This Week in Startups - Negotiating a Term Sheet: Deal killers, what terms are worth fighting for & more with Becki DeGraw | Wilson Sonsini Startup Legal Basics

Episode Date: November 24, 2020

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Welcome back to this week in startups. I'm your host, Jason Kalakanis, you know me. And we are going over legal basics in a special series with my friends over at Wilson Cincinnati. Becky DeGra is back with me. She is a partner at Wilson-Sincini. She has been there since I think 2007. So over a decade at the same firm, you might have heard of this firm. They literally incorporated Google, so they know what they're doing.

But they really love working with young startups. In fact, I got to think, Becky, working with the, young startups versus the big ones, it's kind of more fun to work with the earlier stage ones. Isn't it? The big ones have tons of lawyers, tons of, like, complex issues. It's a lot of fun to work with the small startups, isn't it? It is. It is.

When I started many moons ago at Wilson Sincini, I did a little bit of everything. I worked with startups. I ventured into, you know, capital markets and did also public company representation. And I never really liked the public company representation or the capital market. piece. So now I like solely focus on private companies, early to late stage all all across the private company life cycle. But I'm on that side. I love working with entrepreneurs and growing with them. Yeah. I mean, it's just such a nice feeling. In a way, we have a very similar job, which is I, when companies go public, they kind of forget that I was the third or fourth investor in Uber.

I mean, like Darrow once in a while will retweet me. And he met me at a party. And he's like, oh, yeah, thanks for the support. And I was like, great. You want to have lunch from time? I'm really busy, but yeah, it's great to meet. I was like, I can't even get a meeting with the guy and the third investor. Darev, you're listening. Reach out to your boy. Let's build a relationship. You might need me sometime on CBC to say something nice.

Literally, I've never had lunch with them. I have lunch with every other CEO. But putting all that aside, it is so nice to work with young companies because you can really be helpful. You can really be helpful. And it is great to see entrepreneurs. get things right. And when they make mistakes, man, it's just, it's, it's hard to watch, isn't it, Becky? It is. It is. And, you know, some of the mistakes that that you make early on

can be really costly, not just from a legal fees cleanup standpoint, but a lot of the mistakes can have tax impacts and all sorts of stuff. Yeah, okay. So we, we talked in our previous issue, which is linked on the website and in the playlist, et cetera, about just what type of entity should you create. We got that dialed in. But shortly after you're incorporated, because you're probably incorporating into a C-Corp because you want to get money from an investor. And there is a device called a term sheet. And a term sheet is really when things get real. You'll talk to a lot of people. They'll make promises. But all of that is, you know, the sort of flirting, getting to know-you-stage of investing. When things get serious, a term sheet shows up. Explain to people what a term sheet is

and why do we have a term sheet in this ecosystem? Absolutely. So a term sheet is normally the investor will put it forward and it'll say the terms on which they're willing to invest. So depending on whether it's a note term sheet or a price round, it's going to have the fundamental pieces, right, as to what's the valuation, what are the specifics of rights that they want out of the transaction, are they asking for a board seat, and how much money are they going to put in? And the reason that you want to start with that term sheet is usually it's a very simple, maybe one page, maybe a couple of pages long, but that's where you're going to be able to really focus on, are we at the same place?

Do we have an agreement? and make sure you get that settled before you bring in the lawyers on both sides and start putting all the documents together. Because if you don't have a meeting of the minds at the term sheet stage and you start paying more money to actually put the documents in place, it's going to cost you a whole lot more. So take advantage of the term sheet and say, all right, these are the terms I agree with. Let's move forward. Got it.

And they're pretty standardized at this point. and from my perspective as an investor, sometimes I originate a term sheet. If I'm originating a term sheet, that means I have the highest level of commitment to the company, the highest intent, 10 of 10 that I want to invest. Because preparing a term sheet has a legal cost associated with it for the investor. It also has a reputation cost associated with it and a time cost. The legal cost is hundreds to low thousands of dollars to originate a term sheet. The reputation cost, if you give a term sheet to somebody and then you do not follow through,

this does happen sometimes because you're negotiating and somebody wants to change the terms. You're offering a million dollars for 10% of the company they want, $2 million for 5% of the company. That's a fine moment for the term sheet to not work out, gets ripped up. No big deal. when an investor gives a term sheet and the founder agrees to the terms and the deal doesn't close, how often does that happen and what does that do to the reputation of an investor like myself or another investor? I would say it doesn't happen very often.

If it does, you're going to get a reputation in the community as putting out possibly doing an investment. Once you sign a term sheet, most times the company is under exclusivity, meaning they can't talk to anybody else. And if the company is under that and they've, you know, decided to forego some other investors and they've started spending money on their legal fees of getting documents in place and then you say, yeah, you know what, actually I'm not really that interested. I'm going to back out. If you start getting that reputation among founders, I think you're going to have a hard time actually getting a term sheet sign and getting folks interested. It's a small community out there. And word gets around quickly. Yeah, founders talk to each other. And certainly

investors, I mean, we are playing tennis and going skiing and, you know, doing what rich investors do on their holidays. Like I go on holiday and three or four of my friends are investors and we talk shop. And when somebody pulls a term sheet and there's not a good reason for it, everybody just lean backs and goes, you know what, that can sink a company. It can sink a company. I would estimate a signed term sheet does not follow through but one in a hundred. Is that close to your experience?

Or less. Or less even. So a signed term sheet in our industry is really sacrosanct. You know, we really take that seriously. Now, there is one piece and one caveat there. People will sign a term sheet and sometimes they do what's called due diligence after signing a term sheet. Sometimes people do diligence

before signing a term sheet and sometimes they're in the process of doing diligence throughout the term sheet process. How does that impact everything? And talk a little bit about the diligence process specifically in relation

to the term sheet being constructed and signed. Yeah, usually investors will do business diligence and make sure that they are comfortable with the material pieces of the business, right? How it works,

how whatever their model is going to be and say, yeah, you know what, this works for me. I want to invest in this company, get a term sheet in place. And that's usually when the investors will bring in their lawyers to then do legal diligence, which is totally different than the business diligence side of things. And it's possible that once you start getting into legal diligence, you find some huge issue, right? Like maybe what the company's IP is is in question. Or you find out, oh, there was some big IP infringement lawsuit that's out there. You may then want to say, you know what? I didn't know about that. This changes my whole view and perspective on this investment and I'm no

longer interested. That is, I think, perfectly acceptable, right? You uncovered something new that you didn't know of that is fundamental to the investment decision that you made. Other than that, people don't really walk away unless it is that high of a level of diligence item. We uncover all sorts of random diligence issues and cleanup issues for sure in first rounds of financings. Investors don't walk away because of that. They may say, hey, you got to get it cleaned up before I close, but they don't walk away for that.

So let's just pause for a second. There's legal diligence that occurs after the term sheet typically. sometimes it occurs earlier. And then there is business diligence. Business diligence might be, I use the product, I read the reviews on Amazon, I looked at your glass store, I talked to two or three employees, perhaps. And I talked to a couple customers. You gave me permission to talk to these three customers.

That's the level of diligence we do at my firm launch. And we generally get comfortable. Now we give a term sheet, and I'll give a couple of examples here of when we have actually backed out. In one case, somebody told us they had Google and Facebook as customers. We looked at the product. We were super impressed. We looked at the management team. We were super impressed.

And then we kicked into a higher gear of diligence, which costs us money. We spent thousands of dollars per deal, diligent thing. Low thousand. I would say two to $5,000 diligence in a deal. Would you say that's about what a firm spends between outside consultants and internal time? Pre-term sheet? Pre-term sheet and then post-term sheet.

It's in the couple of thousand dollars? For a Series A, a C-round? For Series A, it's going to be more. Yeah, even more. Wow. Yeah, because, I mean, a lot of times what you're doing at a series A is you're making sure all the capitalization records tie out. You're checking to make sure that all of the employees have actually signed

confidential information and IP assignment provisions. So it usually is significantly more. Yeah. So 10, maybe even 15 or 20. Yep. And this is where the discipline for a founder starts to emerge, I find. A founder of a seed or angel funded company, they may not have done any diligence. A bunch of friends and family give you 25K.

They're taking a flyer. They don't even know what the term due diligence is. They're betting on you. But when it's a $250K or a $2.5 million check and it's a $1,000,000. dollar check and it's other people's money, OPM, other people's money. When it's OPM, you have a higher level as that investor who represents those pool of capitals of making sure that this doesn't blow up in your face. In the story I was starting to tell you, the company who touted in their deck did not

have a contract with Facebook or Google. We asked for the contract. They told us it was for top two customers. And then we found out that they had. had an oral agreement with the two companies. And then I asked, can we talk to those people? And they said, well, we met the Google person at your conference and the Facebook persons, my brother's friend, who works there, and they both said they would do pilots. They're totally committed. And I just thought to myself, oh, my Lord, I almost put a half million dollars into this company. And this person

is a liar. This type of craziness has happened to me one out of every 70,000. Well, that's happened one in 250 deals. But, you know, ratcheting it down in the early stage, I would say deal busting stuff, you know, one every 75, one every 100. What do you see in terms of things that come up in diligence that I gave you the most acute, which I would consider fraud? And then, oh, this person didn't sign their IP assignment. That's just an opportunity to do cleanup work. So let's put that off the table. but things above that that are deal killers.

How often does a deal killer actually happen in the $1 to $3 million term sheet range? I would say maybe I see one every five years. Wow. So that is really great. It's pretty, pretty slim, where it's truly a deal killer. Without talking about a specific instance, give us a composite. Give us a zone of where people really screw up. And when I'm talking about this, I mean the founders making some promise that then comes out later.

Is it finance? Is it lawsuits? Is it a harassment claim? Is it a person had previously done fraud in their last company? Where do you see the deal breakers come up? I think it is going to be in close to the fraud range, right? The only other instance that I can think of is, and I will say, setting COVID aside. When COVID hit in March, there was a few deals that were in process where they got put on pause and then investors ended up not investing.

That aside, I would say it is something like there is a huge lawsuit that's out there. And I always tell the companies that I represent, if you have a huge lawsuit that's out there and you have a good defense behind it, you need to tell investors that pre-term sheet. Talk to them about it up front. And if you're using a law firm to fight that, let them talk to a law firm. But if you don't mention it and you get further and further down in diligence, it looks like you're hiding it. And if it looks like you're hiding it, people are going to think that you're a fraud. when we're looking at a term sheet, what are the things that truly matter and are worth fighting for for a founder? And what are the things in your mind that likely are not going to impact the outcome?

Yeah. So I think kind of two broad categories. You have the economic side of things, and then you have the control side of things. So everybody wants to look at the top line, like, oh, what's my pre-money valuation? That's so important. I'm going to pick the one that has the largest pre-money valuation. One, you need to unpack that number because not all pre-money valuations are equal. You really got to understand, is the investor asking for an option pool increase? If so, that actually is going to reduce your pre-money valuation because they're telling you to do it on a pre-money basis, which gets counted to basically reduce the price per share that the investors are paying. If you have outstanding convertible notes or safes, those are usually done on a pre-money basis. money basis, and they're usually a dollar for dollar plus whatever discount they have,

reduction to your pre-money valuation. So you really want to understand the math and really compare apples to apples. Not all term sheets. Do that. Some are pre-money. Some are post-money. Really understand what's included. And I would say the best way to do that is actually put together a pro forma cap table.

Like thinking about it in your head, maybe all good and well, but seeing the real math, how it works out on paper, seeing your personal ownership percentage, go from, you know, 70% to 40 to 35 or whatever it's going to be, really understand that. So unpack the numbers, I would say, understand the math, take the time to do that. This pro forma cap table is something that founders historically have never done. And my realization is, after now being an investor for 10 years and before that a journalist entrepreneur, is that it is super complex at times. It's time consuming. And I also think there's this little bit of like fear I'm going to kick it down the road and not actually address it.

But today we have tools. A friend of mine, Eric Reese, who wrote the book, The Lean Startup, created something called cap table.io. It's a free cap table piece of software. You just go in there and throw your cap table into it. There are a dozen companies now that make, and I'm not going to mention all of them. I just mentioned Eric's because it's free. But there are a bunch of other ones that allow you to maintain a cap table with software, not Excel or a spreadsheet. And if you take the time to learn those, it makes you a much better negotiator, correct? Absolutely. And ultimately, like, when you have a term sheet in front of you, you should get a lawyer involved. This is not a pitch for me. It's not a pitch for Wilson Sincini. You should get a lawyer involved.

for the same reason that you were talking about earlier of investors backing out of a term sheet, you don't want to sign a term sheet, then get the lawyer involved to do the documents, and then be like, oh, I didn't know I signed up to that. I want to renegotiate it. You don't want to be that founder that is like, oh, I didn't understand it, so I'm going to renegotiate the terms. Get them involved early. The lawyers put the pro forma cap tables together. And this is where, like, if you're worried about legal spend, this is a place where a couple of thousand dollars in legal work could

save you millions to tens of millions to hundreds of millions of dollars down the road if you did it wrong. Control provision is also important. And I've seen some wacky stuff going on because there was this weird thing that occurred a couple years ago where everybody had to have super voting shares, blah, blah, blah. Google and Sergey and Zuckerberg were able to have 100 to one voting shares. And I started to see like companies pre-launch asking for a vote. I said, you know, you guys look kind of silly. You haven't even made anything yet.

What is the best practice today for a series A company? Let's stick in that C to series A company range. They do a deal. People want to have governance. Governance is a good thing. Governance exists for a reason, despite what some people out there might be saying. It's really bad advice to not have governance at a company, correct? Correct. For all sorts of reasons. Just for the number one or two reasons of why governance is good, what are they? Just practically speaking. So you don't end up in lawsuits later. I mean, it's the biggest one, right?

I mean, you want to have, you want to put a board together, right? Whether it's just the two co-founders or not, have a board, have the board make decisions. Get in the good corporate hygiene early. Hygiene. I mean, it's literally the word I use with people. I'm like, would you like to have a three-person, 45-minute board meeting with me three times a year? So that when you do raise venture capital or you raise a big one,

you kind of know how to run a board meeting. And at first they're like, my friends told me boards are going to like dominate over me and I shouldn't do them and I should never have a board. And I'm like, your friends are giving you bad advice. Learning how to have a board is a good thing. And under Delaware law, you kind of got to have one. also the law. Okay.

So governance is good. Control provisions. What's a fair balance for a series A company? I hear five board seats, one for the new investor, one independent, three for the common shares. Is that a good structure? I would say for a series seed A company, I think that's a little overkill. What we usually like to see around that stage is like a three-person board, maybe it's too common and one investor.

Really, I think it's also really hard to attract an independent, a good independent at that early of a stage. Like, it's usually between a B and a C is where we will typically see an independent come in. If you happen to have three founders and they all want to be on the board, fine, you have three common and maybe you have, you know, one preferred. That gets you in a little tricky spot. We don't love to see even numbered boards because, you can't have deadlock. There's other ways to address it.

It doesn't happen too often. Doesn't. But it's, again, back to hygiene. Odd number better than even number. As we're seeing right now when people play out, we're taping this at the time of the presidential election, there is a scenario where it could be even. Not the best scenario to be in. All right.

Well, this has been amazing. Thank you so much for helping us understand term sheets. There's a lot more to unpack here. and if people want to get in touch with what I consider one of the great firms in the history of Silicon Valley, founded by Larry Sonsini, who was nice enough when I was a journalist to spend hours with me and really educate me. And you got to work with Larry, I'm sure, at some point. Of course. Yep, he's still working. He's still working.

Yes. My God, how much money has that kid made? You don't need to go to work anymore. He loves it. You know what? There was a thing. There were two Lurries that Steve Jobs used to take counsel from. Larry Ellison, Larry Sincini.

That was what I was told by when I came into the industry. And I said, who's Larry Sonsini? She's like some kid. They're like, Wilson Sincini, that's who Steve Jobs goes. When Steve Jobs goes on a hike and he has a problem, it's two Lari's he goes on the hike with. Larry Ellison on one side, Larry Sincini on the other side, that tells you everything you need to know. WSGR.com. They're my attorneys.

They should be yours. They do a great job. Becky works there. Don't be afraid to reach out. Becky, what's your email? R-D-G-G-R-A-W at WS-G-R.com? Very simple. R-D-E-G-R-A-W at WS-G-R.com.

Thanks so much for doing this. I really appreciate you doing it on behalf of the founders. We're going to learn a lot. I know that you charge a lot per hour now. You're a partner over there. You're no longer an associate. I know that this is costing us money. All right, we'll see you all next time on startup basics.