Thank you to Muhammad Baig for creating these notes. To contribute to the TWiST PodNotes archive email us.
Episode Date: September 4, 2014
In this "Startup Basics," Jason sits down with special guests, WSGR attorneys Rachel Proffitt and Todd Carpenter, who give us in-depth advice on the legal aspects of getting your startup off the ground. In this episode, Todd and Rachel address the following critical question: How do I negotiate a term sheet? Tune in to find out!
- Convertible Notes and SAFEs don’t put a valuation on your company.
- You shouldn’t feel bad to do a market check and shop your term sheet as long as you do it appropriately. Make sure you do this before you sign any term sheets that you already have.
- Convertible notes and SAFEs are much quicker and cheaper than a priced round.
- Receiving a term sheet is the point in an entrepreneur's journey where their previous efforts and struggles have been validated.
- Most likely the terms will come from the investor first. Founders rarely send the first term sheet, especially if they're first-time founders.
- Angel List is changing the ecosystem. In this case, when there is a syndicate of investors for a party round, the entrepreneur usually comes up with a term sheet.
- Pick the best partner for the long game. An exit could take 5, 7, or more years.
- If an investor's not going to give you the time that you need in order to understand the terms and be comfortable with it, explore other options. Usually, a week to think about the terms is fair and most investors are happy to extend that in good faith.
- In the past, people recommended against convertible notes but now it is the standard.
- Two types of deals: note (convertible debt) and equity (priced round)
- In a note deal, the key factors in a term sheet are:
- How much you're going to raise.
- Interest rate (reasonable rate is 3-6%) The idea is if an investor puts $100k in and got 6% when they convert from this loan to equity, and it took a year, they will get $106k worth of the stock. If an investor doesn't charge a high enough interest rate, there could be tax implications. There's an imputed rate that the IRS will apply. You can't do a 0% interest rate if it's characterized as a loan.
- A valuation cap is a maximum valuation an investor will convert their investment into shares.
- A conversion discount is a discount to the valuation in the equity round that converts the investor's investment.
- Both valuation cap and conversion discount are meant to help insulate the investors from a major homerun on the company side. After all, they're taking more risk by investing earlier. If they put a $10m valuation cap and the company comes raising at a $25m pre-money valuation, they aren't going to be diluted down. They will get the $10m cap. If the company ends up raising at an $8m valuation, they're going to use the discount. The note will always convert at the lesser of the two.
- Convertible note terms can be 1 to 2 years.
- A SAFE agreement, put together by Y Combinator, is similar to the capital contribution agreement. It's the next iteration of it. It's a hybrid debt-equity instrument that doesn't have a maturity date or interest and will convert in a future round into preferred stock.