The Harsh Reality on Today's Term Sheets

The harsh reality is that entrepreneurs are getting a rough ride out there these days. Is it really worth raising the small amounts of money that investors are willing to dole out with such negitive terms? You'll have to answer that for yourself...

http://blogs.wsj.com/venturecapital/2009/05/18/what-is-an-acceptable-term-sheet-these-days/?mod=rss_WSJBlog

May 18, 2009, 1:31 PM ET
What Is An Acceptable Start-Up Term Sheet These Days?

By Ty McMahan
Even at a time when venture capital dollars are scarce, some first-time entrepreneurs remain reluctant to lower valuations and find a way to work with investors on terms.

Valuations skyrocketed in recent years – a $15 billion valuation for Facebook Inc. in 2007, for example – but in the past several months, as the public markets crashed, private-company values have fallen hard, by as much as 40% some investors say. If you’re the head of a hot, young start-up seeking capital, you may not agree and hold steadfast to your terms. But is now the time to lower expectations?

As an example, longtime angel investor Michael Cann brings up a story about a first-time entrepreneur who early last year shopped around a term sheet for an online media company. Over the years Cann has studied more than a few term sheets, making investments in secondary ticket operations StubHub Inc. and Viagogo Ltd., as well as Second Rotation Inc., an online marketplace for second-hand electronics.

The terms of this particular deal didn’t interest him. Cann felt the term sheet offered by the entrepreneur was too aggressive and they couldn’t find a middle ground. “Compared to term sheets I’ve seen in the last five, six, seven years, some of the things he was asking for would be outrageous in any economic environment,” Cann said.

In February of this year, Cann spoke to the same entrepreneur. He had yet to close the round and his terms hadn’t budged. The company did manage to raise “a significant amount of money from some very successful executives” last year, Cann said, adding that he presumes they know little about angel investing.

“If he can get someone to invest on those terms, good for him,” Cann said.

Here is a summary of the terms:
- Seeking $4 million on a $12 million pre-money valuation;
- Multiple closes but no warrant coverage for early investors;
- 1x liquidation preference (not participating);
- Series A gets one board seat and the common stock elects the other two;
- No covenants to restrict how money is spent;
- No vesting;
- Founder and CEO immediately starts paying himself a $225,000 annual cash salary;
- Founder and CEO will reimburse himself for $37,500 for legal expenses; and
- Option pool is 8.3% of the common stock

Cann says he would have agreed to the following terms:
- Seeking 2 million on a $4 million pre-money valuation ($4 million in capital gives them too much runway, Cann says);
- Multiple closes but no warrant coverage for early investors;
- 1x liquidation preference (not participating);
- Five board members: Two company employees, two representatives of Series A investors and one outside director selected by both company and investors (not typical for angel rounds, but $2M is a big angel round, Cann says);
- No Typical covenants to restrict which govern how money is spent;
- No vesting CEO and CTO get 25% of their shares up front to reflect value already created, the rest vests monthly over three years
- Founder and CEO immediately starts paying himself a $ $125,000 annual cash salary;
- Founder and CEO will not reimburse himself for $37,500 for any legal expenses; and
- Option pool is 25% of the common stock

Other background to consider: Cann said this is the founder’s first start-up, though he was a successful executive in the online media field at big companies. The founder and CEO own something like 80% of the common stock, and the management team will need to be built out. The company’s service, which is dependent on online advertising, launched in the summer, and the site attracted an estimated 50,000 unique visitors in April 2009.

(Readers, what do you think - given the information above, which terms do you think are fair?)
Kyle Harris, managing director of New York-based early-stage firm LiquidityWorks, said he continues to receive pitches seeking lofty valuations and conditions.

“First-time entrepreneurs are so unrealistic to begin with they don’t know where to move to,” Harris said. “When they can’t counter when we make an offer, we know they have no perception.”

However, Harris sometimes appreciates an aggressive term sheet.

“To be an entrepreneur you kind of have to have an inflated valuation,” Harris said. “You have to believe you have a trillion-dollar opportunity. But, these guys pushing crazy terms are unrealistic and lack experience. They assume funds will write checks on how great they think their idea is. I don’t mind someone being unrealistic as long as they can defend the opportunity.”
Both Cann and Harris cited executive compensation as one of the more tricky terms.

Similar to the founder who approached Cann, Harris said a first-time founder recently presented a term sheet asking to immediately be paid $180,000 in salary.

“The thing that frustrates me is the guy working in a basement with no money, then expects to go to big money,” Harris said. “He basically wanted a huge piece of equity, a huge salary and a guaranteed exit no matter the success of the business. Executive compensation is a flaw.”