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2nd Cut is the Deepest: Term Sheet tips from Dow Jones VentureWire

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Recently I listened-in on a Dow Jones VentureWire Webinar entitled “How to Craft a Winning Early Round Term Sheet:A Guide for VC and Entrepreneurs.” The speakers included two corporate attorneys who specialize in servicing technology startups or their investors: Jon Avina, a Partner with Wilson Sonsini Goodrich & Rosati; and Michael Conza, a Partner at Bingham McCutchen (the only firm I’ve found that has an appropriate sense of humor about their role in so-called “restructurings”), as well as Sara Reed, the General Counsel for early stage venture firm, Charles River Ventures.

The seminar was heavy in very granular funding stats. I suspect that data slides, like the one that showed the trend in “convertible participating preferred securities issued to investors” over various funding stages might be a bit too “inside baseball” for most of us — but there is one important lesson in it: most of these convertibles were issued in 2nd Rounds and where company valuations were flat. Translation: the 2nd round of funding is often the hardest. Why? It’s make-or-break it for many companies, so founders have to give up proportionally more equity and control to investors. (Where companies make it to a 3rd round, the ratio of (extortionist!) “convertible preferred” shares issued actually goes down.)

This explains why 50% of the listeners on the Webinar said they were in the midst of the their 2nd round of fundraising — they need the most help.

as CRV’s Sara Reed put it:

“Those of you looking for their second round, my heart goes out to you….. I see a lot of our portfolio companies sort of getting stuck there. Series A is just a bunch of slides and promises and a dream and that’s fine. But by Series B you’re expected to have something to show for it besides a few slides and a dream. By Series C you do have traction. So people now are just demanding a lot more milestones before [doing] a Series B, and we’re finding it harder to bring in [new] investors to our [early stage companies] to get to the series B.”

(CRV is finding it hard!?)

So, then Avina and Conza chimed in with a few metrics founders need to produce before even looking for a 2nd round of funding. The minimal 3 things you’ll need to “show for it” are:

  1. ” Huge traction among consumers.” We’re back to the eyeballs model. It can’t just be a good idea. And if you don’t have revenues, you have to show that people want to spend time on your site.
  2. ” A defensible revenue model.” Putting avatars or widgets on your site is a means to a defensible revenue model, so use them. You need more smoke and mirrors, you need bells and whistles.
  3. “Some other proxy for interest.” Your company doesn’t have to be profitable, but you have to show some form of people [being] willing to open their wallets for whatever it is that you’re offering to justify an uptick with a second round.

If and when you have these things, then you can consider going for Round 2, and seek out more granular advice about what to look for your term sheet.

3 Importnat things to look for in your Round2 Term Sheet are:

  1. Stock Incentive Pools: shares that you will want set aside to incentivize your current and future employees.
  2. Protective Provisions: clauses that restrict actions that might effect a change in control of the company, or status of preferred shares, without a majority “say so” of Series A Preferred shareholders. (Founders should always be “Series A Perferred sharesholders!)
  3. Dividends. So that you’re assured of some cash remuneration where possible.

For further definitions of these terms, and a complete sample Term Sheet, see Scribd here, where we’ve uploaded the relevant pages for you. We’ll publish it here in PDF format shortly.

6 Responses to “2nd Cut is the Deepest: Term Sheet tips from Dow Jones VentureWire”

  1. Good model documents on the National Venture Capital Association website:

    A “template” set of model legal documents for venture capital investments put together by a group of leading venture capital attorneys. The model venture capital financing documents consist of:

    * Term Sheet
    * Stock Purchase Agreement
    * Certificate of Incorporation
    * Investor Rights Agreement
    * Voting Agreement
    * Right of First Refusal and Co-Sale Agreement
    * Management Rights Letter
    * Indemnification Agreement


  2. “(Founders should always be Series A Perferred sharesholders!)” Is that really common? I’ve never heard of that happening in any financing or startup company that I know. Founders almost always own Common Shares since that is what exist when the company is created. To become Series A Preferred shareholders they would need to do a share swap during the financing (since Series A Preferred are only created at the financing).

  3. Carleen, does list item ‘2. Protective Provisions’, suggest that only the Founders should be Preferred shareholders in the Series A (rather than founders and investors)? I met an investor that suggested they themselves should be taking Preferred stock in a Series A, and they made no mention of where the founders would sit in relation to this.