by Scott Kupor
Vesting
The term sheet sets the rules for the vesting of both employee and founder shares. The employee vesting section—25 percent of an employee’s stock vests on the one-year anniversary of their hire (often called a “one-year cliff vest”), and the remaining 75 percent vests in equal monthly increments over the next three years—is pretty standard. It’s a total four-year vest, but with the provision that you have to make it through your first full year to vest the first 25 percent.
You’ll also notice that the employee section says that the options will have a post-termination exercise period of ninety days. What does this mean? If an employee leaves the company (whether voluntarily or not), she needs to exercise her shares within three months or she will forfeit the options.
While this is the standard provision in most option agreements, companies increasingly are reconsidering this provision as they stay private a lot longer, well past the time period for which the four-year option vesting program was invented. As we noted earlier, it’s an anachronism from the days in which companies actually went public around four years from founding, but that’s simply not the case anymore: the median time to IPO for venture-backed companies is now in excess of ten years.
So what’s the big deal? Well, if an employee leaves the company after four years (or at any time, for that matter), she has only ninety days in which to exercise or forfeit the options. And exercising requires cash, which the employee might not have. Most startup employees accept lower cash salaries in exchange for the upside that equity options might yield, thus cash is often at a premium. If the company were public at the time the employee had to exercise her shares, this problem would be mitigated because the employee could sell some of the shares in the market and use those proceeds to pay for the remaining exercise costs. In addition, many companies offer what is called a “cashless exercise option,” which means that the employee can surrender some of her shares to the company in lieu of paying out of pocket for the exercise price.
But not only do you have to come up with cash to pay for the exercise price for each share, but, depending on the type of option you own, the IRS then taxes you on the difference between the then-existing fair market value of the stock and the exercise price. There is unfortunately no cashless option for your tax payments; the IRS accepts only US dollars as payment.
For companies whose stock prices have appreciated significantly, the out-of-pocket amounts can be huge and thus prohibitively expensive for many employees. In some ways, it’s a success disaster—that is, employees are penalized for actually succeeding in building a business that is now worth so much (thus they can’t afford to exercise their options). This undermines the cash-equity trade-off that many startup employees make—a willingness to accept lower cash compensation in exchange for the potential to earn income from the appreciation of stock options.
As a result, some startups are giving employees more time than ninety days—in some cases up to ten years—to decide whether to exercise the options. This is perfectly legal, but it does have one tax implication for employees.
Remember we talked earlier about incentive stock options (ISOs) and non-qualified stock options (NQOs). Among other things, a difference between the two is that taxes on the spread between the exercise price and fair market value of the stock are owed on NQOs at the time of exercise, whereas they can be deferred to the time of ultimate sale of the stock for ISOs. A critical element of ISOs, however, is that they must be exercised within ninety days of an employee’s termination from the company. So while the company’s decision to extend the option exercise period for employees has value to the employee by deferring the exercise costs of the option, it converts ISOs into NQOs and thus triggers the tax obligations.
On a positive note, as part of the 2017 tax reform legislation passed by Congress, the tax treatment of stock options has now become more favorable. There are still many details to be worked out, but the new law allows employees to defer taxes for up to five years from when the stock is fully vested. It’s possible of course that this may not solve the problem for everyone given the length of time it is taking companies to go public, but this will certainly help a lot of folks.
Let’s move on to the founder stock vesting section. Our term sheet says that the founder stock vests ratably over four years, starting from the date on which the founders began providing services to the company.
Surprisingly (or not), this term can often be a source of contention in the negotiation between VCs and founders. From the founder’s perspective, she may have been working on this company (or at least this idea) for a while before she engaged with a lawyer to incorporate the company and ultimately raise VC money. Thus, she wants full vesting credit for that time—which makes sense. The VC, on the other hand, is investing largely on the strength of the founder and wants her to be financially incented (in the form of continued vesting of her shares) for as long as possible (as a disincentive for her to leave the company). There is no magic answer to this debate, but often the VC gets comfortable as long as there is some meaningful amount of vesting still to come.
The other provision in this section deals with what happens to the founder stock on an acquisition. The founder would like her stock to become fully vested on an acquisition (this is called “acceleration”) because she has done her job, which was to build a company of value. The VC is concerned that if all her shares automatically vest upon the acquisition, then the acquirer will have less reason to do the deal—in many cases, acquirers are buying the talent as much as they may be buying the going concern of the company—because the founder is free to take her money and leave as of the acquisition.
What’s contemplated in our term sheet is what’s called a “double-trigger acceleration,” which is the more common version of acceleration. It means what it says—there are two triggers to the founder getting her acceleration. The first trigger is the acquisition itself, and the second trigger is the founder getting terminated by the acquirer other than for cause or good reason (these are defined terms that require pretty serious bad behavior, often conviction of a crime, on behalf of the founder). This way if the acquirer wants to retain the founder, it has that option without having to worry about her options automatically vesting. And, if the acquirer doesn’t want her, then since their termination of her employment prohibits her from fully vesting the shares on the normal schedule, it seems fair that she should be accelerated.
Employee and Consultant Agreements
Recall that when we talked about company formation, we mentioned that, since most of the initial value in a company is a function of any proprietary technology that the company is proposing to commercialize, the VCs want to make sure that the company in fact owns the technology free and clear and can protect it. This section in the term sheet operationalizes that. It says that the company agrees to have all of its employees (and consultants) sign nondisclosure agreements and to assign to the company all the technology that they create while working for the company. This is generally pretty simple and noncontroversial stuff, but, as the Waymo case illustrates, can become more much complicated to the extent that founders or employees are developing technology in the startup that they may have been working on previously at a prior employer.
No-Shop
So we’ve now successfully negotiated all these terms and are coming to the end of the deal. But there is a difference between signing the term sheet and closing the actual investment. Closing can happen as fast as you can get the lawyers to document everything and complete their due diligence, but as a practical matter, it often takes from two weeks to as much as a month to get from term sheet to closing, which occurs once the parties sign all the agreements and the VC wires its money to the company.
You’ll notice that the term sheet itself is nonbinding—that is, either party can decide ultimately that they don’t want to proceed with the deal, in which case we are back to square one.
So to provide some hooks into the deal, VCF1 asks for a thirty-day period (it could be shorter or longer, but thirty is pretty standard) in which they tie up XYZ Company. The tie-up is in the form of preventing XYZ from being able to disclose the term sheet to other parties or pursue a deal with somebody else. After all, the last thing VCF1 wants is to have XYZ Company shop this term sheet to other VC firms to see if someone else wants to provide a better deal. The theory is that the parties should hopefully be more committed to one another at this point, so the shopping should have been done before entering into the term sheet stage.
Takeaway: Be Forward Thinking
Okay! We made it through the tour de force of the term sheet or, at least, the more important provisions.
One high-level takeaway from negotiating term sheets is to always be forward thinking about what you agree to in the current term sheet, being mindful that it can have implications for subsequent financings.
In general, simplicity is better. Even if you, the founder, have the negotiating leverage to get some highly favorable term as part of an early-stage financing, it may not always be in your best interest to exercise that leverage, as it may ultimately cost you down the line. Importantly, the same exact sentence is true for VCs.
CHAPTER 11
The Deal Dilemma: Which Deal Is Better?
Now that we have a basic understanding of the major terms of a VC financing, let’s put it to use in a hypothetical fund-raising. Let’s evaluate a trade-off between two different financing options for our make-believe startup, HappyPets (yes, this is an homage to the famous bubble-era company Pets.com).
In this scenario, we have set out to raise VC money and have had very successful meetings. We are lucky enough to get two term sheets. One term sheet is from Haiku Capital and the other is from Indigo Capital (all names have been changed). As we talked about in chapters 9 and 10, let’s evaluate both the economic and the governance terms, starting with the economic terms.
Economic Terms
Haiku Capital
Indigo Capital
$ Invested
$2 million
$4 million
Pre-money Valuation
$8 million
$8 million
Post-money Valuation
$10 million
$12 million
Option Pool %
20% post-money
15% post-money
Liquidation Preference
1x, participating
1x, nonparticipating
Antidilution Protection
Broad-based weighted average
Full ratchet
How would we evaluate which of these deals is better for us?
Building a Cap Table
Let’s start by creating a capitalization table (commonly called the cap table) to help us understand who owns what at the end of the financing. The cap table is a handy way of organizing a company’s percentages of ownership over time—for the founders, investors, employees, and any other owners.
Here’s what our capitalization table looks like if we were to take the Haiku Capital deal:
Shareholder
# of Shares
% Ownership
Founders
4,000,000
60.0%
Haiku Capital
1,333,333
20.0%
Option Pool
1,333,333
20.0%
Total
6,666,666
100.0%
And this is what it looks like under the Indigo Capital deal:
Shareholder
# of Shares
% Ownership
Founders
4,000,000
51.7%
Indigo Capital
2,580,645
33.3%
Option Pool
1,161,290
15.0%
Total
7,741,935
100.0%
So which do you think you’d prefer, between these two potential deals?
When we look at the ownership of the founders, there is about an eight-percentage-point delta between them. The Indigo deal is more dilutive (meaning the founders own less than in the Haiku deal). Some of this is driven by the difference in the amount of capital being invested by the two firms. The higher Indigo investment of $4 million is good, but that will give the Indigo firm an extra thirteen percentage points of ownership relative to the $2 million from Haiku.
Another difference is coming from the size of the option pool—that 5 percent higher pool in the Haiku deal is coming right out of the founders’ pockets. So without that, the Haiku deal would look even more economically attractive to the founders.
What should you do? You should probably first think about whether you can productively put the $4 million Indigo is offering to work versus the $2 million from Haiku. How much do you need the extra $2 million?
As we’ve discussed before, we at a16z often advise companies that the right amount of money to raise in the current round is what you think you need to hit the required milestones for the next round, generally twelve to twenty-four months later. In other words, you optimize for success in the next round by giving yourselves the right amount of execution runway in the current round. Obviously, more money now generally means more dilution, so this is always a balancing act.
If you had the extra $2 million, would that reduce the risks of your being able to achieve the operating milestones for this financing round? Maybe you could hire additional engineers to help ensure that your development plans stay on schedule. Maybe you could hire a sales team earlier than otherwise, which would help increase your confidence level in the sales targets.
The other way to think about the extra funding is not whether it de-risks your ability to achieve the objectives, but whether it would enable you to achieve even more than you were originally anticipating in this financing round. In other words, if you could get the business to an even better set of milestones, presumably the next round investor would give you even more credit in terms of the valuation she would be willing to pay for the next financing round.
Ultimately this is a trade-off between a known level of dilution now and your best forecast as to what dilution might incur in the next round based on various levels of business achievement. Recall from our discussion in chapter 7 that momentum—and the perception of momentum—does really matter in the competitive world of startups, so you want to think about the funding amount that gives you the highest degree of confidence in being able to maintain momentum from one funding round to another.
So let me ask again: What should you do? Well, actually, that’s a trick question! You don’t know yet! We haven’t looked at the rest of the economic terms, nor the governance terms, to see if they are materially different between the two firms.
Take liquidation preference, for example. Haiku has a 1x,
participating liquidation preference, whereas Indigo’s is nonparticipating. Recall what that means: Haiku gets to double dip and not only take its $2 million investment off the table first but also then participate in any additional proceeds as if it were a common shareholder.
One way to evaluate these is to look at the payout matrices for the two offers. The payout matrix shows you at different potential exit price points how the proceeds of that exit are divided between the common and the preferred shareholders.
Haiku not only gets its $2 million investment back at any exit valuation above $2 million but also takes 20 percent of the remaining proceeds. In contrast, above an exit price of $12 million, Indigo will choose to convert its preferred shares to common shares and take only its 33.3 percent of the proceeds that equals its level of economic ownership. Depending on how you think about the likely exit options for your company, you might decide that the greater dilution in the Indigo deal is worth it to avoid having the Haiku team participate beyond its liquidation preference at higher sales prices.
Below is the Haiku payoff matrix:
And here is the Indigo payoff matrix:
The final economic piece to consider here is the antidilution protection provision. Recall that this comes into play if, in a subsequent financing round, the price of the round is less than the current round price. In that case, the VCs are entitled to some price adjustment on their original shares—the exact amount depending on whether there is broad-based weighted average protection or a full ratchet. The Haiku term sheet has the former; the Indigo term sheet has the latter. Recall that the weighted average formula is friendlier to the common shareholders in that it dampens the effect of a lower-priced round by weighting the price adjustment based upon the relative size of the new financing round. In contrast, the full ratchet is most dilutive to the common shareholders by effectively resetting the purchase price of the previous round investors to that of the current financing proposal.