Hacking the venture process

I just stumbled upon (not StumbledUpon) a site that discusses venture funding: Venture Hacks. Started by Babak Nivi and Naval Ravikant, both of whom have been on the entrepreneur and VC side of things, the site brings oodles of information for you, the entrepreneur. They present a series of articles on term-sheet-hacks.

The VCs know more than you do.

You, the entrepreneur, negotiate a term sheet once every few years. You negotiate your most important term sheet (the Series A) when you have the least experience. You negotiate against a VC firm that issues two to three term sheets per month. You negotiate against a “standard” term sheet that encapsulates decades of combined knowledge from hundreds of venture firms.

If you're a newbie to what a "term sheet" means, join the gang. You might want to read Brad Feld's term sheet series first.

Let me give you the low down: Term sheets are what VCs use to tighten hold on your private parts. If you don't negotiate, you will be left with a very painful experience. Don't let them get to you.

You probably know this, but both Venture Hacks and Feld's series are representative of VC points of view. Yes, they're both much more leaning to the entrepreneur, but you'll note a subtle VC bias in the approach, which simply means making more money for the VC at the cost of the entrepreneur. They never tell the entrepreneur to break a deal on a clause, but mention how VCs will take certain things like no-founder-vesting as a dealbreaker. Just so you know.

One thing though: these hacks assume that VCs are willing to "discuss" elements of term sheets, and that you have some reason for the VC to listen to you ("leverage"). If you find that is not the case with you, you can shut down your browser and either take what you can get or carry on without the VC world.

You might think that all of these things are applicable to India. They are, but you have to see them in the right context.

1. Convertible preference shares are "debentures" in the Indian context.

2. Very few Indian lawyers that know anything about negotation will come cheap, so if you hire a lawyer, be ready to shell out lots of Mahatma Gandhi adorned pieces of paper.

3. The legal process takes a lot of time in India, so please expect a lot more anti-entrepreneur clauses in Indian term-sheets.

4. Option pools have a serious Fringe Benefit Tax impact. If you set up an option pool based on VC term sheet, be ready to understand how this impacts your revenue guidance, since FBT is payable by the company. (Yes, you can bill it to the employee, but which employee will pay for illiquid stock?)

A better approach is to create a trust that will issue the ESOP, but the company must not own the trust. VCs will balk at this. Why?

Think about it. Let's say you get a pre-money valuation of 8 crores (for say 10 lakh shares), and VC puts in 4 crores. You think, heck this is great! 33% to VCs, rest to founders! Founders are worth 8 crores!

But they say they want a 20% option pool, created pre-money. Means, post their investment, they will have 4 cr. worth shares, option pool is another 2.4 cr. and you have the remaining - 5.6 cr. worth shares. Suddenly you're worth a lot lesser. And since the option pool is not vested yet, the real shares issued are worth 5.6 cr. (to founders) and 4 cr. (to VCs). This means they hold 42% of the company at investment.

If you went and created an option holding trust, the VCs only get 33% (since the option shares are issued to the trust). That's not in their favour - if they get a buyer they will benefit from unvested shares in the first case, but with a trust the trustees will benefit (and the founders will be the trustees). VCs will not be happy.

I hope you enjoy the sites. I did. I will write more about the Indian context to these options.