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Venture Deals Part 1: Term Sheets

Bryon Harris

Welcome to Dr. Miles Aron’s series on the book Venture Deals. He provides zero-cost access to information about the art, the science, and the history of venture building.

Venture Deals is required reading for entrepreneurs, VCs, angels, and even attorneys. In this series, he will share some important learnings about term sheets and how they can impact your business.

Transcripts (the following transcripts are auto-generated and may have typos or inaccuracies):

hi in this series we’re going to becovering the book Venture deals thisbook is um highly recommended by prettymuch every accelerator investorsuccessful founder as just requiredreading and talks about the formationand structure of venture capital firmsit talks about all the different playersinvolved in the process so I figuredthis would be a great place to start ourjourney hereto give us a firm foundation from whichwe can then go on and talk about what’shappening in Venture Capital with thatbackground so let’s get into it arcaniumwelcome to a production by Dr MilesAaron[Music]Neo and co-founder at Arcadian Ventureswhat are you building[Music]please comment belowdon’t forget to subscribe subscribesubscribeall right so as I mentioned this seriesis drawing from information from thebook Venture deals by Feld and Mendelsonwe’ll throw the links in the descriptionrelated to the book you shoulddefinitely make sure you buy the bookI’m giving some very high level factsthat I found useful but there’s muchmuch more to find in the book so goahead and click on those links in thedescription there’s no affiliate linkI’m not making any money on this this isjust a book that you should absolutelyhave on your bookshelf if you don’t haveit already Okay you’re pitching aninvestor and a very likely conversationthat’s going to happen is that they’regoing to ask you okay well how much areyou looking to raise and at whatvaluation and you need to be preparedfor that conversationum so that you come across as having aneducated answer and so that you anchorthe conversationum to evaluation that you’re happy withsoit’s important to know the differenceand the language that’s used thedifference between the different termsthat are used in that conversationum you’re going to hear terms likepre-money valuation post money valuationand so you need to know what thesethings mean so that you understand thepercentage that you’re going to end upwith you need to understand the impactof the options pool is the options poolum going to be something that theinvestors take part in that they um thatthey take dilution as a result ofchanging the option pool size or are yougoing to take dilution because ithappens before the investment comes inor before before your investment closesso all of these things matter in effecthow much money you’re going to make outof your company at the end of the day soit’s absolutely critical that youunderstand themso free money is it’s very simply justmeans this is how much money we’revaluing the company at before theinvestment comes in so let’s say you’reat 8 million pre-money and you’reraising you’re you’re valuing yourcompany at 8 million you’re raising twomillion dollars from an investorum so once that 2 million comes in it’sgoing to be worth eight million plus the2 million and nowum your evaluation is at 10 million soum we call that valuation the 10 millionpost money valuation so your pre-moneyvaluation would be at 8 million in thatcase you raised let’s say a two milliondollar seed round for twenty percentmaybe it’s aum a slower growing company but it’sstill exciting you’re able to raise thatround you dilute by in that case 20because your post money is 10 millionnow if your post money was 8 million soyou got the terms flipped and you toldyour investor you want a valuation of 8million and they assumed you meant postmoney now you’re actually valued yourcompany at 6 millionand the 2 millionum is what was invested to bring you to8 million well guess what now you’vegiven up 25 of your company so it’s abig difference between 20 and 25 percentmodern term sheets are putting thepre-money valuation right there manyinvestors however are going to sendcontracts that haveum wording that can be a little moredifficult to understand soum rather than go through all thoseexamples I’d recommend one that you buythe book and two if you’re getting aterm sheet and you’re not totally clearon what it means go over it with a goodlawyer make sure that you actuallyunderstand the deal that you’re gettingbefore you sign off on it anotherimportant factor in your term sheet isgoing to be your unissued optionsor your option pool and once that termsheet once you go forward with the dealit’s important to know that unallocatedoptions Shares are effectively going tovanish it’s like they never happened andit’s also important to understand thatas a CEO or a Founder that maybe you’reon the board and you approve the issuingof options to employees that you areeffectively diluting yourself because ifyou didn’t do thatyou would have a larger share in thecompany because those options wouldvanish so what is an options pool incase you’re not sure or you haven’tencountered this yet um maybe becauseyou’re running an LLC for example andnow you’re looking to start a C Corpwhere it’s going to be a little easierto set up that options pool in a more standardized wayum so you you you start up your C Corpand you set you know your Founders takeequal share for example let’s say youhave 10 million sharesum and 4 million shares go to two different co-founders that’s eight million and you say we’re going to put 2million shares into our employee optionspool this is going to be used to enticegood talent to entice critical peoplethat may have joined early but are notFounders to stay with the companyusually you’re going to use some vestingterms so they’re not going to get all ofthat Equity right away it might takeum you know typically four years maybethere’s a one-year Cliff so if they quitwithin the first year they’re notwalking away with a big chunk of yourcompany they have to earn it but after ayear they start to get Equity from thatoptions pool you know maybe it’s two orthree four year term and they’re goingto be vesting shares every month thatyour company operates from then on outum earning that that uh that hopefullymore valuable stock in the futureand so obviously it’s important to havean options pool if you’re intending togrow and hire people and you want toattract the best talent it’s going tolower your cost of talent because youcan entice people to come on boardum for for Equity it’s going to increasethe total comp you can offer but you dohave to keep in mind you’re giving upum you are diluting yourself as you usethat options pull the other thing tokeep in mind is that it is possiblelet’s say you’ve had a 10 options poolit is possible for investors to say Heyyou know we’re going to invest but wewant you to increase to a 20 optionspool so we want you toissueum new shares andum maybe they’re unallocated but we wantyou to issue new sharesum and you need to ask is that before weget your money or is that you know isthat pre-money or is that post moneyum because if it’s pre-money guess who’sgetting dilutedyou are the founder is going to getdiluted right because you’re you’reincreasing the number of shares you’rethe owner there so now your share hasshrunk now if they’re unallocated youknow it doesn’t matter in that momentbut once you take that money in once youget that investment it does matterbecause now the investors have come inyour option pool was increased so yougot diluted they didn’t have to getdiluted you already agreed on thepercentage they were get you alreadyagreed on the valuation and so it it canum unnecessarily or perhapsum just unknowingly dilute yourself nowyou you can ask an investor can weum like hey you know I this is a classicexample from the book as well hey Idon’t think that we need to diluteourselves at this point we think we haveenough options can you uh invest in thecompany and then we’ll dilute afterwardum as needed and that way when thedilution comes in afterward everybody’splaying the same game and maybe you caneven offer some protectiveum provision for that investor to sayHey you know we’re not going to expandthe options pool now because I don’twant to get diluted right now and Idon’t think we need it but if we do itin the future we’ll put someanti-dilution protection in for you sothat it’s not going to affect you eitherway we just don’t want to take thedilution up front and soumthese are some of the things that youmight see as you get a term sheet justkeep in mind how large is my optionspool is it is it big enough for me to dowhat needs to be done and how much am Igoing to get diluted as a result and oneof the exercisesum from Venture deals that I saw thatwas that was incredibly useful was youknow go ahead and set up your hiringroadmap for the nextusually you’re invested when you take inInvestments to get your company 18months into the future but go ahead anddo it for two years give yourself alittle more time so you get your twoyear hiring roadmap everything you couldpossibly needassume this is going to be a lower boundestimate and that actually you’re goingto need moreand then think how much Equity do I wantto give to each of these people and geta plan togetherso that you’re not creating an optionspool that’s way bigger than you need andso that as you start hiring your firstemployees you’re giving the right amountof equity so that there’s enough equityto bring on the talent that you plan tobring on in the future so this issomething that you can have control ofif you have a plan and it all startswith that hiring roadmap having anoptions pool and a hat just having aconversation around the founders aroundwhat’s our plan and what do we need toactually make this company go it’s notabout necessarily following the most uhtried and true path although I thinkthat’s probably the best case if you’restarting a c-corp you expect to be ahigh growth company just set up a 20options pool it’s easy10 to 20 you’re going to be fine but umif you want to be more tactical with itif you’re a little more experienced thenum you know go ahead and have thatconversation and figure out what worksfor you