Daniel Lorer from BrightCap Ventures (one of the leading early-stage VC funds based in Sofia) and Peter Lozanov from BattlePass Studio meet to discuss one of the most important documents that startup teams have to be familiar with - the term sheet. The video stream was organized by Besco - a non-governmental organization that acts as a bridge between startups, private and institutional investors, the government and other stakeholders in the innovation industry.
BESCO believes that a course set towards added-value activities based on research and development, innovation and entrepreneurial inspiration will shape the local economy. Their mission is to upgrade the current Bulgarian legislation and propose contemporary market-driven policies based on innovation and progressive thinking.
The term sheet is a fundamental document in the interaction between a startup and a VC - so let’s clear the common misunderstandings surrounding it.
Daniel has been a tech entrepreneur for nearly two decades with international experience in technology start-ups and large multinationals.
Previously, Daniel was a founding partner at OPTiiM, a new EMEA system integrator, which he started with his partners in 2009 and exited in 2016. Earlier, he was responsible for EMEA pre-sales of several products at HP Software. Prior to HP, Daniel was part of EMEA customer R&D and presales at Mercury Interactive, the #1 testing software company at the time, acquired by Hewlett-Packard for €4.5bn. In 1999, he created his first e-commerce start-up, FranceBusinessPlus in Paris, as co-founder and lead developer and exited to a private angel in 28 months.
Daniel holds a degree in Computer Science and Business Administration.
Peter: What exactly is a Term sheet? Does it mean investment? Is it as enforceable as a contract?
Daniel: The Term sheet is first and foremost a gentleman's agreement between the founder and the venture capital investor. The term sheet is not a binding contract.
The interaction between the founder and the VC starts informally as the two parties exchange pitch decks, ideas, etc., which can take several iterations and at one point the VC may decide that this startup is interesting enough to offer them an agreement. This is exactly the stage when the founder receives a Term sheet, ie. it is primarily indicative of what kind of a deal the VC is offering at the moment. The deal that has been proposed is not mandatory and unfortunately it could be withdrawn. This is a rare practice, but it happens. After this Term sheet has been signed by both parties, a due diligence process begins, which is conducted by the VC and ultimately leads to the signing of a contract. The term sheet can be withdrawn if, in the course of the due diligence, new facts come out that have not been revealed before, which the VC finds worrisome or some kind of disaster like COVID occurs, which can halt all deals.
Peter: What are the main goals that are pursued?
Daniel: The Term sheet outlines the terms of the deal and it contains two main parts:
- Governance - how to build confidence that everyone will fulfill what they have promised, as most of the weight, of course, is imposed on the startup, ie. 99% of the terms refer to the founders and their team.
Naturally, the most important parameter in a TS is the valuation. If we look back at how investors evaluate companies, the most traditional model would be the discounted cash flow (DCF), in other words we look at what profit the company makes and what cash remains, we calculate it for a few years ahead, add risk and here is how much this company costs today. The problem with most startups is that there is no cash flow, so this valuation model does not work.
Another way to evaluate companies is comparables - comparing similar companies in the same industry, maybe a bit bigger, maybe in a different geolocation, but doing more or less the same thing, how much they are worth and say - Zoom costs this much, so Google Meet should cost something like that. This is also a good way to evaluate companies, but if the startup is innovative and different enough, there may be no suitable comparables to compare it with. Therefore, this method could also be not quite relevant for the evaluation of startups in the very initial phase.
Then comes the question of how do we evaluate these startups and the answer is - the endless optimism of the venture capitalists who finance startups. The valuation of a company at this stage is estimated mainly on the hope that something good will happen to the company in the not-too-distant future. VCs believe that by investing in this team they will have a huge return in the future and share this hope with the founders, giving them a much higher rating now than it would be real if they were evaluated through some other mechanism.
Peter: Should founders aim for a really high valuation from the very beginning or does that pose any threats to them?
Daniel: The really high valuation is also risky, yes, because it also implies that a large ticket is to be invested, which raises many expectations of the company. When expectations are high and cannot be met, this leads to a collapse and a down round, meaning that the company reaches the next round with a lower score, which is a very unpleasant event. Therefore, it is better to pursue a more realistic assessment.
Many startups are actually sinking into a sea of cash these days due to the expectations of high returns. As the hopes of VCs are related to the economic situation - when markets grow and there is liquidity, VCs are full of hope that everything will continue to grow forever and therefore the assessments of companies are quite liberal. When markets start to fall or shrink, or there is no liquidity due to some macroeconomic reasons, the hopes of VCs diminish and they start to turn to more conservative valuation methods.
Peter: What are the main models that a founder can come across in TS in terms of funding? What do you do in BrightCap?
Daniel: The simplest tool that VCs use, which can also be part of TS, is a convertible - a loan that must be repaid with a minimum interest rate. Its purpose, however, is not to be repaid, but to be converted into shares, when a positive next round occurs. There can also be a cap - ie. we convert your loan into company shares when you reach a valuation of 5 million. We also regularly take advantage of a variation of the convertible - the SAFE, which is an American invention. It's even simpler, since there's not even any interest. However, it is a bit difficult to apply in Bulgaria, as it is a form of contract that is a bit more special. Our legislation is not very clear on how to give money without a loan, without any interest whatsoever.
The third way to take money from a VC is to exchange it for equity straightaway. This, of course, requires a legal relationship - the VC becomes part of the company. This option is a bit longer and a bit more expensive, in most cases it is practiced for companies that are more stable and their chance of disappearing after a year is not around 90% or more.
Peter: Can you tell us what the most important things that a founder has to fight for at this stage are, based on TS?
Daniel: The format is dictated to a large extent by the VC itself and the size of the round, as well as the stability of the company. You see, convertibles that accumulate on top of each other also lead to danger, because they are not taken directly from the company's shares. When they pile up on top of each other without converting for a long time at different valuations, chaos erupts and the founder cannot even realize how much of the company is already out of his reach - until the conversion comes in the next round of equity. So convertibles and SAFEs are great to start with, but more than one or two cycles with them start to get dangerous.
Peter: How much money to take?
Daniel: In general, the dilution that should happen in each round is between 10-20% depending on how much money we raise and what round we are in. In the beginning it is desirable to be up to 10%, then we can reach for 20%.
Peter: So, it is most important to have a balanced cap table in which the motivation and to some extent the control of the founders is not too affected at an early stage?
Daniel: Exactly. This is part of the dance between investors and founders, which are also starting to observe in Bulgaria. There are no longer any ambitions to take 50% of the company, because it is clear that the founders start to lose motivation to do anything when they have lost control so early and when they practically do not have the opportunity to grow enough.
Another important part of the investment economy is Liquidation Preference. When we sell the company or parts of it, how much will the investors take before it is the founders’ turn? The ‘Liquidation preference’ specifies the amount that VCs can cash out, before the founders themselves. When there is something that worries the investor, this number is higher. For example, when COVID started, the few deals that continued to be made had a greater liquidation preference precisely because VC did not have any certainty that there would be a large exit.
We also need to take into consideration the employee stock option plan (ESOP). Again a kind of dilution for the founder, but most VCs highlight the fact that there are a number of important people around the CEO who need to be properly motivated as well. Therefore, most TSs state that the founder must set aside 5 to 15% of their shares before the said round and then these shares are to be distributed as options to employees.
The governance of a company should be predefined when the investors join it. The good thing is that VCs, especially in the early stage, can be extremely useful and do not interfere with the everyday operations. Our aim is to help, to provide wisdom when asked for, but in no case to manage the company on behalf of its founders or to actively control it. Therefore, our control options are extremely light and concern only the proper operation of the company.
Most often in the TS there are different definitions of what the company's board should look like. The board has to meet once a month to discuss what we do and how we do it. Usually the correct structure is to have 1-2 representatives of the founders (common), then the same number of representatives of the investors (preferred). It is advisable to include an intermediary - one independent person, who usually is someone liked by both parties. In case of a debate he or she can get involved to take sides. However, in very early startups, the independent is often missing.
The other thing that the founders have to accept is Vesting. Both the shares of the founders and the options of the employees are subject to vesting, which usually lasts between 3 and 4 years. The only guarantee for the investor that a startup may have a chance of success is the team that drives it. If the team leaves, everything crumbles. So in case the founder leaves, he or she is left without their shares in the company which is a huge incentive for them to stay.
We should also mention the Right of first refusal (ROFR) & Co-sale. ROFR states that no one can sell shares without first offering them to the rest of the people in the company. The idea is, again, to preserve the founders. Co-sale is the opposite - if someone finds another party to buy their shares outside the company's investors, then all investors have the right to sell to the same new investor as well.
The idea of drag along is to protect from minority blockage. For example, if there is a deal, but 2, 3 or 5% of stockholders do not want to sell for some reason, they could block the deal. Drag along obliges these minority shareholders to sell.
Another type of protective provisions that are standard is the board permission - a mechanism that allows the investor to control the company to some extent. The most serious decisions must be made with the permission of the board - selling shares, buying shares, issuing a loan, selling intellectual property or parts of it, hiring key executives in the company, etc. The founder cannot decide everything on their own - the board must help them with some of these decisions.
We will highlight some things that better be absent in your TS.
- Special majorities - special rights for a few investors. This should be avoided unless there is a very urgent need for it. All investors and founders should be on the same boat and there should be no subgroups in it at all.
- Breakup fees - to be stated in the TS that if the deal does not happen you have to pay fees for review, etc.
It is also quite common nowadays to have Legal fees - if there is a deal, some amount of the money from for legal advice will be considered to be a part of the transaction price, ie. the company receives the investment minus the legal fees.
It is also normal to have a No shop. This is to protect the investor, guaranteeing that you will not use the TS, which the two of you have signed, to look for better offers within the next 1-2 months. Then, if there is no deal you are free to look for TS again elsewhere. Keep in mind, if the company is hot, the VCs have a great interest in giving and then signing the TS - as soon as possible.
We need to mention the concept of pre-money - the value of the company before the new cash flows in. After the occurrence of this event we have the post-money, which is the brand new value of the company. For instance, if the company is worth 40 million USD. and raises 10 million USD, the company’s worth becomes 50 million USD.
And let’s not forget about anti-dilution - the insurance for the VC, in case of a down round. When companies take off and the rounds increase - everyone is happy, but if the company has a down round, then the VCs usually want to be insured that their money will not be completely lost. Among the unpleasant mechanisms is the so-called full ratchet, which fortunately is almost completely forsaken. A full ratchet means that the money the VC has provided during the high valuation round is recalculated at the low valuation one so that the VC ends up with the same percentage of the company. It is important that there is no full ratchet in your TS.
You can check out the whole conversation in the video below (it is in Bulgarian):
If you need any help with understanding term sheets or with getting funding from VCs, feel free to get in touch with the BattlePass team.