[Editor's note: Ted Wang is an attorney at Silicon Valley law firm Fenwick & West. Disclosure: VentureBeat is a client of Fenwick's, though does not have a relationship with Ted.]
The release of our firm’s Trends in Terms of Venture Financings shows that this remains a strong market for entrepreneurs to raise venture capital. The survey finds that valuations have continued to increase, while some tough terms negotiated by venture capitalists such as multiple liquidation preference and “ratchet” anti-dilution remain comparatively rare.
There is, however, a danger that the current climate is encouraging entrepreneurs to go too far. We are increasingly hearing requests for odd-ball terms such as very short vesting schedules (2 years?!) and founders’ protective provisions that recall the heady days of the Bubble.
In my opinion founders should resist the temptation to think outside the box with respect to the terms in their founders’ agreements and financing documents. Obviously, valuation and liquidation preference are key areas of negotiation, but for other areas I am a strong believer in plain “vanilla” terms.
If the market is good, why shouldn’t founders get the best terms that they can? My rationale is as follows:
• Standard venture financing terms represent a compromise between investors and entrepreneurs that is informed by years of experience.
• Developing and negotiating unusual terms is a waste of a company’s two most precious resources, time and money. Unique terms are highly unlikely to provide any return on investment and are certainly not correlated to the potential success of the enterprise.
• With respect to founders’ vesting, the people who build the company are the most likely to be the ones who lose out with “creative” vesting schedules. Most founders think about how to protect themselves from being ejected by VCs, however, the vast majority of the time, it’s the founders who get rid of one another when someone is behaving badly or not pulling his or her weight. With aggressive vesting, this can result in an ex-founder owning a huge chunk of stock, while the remaining founders work like dogs to make it valuable.
Someone out in the blogosphere has surely already begun typing, “Fenwick represents Kleiner, Sequoia and others and you’re just a shill for the VCs. Founders should get what they can, when they can!”
In response, I note first that the vast majority of my clients are on the company (as opposed to the VC) side. Second, and far more importantly, this is the same advice I give to my company clients. It may seem counterintuitve not to push for the “best” terms, but in my experience the marginal value of improved terms is not worth the investment in time and effort required to incur such gains.
This is an excellent time to form a start-up and raise venture capital. Use standard vesting, get a good valuation with a low liquidation preference and spend your time and effort building a great company.
7 Comments
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Peter Cranstone said:
Ted,
What’s an appropriate vesting schedule? Can you give some concrete examples, i.e. how many shares over how long.
Thanks,
Peter
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You Mon Tsang said:
As an entrepreneur, I think this is good advice. It is simple but a founder and VC should want a successful outcome to make both parties happy.
Also, unusual terms now can also make the next round tougher to raise.
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Ted Wang said:
Four years is the industry standard for vesting. Usually all of the founders’ shares are subject to such vesting. The key issue is around when does the four year period start.
IMHO the most equitable answer is when the founder began working full time on the idea.Since clean tech is so hot, I note that the vesting cycle is typically longer for these companies because of the longer time to market.
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David Cowan said:
Ted,
So what happens if the founder started working on the idea 3 years before the first venture round? As a VC, I don’t want to invest in a company where the founder has little incentive to stay after a year. (Believe it or not, I want founders to stay.) A fair compromise I have made is to subject the founder’s shares to four year vesting, but the founder’s shares accelerate by three years if he’s fired (effectively, the vesting is retroactive to when the founder started with the company). But if he quits, his unvested shares go back into the pool, to help recruit a replacement.
Thanks for the thoughtful post.
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Krish said:
David,
While your suggestion is valid, will it not by itself be a great incentive for VCs (or other majority holders) to oppress the long standing founders and force them to quit, especially if they are in the minority…? That way, by your argument the unvested shares get back into the pool and the VC can fill the Board with the replacement cherry he picks…??
May be Ted can address this too while making his reply to David.
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Ted Wang said:
When a founder has put significant (i.e. more than a year of full time work) time into developing a product and then raises money, you can conceptually divide the founder’s shares into two parts. The first represents the value of the initial work and the second represents the value that will be created by putting the investment to work in commercializing the idea or expanding the business.
A solution in this case is to make first bucket of stock fully vested at the time of the funding and the second bucket vest over a four year vesting schedule. Typically where this falls out is a 25%/75% split, with the larger number subject to four year vesting. After all, ideas are a dime a dozen, but the ability to execute on a plan is the real coin of the realm.
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Peter Cranstone said:
Ted,
Nicely done. It’s all about execution… do it well and no one will care. Do it badly and, well you know what happens :)
