The Terms of Term Sheets
In this episode of Matrix Moments, Avnish Bajaj, Founder & MD, Matrix Partners India, and Rajinder Balaraman, Director, Matrix Partners India, do a deep dive on the significance of terms within a Term Sheet, what founders should focus on, and essentially provide a guide for founders who are working on a Term Sheet for the very first...
In this episode of Matrix Moments, Avnish Bajaj, Founder & MD, Matrix Partners India, and Rajinder Balaraman, Director, Matrix Partners India, do a deep dive on the significance of terms within a Term Sheet, what founders should focus on, and essentially provide a guide for founders who are working on a Term Sheet for the very first time.
Rajinder: Welcome to Matrix Moments. On this podcast, I am stepping in for Salonie. My name is Rajinder and I am a Director at Matrix Partners. Avnish, thanks for...
Rajinder: Welcome to Matrix Moments. On this podcast, I am stepping in for Salonie. My name is Rajinder and I am a Director at Matrix Partners. Avnish, thanks for spending time on this topic. Term sheets are something that founders and investors care a great deal about. So, let’s dive in. I have seen one page term sheets and multi-page term sheets. What’s the significance of a term sheet and why does it matter?
Avnish: First of all, Rajinder, great to have here. I know you have stepped in for a technical topic. Maybe this is something you will start doing as a profession soon. Term sheets honestly shouldn’t matter. But, they do matter. And I’ll tell you the perspective will come to number of pages and stuff like that. I will tell you the perspective that I take and I tell founders as well as sometimes co-investors. See, money is not made on terms. Money is made for as an investor by getting into business with the best founders and obviously building great businesses.
For a founder, by building a great business, not by raising money. So if you keep that high level perspective, term sheet is by the way until if you just step back and think about it the journey of fund raising until then usually a founder is wooing an investor and increasingly an investor is wooing the founder. This is the first potential point of divergence that happens. One could argue potential point of conflict. And in my view it’s actually a great opportunity to learn about each other.
When you are in the weeds of that situation, I think both sides should take a deep breath, take a step back and remember what I just said which is the VC is not going to make money on terms. The founder is not going to make money by raising money. If both focus on what their objectives are, I think the rest of it kind of takes care of itself.
Now, there is a lot of literature. So, should it be a one-page term, should it be a four-page term sheet, there is a lot of literature on both sides. I am very clear. It should be as detailed as possible. Sometimes in order to get in a deal, I have seen very large amounts being promised on single-page term sheets. Now to be fair if those investors follow-through and their actual document, which is the SHA, mimics that simplicity of the term sheet, it’s fine. But, it never happens. It then has 50 other terms and it’s a negative surprise. So I think term sheet defines rules of engagement. It defines what the SHA going to look like. And I think the more detailed upfront, the better while keeping the bigger picture in mind.
There is one more comment I want to make, there is this whole trend globally of being founder friendly. If you are not founder friendly - now, remember we are founders first. We consider ourselves the most founder friendly firm out there. But I think investors that potentially compromise on a lot of key terms teach founder the wrong things. That’s not real life. It’s like with your kid if you are putting them in a bubble. So I think this thing has gone a little bit too extreme.
Investors think they have to follow this new thing of founder friendly and we don’t care. Terms matter. This is business. We are getting into - the objective of those terms is to say, we have to think through possibilities, not the probabilities. This is where people kind of get sometimes wound up too much. We have to think of all possibilities. We are the investors. So I think as long as a founder keeps in mind, it should not be founder friendly. It should not be investor friendly. It should be neutral.
If you want to raise money from multiple investors, you should not have a term sheet or terms that may get hard for new investors to get over the line. You will soon self-select yourself into a smaller and smaller set. So I think as long as that is kept in mind, I actually believe it’s more a rules of engagement. And ultimately, a founder should be focused on building a business where terms don’t matter.
Rajinder: It’s good advice. I think you said rules of engagement and you said, key terms. So what are the key terms? And, which ones do you think are the ones which are most contentious or worth discussing where the investor and founder have to find some version of a neutral ground.
Avnish: Yes. So, we’ll go to that just one piece of advice for founder is please use a lawyer. And I have seen in the past I have actually had founders I have asked them are you using a lawyer because we are sending you a term sheet? They will say, no, we’ll figure it ourselves. And you can Google it and you can figure it out which by the way frankly I had done in my first when I was running Baazee. I just think it’s a bad idea.
I think you should realize that ultimately there is a professional asymmetric relationship. Somebody is putting their money. Other person is putting in their life. They have sweat equity. You have money equity. There will be some level of difference in interest. And there should be a third party that the founder should be taking advice from. So I actually strongly encourage founders to take lawyers.
Now the converse is please take a lawyer who has done enough of these kind of deals because then lawyers try to add value and they will reinvent the wheel. These are general market and settle things. And so, please get a lawyer, but please get a lawyer who has done venture capital before if you are looking raise from VC, not private equity. Those are very different things. As long as the person has enough exposure to venture capital and with working with tier one or good quality firms, I think people should be using lawyers.
What are the terms? Well, let’s start with I would say think about it as commercial and then we will come to the others. Number one is pre money, post money valuation. The only reason I bring it up because that’s obviously a commercial discussion typically, pre term sheet. I don’t think founders sometimes think hard enough about the fact that any multiple that they are valuing themselves on especially if it’s post seed stage, is a post money multiple.
After you have raised this money, next time you go out in the market, your valuation is post money not pre money. So if you are a $2 million business and you are raising money at $25 million pre, but you are raising $10 million, you are effectively - in your mind most founders will say I am raising it at 12 times which by the way is crazy. It’s very high. But actually as you, right after this round closes, you have to raise more money. Your multiple, your pre money is now $35 million. That’s an 18 times multiple.
I think this is very important because you and I were just chatting with a founder in this regard, I really encourage founders. Just like an investor is taking on punt and bet and in some ways putting their destiny in the founder’s hands. Much more than the founder is putting their destiny in the investor’s hand. Founder runs the company. There is a my view responsibility on the part of the founder to generate value for the investors. It’s great to try to optimize value valuation right now. But ultimately you are not making money out of it. And you are going to make money only at exit. And you have overpriced it; the investor is going to constantly keep feeling the pressure.
So I am using the opportunity to slip in a message on valuations. We will come to the terms. But I really think founders should think next round backwards. Think about their pessimistic case of the next round, not their optimistic case. Pessimistic case of their next round and make sure the price such that their current investor at least 2-3x in the money when they go for the next round. So that’s where I think pre money, post money and multiples matter.
Then again in my view we discussed in the first question that money is not made on terms. Now there are certain terms which investors have put in globally which I am surprised that it’s still I think it’s mostly dying, but for example, liquidation preference. There is this concept of participating preferred and my colleague Tarun actually has a post on it. It’s just very complex. How liquidation preferences work, but go from straight 1x simple.
My advice to co-investors, I have personally made the mistake of asking for and participating in prefer. Will never ask for. Will never give it anymore. And the reason is in a success scenario, it doesn’t matter. But you know venture capital success scenario is less than 10%. In the failure scenario, maybe doesn’t matter. But in the middle scenario, it does matter. And if you are double dipping which is basically the concept of participating in preferred, you are essentially going to create a disincentive for the founder to try to create incremental value. That extra million. The extra 2 million. The extra 3 million because a lot of that value is getting clawed back by the investors.
Non-incremental value like we said, it doesn’t matter. You come up with big outcomes. Size of stock options pool, I think it’s very important. There is this thing I often hear from the best founders. First of all there will be an argument on the size of the option. It used to very easy, 20% post money. If you are at an early stage, 20% post money option pool. Sometimes it gets negotiated to 15%, 12%. I actually find it surprising sometimes honestly because if you are going to create a large company and you know that you are going to have to attract world class talent to do that, you should be able to - you should be more than happy to get so much equity. I think at Baazee we got 22 or 25% and it was all issued out. That said, if you are multiple co-founders, you have already solved for some of the key functions by virtue of having those people as your co-founders including let’s say your tech co-founder. Can it be argued that you can get away with 12 - 15%? Probably.
At the next level argument that comes which I just think is and by the way I have also seen it come with co-investors is okay, we will have a 15% option pool, but if you don’t issue it out, the equity comes back to me, i.e., the founder or i.e., the co-investor. Why? You are just creating such a disincentive. Misaligned incentive. Founder when they are thinking of hiring somebody is thinking only their dilution because if they don’t give that out, it’ll come back to them. So, the answer is a simple no. It’s called over optimization. Neither the investors nor the founders should be encouraging it.
There is this founder reverse vesting which typically comes in at very early stages. Interestingly, the best founders have figured out it’s in their interest. So why is it in the investment – what is the concept you have 100 shares, you are starting the company, we are coming in to invest, but those shares will now vest over four years. So if you leave for whatever reason after two years, those shares come back to the pool. For an investor why does it make sense? Obvious, we have invested in you, but we are not there anymore. So we will have to bring somebody else whatever be the reasons that you are not there. So, the value - we shouldn’t have to dilute again for that person. We have to have an equity pool for that.
Why is it right for founders? Most of the time there are co-founders involved. Sometimes co-founder relationships don’t work. And if co-founder relationships are not working, do you want that chunk sitting with somebody who is no longer at the company. So in my view, it’s going to become increasingly market even for the best founders to essentially have founder reverse vesting. But, this is sometimes a contentious point. There are transfer restrictions on our shares and there are transfer restrictions on founder shares.
Actually, there are no transfer restrictions on our shares. There are transfer restrictions on founder shares. Often I will find founder saying, yeh to symmetric nahi hai. Nahi hai. Waisa hi hota hai because hum paisa dal rahe hai. So these are not things that are meant to be symmetric. We are putting in money. We are in the business of entering and exiting companies. We cannot have any restrictions.
Founder we have put money into your company if you can transfer out, it’s a problem for us. So these things are generally not symmetric. Lots of nuances get added by founders. You cannot transfer to competition. You cannot - we need a ROFO - ROFR. My view is that early stages founders should not be worrying this. This is not market. You know sometimes we give concessions, but that’s generally after value creation. If you have created value for the investors, the investor is in a good mood. Then you ask stuff . But asking too early I just think is not market. And I like we discussed in the first part, you should be making your company so investor neutral if you can make it investor friendly awesome. But at least investor neutral where investors don’t cringe at terms and say, this is a problem.
Board composition, typically ends up being debated. I think there is a post somewhere from Sam Altman talks about two founders, two investors, one independent, ideal board. I have also seen two and two to start with. It works. Founders often I have found - actually, no, I think most founders are okay with board observer rights, but they don’t get it why people are asking for it. And often when you’re investing in early stage you doing it A) for company building together, but also excitement. You want to be involved at various stages. So I think board observe seats should be something that people give away. It doesn’t really matter. You will A) Get more commitment out of that investor. And B) They may be able to add value. But technically speaking if you just want them to be quite, that’s what they have to do and they can’t vote.
Big point of debate are what are called AVIs, affirmative vote items or reversed matters. And these are essentially minority protection rights which without the investor’s permission you can’t do x, y, z activities. Again something that founder say that I want protection rights also. Well, no, you are running the company. We are the minority shareholders. You may be – in later stage companies sometimes founders end up in minority share ownership. But that there is a difference between ownership and control. What founder sometimes get confused on is boss, you still have control. I have no control. Because I have no control, I have to ask for some of these protections. You are running the company, so you don’t need the protections. I do. So there is fundamental asymmetry in some of these relationships which one has to understand. And typically AVIs are in three buckets. Economic, my rights as an investor, my share holding related preferences, economic rights. Operating, which is deviation from business plan of x, y, z, taking that of x amount, you need our permission. And governance, how will you - setting up an ESOP plan, frequency of board meetings and stuff like that. by the way in economic rights would be just changing the nature of the business of the company or doing an acquisition.
With stage over a period of time as you have multiple investors, it is good for the company and the investors to get more nuanced about it, to break these up, and to have different thresholds for approvals. So, what I like to do is operating I like to give away as much as possible. I don’t want to hold the founders back especially if there are eight investors. So these things over a period of time become more and more sophisticated. But again asking for it upfront will just unnecessarily create brain damage for yourself and for the incoming investor.
The other one I have seen debated which should not be debated, my friendly advice to founders, anti-dilution and pro rata. That’s bread and butter for us. We need anti-dilution. We need pro rata. Pro rata all we are saying is we should be able to invest as much as we own. And sometimes founders say well, I should also invest. Well, if you want to sure, but then how will you get a new investor. So, market terms, table stakes should not be debating.
There is this highly controversial term called super pro rata. And which by the same sometimes we have asked for and again, if you Google it most of the value literature will say, bad idea. I actually disagree. I think the time we ask for super pro rata is when we have low ownership and we want to accrete ownership. And the reason people disagree in the valley is if I don’t exercise - two reasons, one if I don’t exercise my supper pro rata, I am sending a negative signal to the market which is fair and we will talk about it. Or, B) If everybody asks for super pro rata, how do you get new investors? So my view is the following, my view is yes, I can see the signally effect. but, let’s actually go beyond theory into practice which is either the company is doing very well. Or, the company is in the middle, or they are not doing well. Not doing well, nobody worries. Doing very well, other investors are coming in, I am trying to exercise super pro rata. Let’s say the other investor says, no, I need my ownership. What am I going to say? No, don’t raise money. Of course I am going to let the company raise money. It’s the situation in the middle now. Now I will come back to why number is important. In the middle, we are most likely not being able to raise money. What will happen? We will now exercise super pro rata? No, I will do internal round. If I am doing internal round anyway I am going to accrete. So I am going to hit the threshold beyond it. It’s in the first situation where as an early stage - sorry, the one we just spoke about, where as an early stage investor I have taken a bet on the company, on the founder without enough ownership for whatever reason, competitive dynamic, valuation, founder not wanting to dilute and I want accrete my ownership. It gives the founder a tool to negotiate with the new investor saying this is what I owe my existing investor. So then at least the starting point is not the 12% I own, but the 15% I am entitled to own by virtue of the super pro rata. That’s the starting point of the negotiation. That’s all we are asking for. We are not going to mess with the company’s future and blew up a route. So that’s where I have a different point of view. I think we have demonstrated through practice that we have always stuck by it. But this is definitely a controversial part.
It’s been a long answer, so let me close with a point on confidentiality and exclusivity. I am surprised how many founders don’t realize that a non-binding term sheet is binding - legally binding on confidentiality and exclusivity. That is when you read a term sheet, you will see everything is non-binding except these two clauses. And I think maybe even - I think these two largely. So please recognize that it’s actually legally binding. That’s a legally binding doc. And I have often found even in situations where we have signed a term sheet and we have a great relationship with the founder, the founder coming back and saying, by the way I am talking to that other investor about something. And they don’t realize that they are actually violating a legally binding clause. So, people should remember that.
Rajinder: Avnish, thanks. That’s actually a super detailed answer. I am actually going to go back to some of the things that you said and I want to double click on a few of these. Let’s start with founder reverse vest. That’s one where it has been seen that there have been co-founders who have drifted apart of have different vision for the future and moved on. What happens to that equity in that scenario? And what’s kind of market practice and market standard with the reverse vest?
Avnish: I think it’s a great question. So that equity should go back to a pool. So by the way, this is what I think is the right answer. People have other kinds of answers. So in my view, if I am investing in a company with a certain founder pool, somebody from the founder pool leaves, it should go back to a founder pool, not to existing founders such that we can use it to bring in new people. But I have also seen situations where it goes back to the overall pool, which means it benefits the existing investors. That’s not why I am looking for.
I think what should happen is, it should go back to some kind of trust or founder pool and it should be used either add to the ESOP pool, but ideally should be used to bring in an equivalent founder level person and then whatever is left all goes to ESOP pool. In my view, it should not be benefiting the investors. Investors can argue that it should because effectively it would reduce the pre money valuation, which given that somebody is left might have happened. Anyway, where I net out is should go to founder and ESOP pool.
I have one more point which I forget to make. Legal fees and expenses, highly negotiated clause. My request to the founders, this is truly something that comes out of our pocket. If you don’t pay for it, so please recognize that it is coming out of the proceeds that you are raising. If you say no to legal fees and diligence expenses and all of that, it literally comes out from the VC’s pocket. It doesn’t come out from the fund. At least that’s how our fund is structured.
So request that within reason one should not be over negotiating that clause.
Rajinder: Yes. Going to go back to one of the option pool. So, I have seen term sheets where there is specific callout for allocated versus unallocated pool and you had referenced some numbers at the start. Was that more for companies which are just starting up? And how should founders think about what is allocated versus unallocated whenever they are going through successive rounds of fund raising?
Avnish: It’s a great question. So, I would say when you start out everything is unallocated. So, the numbers I was talking what was unallocated typically at seeds or series A stage. Probably one rule of thumb that I have followed or found to work is for every stage assume that the unallocated will need to be half of the previous stage.
So if you have started with 15 unallocated or 20, after series B, typically 7, 8, 10% is what one would like to see. C, 4, 5, 6%. D, 3%. By that time, you are issuing out a lot, value of company is increasing, and we are going to do actually a podcast Salonie and I on this topic, so the amount you have to issue out also goes down because the value that we are issuing out is much larger. So by definition the percentages start going down. But, it was unallocated.
Rajinder: Got it. You spoke of AVIs and this is one where I think some founders have actually had a ask where they say do these AVIs continue into perpetuity and how should I think about when there are lots of investors some of them who have significant ownership, someone of them who don’t. How should they think about who to offer these AVIs to and who not to?
Avnish: AVIs continue until IPO. So, if the founders don’t want AVIs, they should create a large company which goes public. I am just kidding. It’s very important like I said earlier to break it up into economic, operating, and governance. I am the most flexible with operating which by the way would net net be let’s agree on an annual operating plan as long as within - you are within that annual operating plan, you don’t need to come to us.
Now if there are significant deviations from the operating plan - now what is significant, keeps changing with the stage of the company. Economic, no investor is going give away. It’s our shares. How can somebody else decide what can be done to our shares? But there are thresholds that have to start happening because I said - so let’s say change to of the rights and preferences of my shares, no one else can have a view on. But, should a company be sold, should a company do an M&A, should it we do IPO? Should I alone even as a smaller shareholder have the veto? No, absolutely not.
So, what happens is what we have also seen companies do well is A) You break this up. B) You bring in thresholds. So my rights always my veto. Important economic actions like M&A, IPO, it will become sometimes at the very minimum majority of the investors and then it starts going more and more towards super majority of investors. The more material the economic event, the more consensus would be required. So you could go all the way from majority of investors to 90% of the voting capital of the company. So that’s typically how it works and most good investors would actually encourage that very early. So we typically by series B, we stop asking for vetos for ourselves. We actually start putting in let’s say there are three investors, say two out three. Or, start inputting in some concept of majority like referring back to the first question that we have to create terms that are scalable.
Rajinder: So we didn’t talk about one topic which is angels and how should these terms and documents be read by founders in the context of if they have lots of angels many of whom who have a very small percentage shareholding in the company, obviously these founders may want for these angels to continue to participate in the upside of the story. But offering all these rights to angels, is that market practice? What does one do?
Avnish: It’s not market practice. And I think the best angels get it. They don’t even ask for it. So now there are two thoughts. One, I strongly encourage companies that know their angels personally meaning the founders. Let’s say it was through a angel network. Or, that had too many angels to have what is called a PoA power of attorney such that one or two angels can sign on behalf. I have seen so many rounds get stuck for 30, 40, 60, 90 days because one angel has not signed.
Typically by the way in our as a company scales, the SHA will start saying things like one person can sign on behalf of others. Or, for most things their approval is not required. And the best angels get it. Everybody plays at a certain stage in the ecosystem. And when a company is getting funded by great investors, no good investor worth their salt will ever screw around with angels. Why? They are important part of the ecosystem.
So, the best angels get it. The best investors get it. And therefore, I think this is not as big a deal. And most good founders also then realize that lot of those rights are dialed back.
Now sometimes what I have seen is if there a group of angels that came in together and in aggregate let’s say their ownership is material, then should as a group they have some right? Of course, they should.
Rajinder: One more question. There is a pretty significant block in every term sheet focused on exit provisions. Why is that an important section to be covered in such detail starting with say the timeline for exit, the various methods of exit whether it’s IPO or strategic sale, buyback et cetera? What is the significance of detailing it out? And how should founders think about what’s appropriate? What’s market practice here?
Avnish: What's been the biggest problem with Indian venture capital till maybe last year?
Rajinder: I guess exits?
Avnish: So I guess, we haven’t figured it out that is important. So, that’s the point. We are in the business of investing money and then harvesting money. That’s our business. And other than the investment decision, the most important decision is the exit decision. So that’s what we are paid to do. That’s our fiduciary responsibility to our LPs or investors. And therefore, that is a critical term. But, I don’t think founders should worry too much about it. And there is one element of it which they should know that they are signing up for. I can’t exit a company that’s not exitable. can’t do anything about it. But, ultimately there will be some companies in the middle which could be sold but the founder may not want to sell. Now at some stage in this so called exit waterfall, we have what is called a drag rate. So we can essentially force this company to sell. Hundred plus investments and Matrix never exercised it.
Who will do that? I mean we talk about being founders first. It’s truly the emotion also. We will not do it. We will say, okay, we will wait if the founder believes there is value creation potential. Otherwise, we have a discussion and see if it’s worth it. Like I said never exercised it. But, do I or do we as investors need a guaranteed failsafe option that we can exit this company if it is exitable? Absolutely, we do.
When people get wrapped-up in all this, what they don’t realize is companies are bought, not sold. I may want to sell. If there is no buyer, I can’t sell it. And if there are buyers, there are usually multiple options. So generally this term doesn’t matter. But, yes, founders are signing up for a failsafe option for an investor to exit where if all else fails, I should be able to force the sale of company.
Rajinder: This is very helpful. Any final thoughts of advice for founders? You started out saying businesses are built not on terms but on building a great business. Any place where all of this can go wrong? And any final advice for founders?
Avnish: Yes, so I think the advice A) Build the business such that the terms don’t matter. B) I actually think the term sheet discussions are not going to maybe even negotiation with an investor. Is your instance where you are going to feel like you are on opposite sides and that is a great opportunity in my view threat as well as an opportunity. A threat for the relationship to go off, for the wheels to fall off. Or, an opportunity for the relationship to go to the next level. Until then you are both dating and putting your best foot forward. This is when the rubber is hitting the road and you are saying the nahi, mere ko yehi chahiye even if that other guy or lady is disagreeing.
I think you use that opportunity. I think in almost all cases I have learnt a lot about the founder. It hasn’t changed my decision whether to invest or not, but it has told me how best to engage with them in situations where we may not necessarily be on the same side. And I think it’s a great opportunity for the founder. And I have almost always and you know in our inventory of skills, we mention in one place that are you able to resolve difficult situations with the founder and yet take the relationship to the next level, right? I think this is one of those opportunities and should be used fully.
Rajinder: Thank you.
Avnish: Great. Thanks.