Nivi · September 23rd, 2009
I recently received an email from an entrepreneur who had questions about a term sheet he received. Here are his questions and my answers.
Bridge before Series A
The entrepreneur says,
“The investors are in the process of closing a fund so they want to give us a bridge loan now and do the Series A later in a few months after they’ve closed their fund.”
VC firms make seed investments all the time. If you have alternatives, take money from a firm that actually has the capital to invest in a Series A.
Even if the firm has capital, you won’t be able to raise a Series A from anyone if the bridge firm doesn’t like your progress after the bridge.
Read this article from our archives: Keep your Series A options open if you raise debt.
“The board consists of 2 investors, 1 independent, 1 CEO, and 1 founder.”
This is too heavy for a bridge or a Series A. I recommend 1 investor, 2 founders for the bridge. Worst case: 1 investor, 1 founder, 1 independent. Best case: 0 investors, 2 founders. Use this quote from Marc Andreessen as normative leverage:
“In many cases, we don’t even think today’s raw startups should have boards.”
He’s talking about seed stage companies like you.
For the Series A, the worst case is 2 investors, 1 independent, 2 founders, 1 CEO (if and when we hire one). Read these articles: Create a board that reflects the ownership of the company, Make a new board seat for a new CEO, and Control is a one way street.
“What are you seeing for valuations nowadays? Our prospective investor tells me ‘market’ is 40-40-20 (founders, investors, option pool) after the Series A.”
Market is whatever the market says, not what one investor says. You need at least two competing offers to create a market. If you have only have one offer, you’re going to have a tough time negotiating — although it can be done and companies do it all the time.
I would strive for 70 – 20 – 10 (founders, investors, option pool), depending on how much you’re raising. The more you raise, the greater your dilution. And I would settle for 60-25-15. These goals will be dramatically easier if you only have one investor in your Series A syndicate.
Read these articles: Create a market for your shares, Tips from a ex-VC who helps entrepreneurs raise money, and Should I shop around?.
“The investors want to replace the CEO during the Series A.”
This is a big red flag, especially if you aren’t interested in giving up the CEO spot right now. Fred Wilson says it well in The Human Piece Of The Venture Equation:
“I’ve learned that nothing can replace the entrepreneur’s passion and vision for the product and the company. If you rip that out of the company too early, you’ll lose your investment. I think it’s best to wait until the initial product has succeeded in obtaining a critical mass of users and a business model has been developed that works and make sense for the business and is scaling. Then, if its warranted, you can sit down and have the conversation about bringing in experienced management.”
Use this quote as normative leverage.
This doesn’t mean you can’t collaborate with your investors to find a new CEO if you think the company needs one. Ask for references from all of the founding CEOs they’ve replaced — including the bad references. Fred Wilson also has a great post on how to bring in a new CEO: I baked the cake, you can ice it, but don’t screw it up.
Startups are not assets under management
Finally, who are the investors? If the investors are a well-known firm, they’re probably trying to anchor you and there’s a lot of room to negotiate.
But if the investors are from an unknown firm, they might think this is a fair deal. They might have the mindset that they’re investing in an asset that’s going to be “managed” by the founders or new management. That’s not the way startups work. If the founders give up too much of the company too early, they lose their drive to create value for the common and preferred shareholders alike.