litigation review of a business-process patent through an expansion of the covered business method statute

I reached out to several attorneys in Des Moines who are know for their work in intellectual property, including patents.  Several who represent small, innovation focused companies, warn of a chill that could befall such small companies due to the need for paying winner’s attorney’s fees, as they fear that large companies could simply bury the small company under legal costs. Similarly, members of the software community who have business process patents are naturally against provisions that could expand a review of a previously issued patent. I feel that the innovation community is at a greater risk of being attacked by trolls who are using old patents from now defunct companies. These patents, issued in huge quantities after their 1996 allowance, and bought up during the dot-com crash, now are utilized by entities that exist solely to litigate.
Though we haven’t seen this in the Iowa investment community, Jason and Brad both talked at length about how the companies they see closely tend to come into the trolls sights right about the time they receive serious funding or exhibit commercial viability and success. Companies are actively being formed to go acquire patents from companies in bankruptcy for the sole purpose of litigating with that portfolio.
The meetings at Senators’ offices proved very detailed. There was hardly any fluff in the 20-30 minutes we had with each senator, and the Senators and staff did an equal amount of talking and asking. Since we didn’t need to push an agenda with senators  who are already on board with patent reform, we offered help and the meetings entered meaningful discussion about ideas, alternatives, and potential solutions. Today, there are the Leahy-Lee (S 1720) and Cornyn-Grassley (S 1013) bills that represent the Senate position and the underlying conversations.  Sen Schumer adds teeth to the Leahy-Lee bill via Schumer (Senate 866).
I am a huge fan of the Cornyn-Grassley bill as it clearly covers most of my desired outcomes. Passed independently, either the Leahy or the Cornyn-Grassley bill would resolve a lot.  If Leahy-Lee-Cornyn-Grassley-Schumer got married into a single bill, our work today would be very productive.
I left DC with that hope, and plan to remain engaged with the Iowa Senators. The fitting end to the day was flying along side with Iowa Attorney General Tom Miller and being able to thank him on his action on this issue.
 

Every business doesn't begin with millions in cash

There is ample news about the idea that popped into an entrepreneur’s head in the shower, the demo was created by lunch, VCs lined up to lend money by dinner and acquisition happened in the quarter that followed.  Scant attention is shared about those who logged 60 hours a week developing a business while holding down a 40-hour square job, worked for years to build revenue, adjusting the model along the way until finding success in the trenches.
It is interesting to be surrounded by those who have done just that in the Des Moines technology ecosystem.  Des Moines’ dmJuice recently published an article about my friend, relative and partner, Erin Ginkens’ Entrepreneurial Technologies.  The article highlights the company’s evolution from a product company to service and now a hybrid.  Hard work is reflected remarkably in the creation of Tablenabbr, a mobile phone application that helps potential diners find restaurants with open tables in real time.
Similarly, the story of Brian Hemesath, the CEO of Catchwind and President of VolunteerLocal and involved in other endeavors, takes us through a decade of work.  Brian’s work has enriched the local technology ecosystem and his helpful presence at Des Moines startup events is inspirational to aspiring startups.  If you haven’t had a chance to hear his story, September 21st presents a great opportunity to hear him speak at the BIZ’s luncheon series, aptly titled Lessons Learned while Bootstrapping Business: The Non-Fundraising Path.
Bootstrapping is a strategy that works when designing a business driven by a need/desire for organic growth, a product that is largely service based with the entrepreneur’s expertise in delivering the product, secured by rock solid IP, and/or the unavailability of external money to fuel growth.  It rarely works when time to market is paramount and competition is circling your customers and employees.
Whichever strategy you choose — know that resources are available to discuss, quantify, qualify and critique your business model.  My local community is filled with events that support bootstrappers, angel funded and VC funded enterprises.  Find them, talk to them, share their experience and learn from their mistakes — I know that after 29 years in technology, 18 years in small-business and a year into a sabbatical, I still am.

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