I got a lot of feedback from my post on liquidation preference (some constructive, some very critical). This post essentially addresses those criticisms and makes some new points about seed financing.
First off, I'm not a so-called super angel, which I've made abundantly clear from the beginning. I'm just an entrepreneur who is starting to get into angel investing. And even then I'm an outsider/outlier. I've never taken investment beyond friends and family for any of my companies. I don't live in the valley or Boston or NYC (Philly actually). And I'm very-technical hacker (the good kind).
First off, I'm not a so-called super angel, which I've made abundantly clear from the beginning. I'm just an entrepreneur who is starting to get into angel investing. And even then I'm an outsider/outlier. I've never taken investment beyond friends and family for any of my companies. I don't live in the valley or Boston or NYC (Philly actually). And I'm very-technical hacker (the good kind).
I'm opening up my new angel thought processes in real time as I get into it. I think this approach is very rare and that there needs to be more of it, so I figured I'd start in hope others would follow! I realized from the get-go this approach would generate a lot of flack, but that is par for the course. I grew a think skin a while ago, mainly from stuff like this. Needless to say, however, personal attacks, condescending tones, and snide remarks still annoy me. I'd appreciate it if you kept those things off of my blog (and everywhere for that matter).
I want to make clear I was never suggesting I would insist on this term in mass syndication deals. In fact, I'm not insisting on it at all. I thought it was obvious I was talking in the context of a term sheet negotiation where I was leading, i.e. playing off of valuation, etc. I realize now that wasn't clear and I should have qualified my post from the get-go. You live, you learn.
That said, the bigger point I want to make is...
Anyway, in effort to continue my thinking and engender some more discussion, I want to address the various criticisms that have come up in response to my first post. The biggest point, which Nivi made best, was that I was proposing a non-standard term, and non-standard terms should be rejected out of hand for process reasons (as they will hurt your deal flow, among other things).
That said, the bigger point I want to make is...
- Would the real standard terms please stand up? Everyone's talking about "standard terms" without naming them. I've personally been collecting angel financing agreements over the past few years and they're *all different*. When people continually make reference to this magical standard they're implying that 90+% of deals look the same, and I'm proposing something in that wacky third-rail 10%.
There is no 90%. For each term, there are certain leading types people use. But often the leading one within those types doesn't even get a majority. And that's not even addressing specific language (implementation of the term type), which definitely matters btw. When you vary each term across the whole term sheet, each final term sheet looks pretty different.
Every angel or angel group has their own lawyer, and in turn, their own docs they'd like to push. And those docs are all different. And not just slightly different; widely different. As I said, they not only vary on terms, but also on specific language for those terms. They also vary on side-agreements they want to you sign, e.g. employment/IP/vesting agreements, etc.
Only in the past few years have so-called standard docs appeared on the seed scene. By my count there are four of them that people take seriously--Techstars, YC, Series Seed & Founders Institute--and they vary widely too! There's a great post on some of the macro differences between YC, Techstars & Series Seed.
For example, Techstars has broad-based weighted average anti-dilution whereas YC and series seed have none. Each has different protective provisions. Series seed has a right of first refusal, whereas YC and Techstars are silent on that point. Series Seed also has drag-along rights while the others don't. YC has no future rights, whereas both Techstars and Series Seed have different future rights. etc. etc. Bottom line is they're different. And none of those differences even addresses the macro convertible debt trend. (Even when they agree on a macro level, again, the micro language varies.)
Recently, Brad Feld tried to get these to converge into one set and then quickly gave up because basically no one could agree and had no compelling reason to do so. So bottom line, I reject the premise that there are standard terms in seed deals.
I've tried to find hard data on it, and I'd welcome/encourage/love more experienced people to provide some. All I can find on liquidation preference in particular is WSGR's market data (part of their Term Sheet Generator). As you can see, it varies a lot. Yes, I realize these are Series A rounds, but it's all I have at the moment (besides the deals I've collected personally, which I said are all over the map). In any case, the VC world is being disrupted. VCs/angel groups who do Series A rounds are also doing seed rounds, and as far as I can tell they're bringing their terms with them, or at least some of them. - There are good reasons there are no standard terms. Why can't anyone agree on magical standard terms? There are a lot of reasons, e.g. people have varied experiences (edge-cases they want to cover), people see different types of deals (even seed deals), and it's hard to get rich lawyer types to agree in the first place :). Brad has another good post on why it's hard to agree to particular language.
But there is an important underlying point here that all seed deals and their terms shouldn't look alike. That is, every deal is indeed different. Three examples are 1) each deal has a unique set of risks and sometimes you want specific terms to account for those risks; 2) some entrepreneurs and investors want specific terms, e.g. certain valuations, and so other terms need to crop up to come to an agreement (if both sides really want to make a deal); and 3) deals come in different shapes and sizes.
On this third example, consider my case. I'm ideally looking to deals really early in really small rounds (<=250K) where, if everything goes well, there will be no need for follow-on VC. Those specifics change a lot of things with regards to terms, and I hope put my original post into a bit more context. This is another thing I should have made abundantly clear in my first post, but failed to do so.
In that context, convertible debt doesn't make sense since there will ideally be no follow-on round. Additionally, a pile-on preference is likely to matter less, since if they do end up taking VC, it's likely to be a smallish Series A (or even another angel round).
For the record though, I welcome standardization as much as it is possible. I don't want to pay any legal costs like anyone else (well, mostly everyone), and I'd love to use these converged standard docs, which is why I think... - My proposed docs are arguably more standard than you're going to find elsewhere. Like I said in my first post, I'd like to use the Series Seed docs pretty much *verbatim*. In fact, my proposal was literally to change one word in them, from a one to a two. I'm guessing other people using Series Seed are changing things here or there and adding side agreements on top of them. But more to the point, if you go out and try to get financing, you're, for the most part, not going to get open source docs that you can read ahead of time. I'd personally like to be able to offer those.
- Liquidation preference is a negotiation wrt to the whole term sheet. As I said above, if you want to insist on particular terms, all you're doing is pushing all the negotiation onto valuation (and option pool size). That's fine I suppose, but you can arrive at better compromises in certain situations by opening up more terms to negotiation. That's what I heard from Fred in his post. He negotiates in various types of liquidation preference in certain situations, mainly when there is disagreement on valuation.
OK that's all well and good you say, but 2x liquidation is still non-standard and no one wants it, to which I reply. - I'm not wed to a 2x non-participating preference. Several well known angels commented to me that they prefer other liquidation preferences (other than 1x, non-participating) including 1.5 participating (with a cap) or dividends. George Grellas (startup lawyer) said on Hacker News "in my experience, in all normal investment environments, founders will resit it for 1x only (usually going for participation with a cap)." First of all, this further goes to the point of there not being a universal standard. Secondly, I don't so much mind any of these choices. They're all basically the same if you run the different scenarios on them.
I picked 2x non-participating as an alternative to participation, in response to Fred's comment (and my limited experience) about entrepreneurs hating so-called "double-dipping." I have also read that dividends can cause accounting headaches and in some cases on-the-books insolvency. So my response was basically summed up in: OK, people hate participation and dividends, and you can get to the same place using 2x non-participating, so why not go there? The insistence that it is somehow worse than those seems a bit silly to me. Is it for no other reason than you see that less nowadays? Btw, in Brad's post on participation he notes how the so-called "standard" has evolved and is different to begin with across coasts.
Going further, why is that all these other things are allowed to vary across the docs, but people have some problem with liquidation preference in particular? Or is it just that I brought it up, everyone has different opinions, and people just react to things they're not used to within their experience?
But like I said, I'm pretty much indifferent across these economic terms. At this point I'm just intrigued. - I don't want the entrepreneur to take all the risk. A bunch of entrepreneurs were pretty angry that I had the audacity to even suggest making a term more investor friendly. Again, I want to be clear that this is in the context of an overall term sheet (including valuation) discussion.
My point was that I'd prefer to give on valuation a bit to make it more likely to make a modest return on a liquidation event such that I can continue to make angel investments, which would of course be allocated to fund more entrepreneurs. I'm putting up my hard-earned money (I got from entrepreneurship btw), and, if five years down the road, the company liquidates assets for some small amount, I don't think it is unreasonable to get a small return on that investment.
Let's consider two cases. I was essentially advocating for approximately a 15% nominal return. The real return would be less due to inflation. A 1x straight preference (non-participating) would be a 0% nominal return, and it's really significantly negative, again because of inflation.
The second case is if you just got common, which a bunch of people said they would insist on. In that case, I would essentially lose most of my money whereas the entrepreneur would get most of the sale price (in this liquidation scenario). I'm not saying I know for sure what is fair, but that doesn't seem fair to me. And more to the point, I'm not going to invest in anything for just common. As Fred said in his post's comments, "i think everyone who has cash at risk in a deal should have preferred stock. i have no idea why angels do these investments in common.". - I hope the liquidation preference never triggers. Contrary to what some people implied, I never want the preference to trigger. People seem to think at a 2x, nonparticipating preference (in a small round) skews incentives so much that I would want the entrepreneur to take a small exit. Nothing could be further from the truth. I only want to invest in things I think will have a decent chance of a medium sized return, i.e. one where this preference would never come into play because everyone involved will have done very well.
That was sort of my point about choosing this value. Sure, weird preferences in certain situations can skew incentives, but I don't think this is one of them, especially in context of the deals I want to do. I'm considering very small rounds where the preference amount wouldn't exceed 500K total. - I'm looking for investments that, if all goes well, won't need VC. Of course, this could be a terrible strategy and I'm open to changing it, but that's what I'm going for right now. The most insightful argument I think was from Mark Suster, who said in the long-run this is bad because later investors will pile-on preference. Other people suggested every one should just be using convertible debt. I'm not saying any of that isn't true or great, but it doesn't work for this current strategy. Like I said above, when there is no VC, convertible debt doesn't make sense. And also, there is less of a risk of screwing up an eventual VC round.
The point for the preference discussion in the first place, which no one really commented on, was that new angel investors could make more deals, and that's good for the ecosystem. Not that people should make personal decisions based on externalities, but I do think on a macro level more angel investments should be encouraged. So in small deals where there is no need for follow-on VC, why shouldn't the standard be for a modest preference to allow for those angels to do more deals?
All that being said, I'm really not that obstinate about any of this. I'm thinking out loud so of course my thinking is likely to evolve over time. Thank you all for the continued constructive discussion.
