

A founder-friendly term sheet - sama
http://blog.samaltman.com/a-founder-friendly-term-sheet

======
grellas
Very simple. Very clean. Kudos for having the right spirit of honesty and
transparency. VCs have lately taken to bearing their own attorneys' fees on
occasion but I have rarely seen a significant VC deal in which the option pool
is not brought in as a back-door way of lowering valuation for the founders.
Removing that bit of legerdemain from the valuation equation is really quite
stunning.

Of course, the question is whether this will catch on and stick, even during
bad times. When markets are sunny for investors, it is not too hard to bend
for the founder concerns. When things are tight, though, the pattern has
always been one of merciless slaughter of the founder interest, as evidenced
by any down round within memory. So too, in bad times such as the dot-bust
period, atrocities like participating preferred and multiple-x liquidation
preferences frequently reared their heads and would, I think do so again in
any new time of debacle. While individual investors such as Mr. Altman may
refrain from this sort of thing, I wonder whether such moderation would ever
become the norm. I would tend to doubt it.

I also think that even this particular term sheet, though undoubtedly fair to
founders in its overall sweep, would need to be adapted to avoid unfairness as
it is applied to various cases. If a founder has built large value by the time
of Series A, it is very non-standard to require that founder to put the
entirety of his stake at risk of forfeiture all over again as a condition to
getting funded. That, I assume, would be an obvious point of negotiation and
one on which any investor would very likely yield when pressed.

These are mere quibbles, though. It is really the spirit of the thing that
counts and not the legalese as such. Just as the best contract in the world
will not really protect you if you happen to be dealing with a scoundrel, so
too the flimsiest of contracts will likely not cause you too much trouble if
you are dealing with someone of honesty and integrity. This term sheet
reflects the right values that an investor should bring to a deal and, if you
get that as a founder, you are 99% of the way there as long as your business
interests can match. In the end, that is what counts most of all.

~~~
jpdoctor
> _the pattern has always been one of merciless slaughter of the founder
> interest, as evidenced by any down round within memory._

It would be interesting to see the stats for investor payoff when that
dilution is included. The few cases I know: Anytime the founders were singled
out for big dilution the result was sizeable loss for investors (and everyone
else, because the companies eventually got sold for parts.)

------
jorgeortiz85
One clause that's gone uncommented:

    
    
        Transfer Restrictions:
        Bylaws and option plan documents shall include limitations on
        certain transfers, including on secondary markets, to
        competitors, or that may trigger public reporting obligations.
    

In order for investors, founders, and employees to cash out on their stock
holdings, companies need to have an exit. An exit can be an acquisition by an
already-public company, or an IPO (taking the company public).

In the first Dot Com bubble, companies would IPO before reaching profitability
and sometimes even before reaching significant revenue. For a number of
reasons (scrutiny from Wall Street, public reporting obligations, Sarbanes-
Oxley), companies that intend to go public increasingly choose to delay their
IPOs.

In 2004, Google went public with 2003 revenues of $960m and profits of $105m.
In 2012, Facebook went public with 2011 revenues of $3700m and profits of
$1000m.

One way shareholders managed their longer time-until-IPO horizons is by
selling their stock on the secondary market. Many startups (SecondMarket,
SharesPost, etc) were set up to help shareholders of successful companies like
Facebook and Twitter sell their private company stock to qualified investors.

The transfer restriction quoted above means shareholders can't transfer (sell)
their stock until IPO or unless they have the consent of the board.

Investors tend to have long-term horizons and may not care about getting
locked up in an investment until IPO. In any case, investors are well
represented on boards. Founders have leverage with the board and can negotiate
partial cash-outs (selling some of their common stock to investors), but in
any case own their shares outright and can hold on to them until IPO.

Employees with incentive stock options, however, can get screwed. Options are
not stock and (even after having vested!) will expire if the employee quits or
gets fired. If the company is doing well, the Fair Market Value (FMV) of the
stock may be much higher than the employee's exercise price, which means
exercising the options will incur a large Alternative Minimum Tax (AMT)
penalty. This means an employee might have very valuable, vested stock options
but no way to keep them upon leaving the company because exercising can put
them in a tricky cash flow situation where the IRS expects them to pay taxes
on unrealized (and unrealizable, because of transfer restrictions) capital
gains.

This term sheet is generally founder-friendly, but the transfer restriction is
certainly not employee-friendly.

~~~
sama
This is intentional. I believe that secondary markets are usually bad, and
always distracting. I'm not opposed to pre-exit liquidity, but a secondary
market that the company does not oversee causes huge issues. Most companies
now prevent this.

Your point about ISOs expiring is reasonable--I think a lot of companies are
using RSUs partly for this reason.

~~~
paulsutter
Could you expand on be "huge issues" caused by secondary sales? I'm having
trouble thinking of any. The most common criticism I've heard is that
secondary sales can make it difficult for the company to maintain a fiction
about their common share price, but that amounts to a tax dodge anyway. Love
to hear some concrete thoughts on the matter.

~~~
kogir
A good example would be 409A valuations[1], which set the price at which
options can be granted. Sale of employee stock on a secondary market can
dramatically raise the price at which the company has to grant future options,
making it harder to hire, and hurting future employees.

While this might be ok in open markets with real competition, it's possible
(and in fact common) for common stock in trending companies to be overvalued
on secondary markets.

[1]
[http://en.wikipedia.org/wiki/Internal_Revenue_Code_section_4...](http://en.wikipedia.org/wiki/Internal_Revenue_Code_section_409A)

------
midas
The no option pool part is great. Taking the option pool out of the pre money
creates horrible incentives: founders are incentivized to tell investors they
only need a tiny option pool and then once they've exhausted it come back to
the board later to ask for a larger pool (that will now dilute everyone).

Founders and Investors should be incentivized to work together for the benefit
of the company, not work against each other to the benefit of themselves.

tl:dr; Sam is right, and I hope this becomes standard practice.

~~~
vosper
I'm an employee with options, and I'm trying to understand how all of this
works. Can you please tell me if I have this correct:

1\. During initial funding ("pre money") talks the founder is incentivized to
ask for a small option pool because she doesn't want to divert a lot of her
stock into the option pool

2\. After the option pool has been exhausted through new hires the founder
then asks the board for a larger pool, which is now created from the combined
stock of the founders and the investors - thus the founder is diluted less
than if the expanded pool had been created at the start.

~~~
midas
That's it!

Keep in mind that not all founders are this savvy when it comes to deal terms,
and most investors will push founders to issue a larger option pool than
needed. The investor will say something like "we want to be sure we have
enough options available to recruit the best employees" or "we don't want to
have to issue more options later because it would be a distraction". Both of
these arguments have a kernel of truth in them, but they're not very good. You
can always issue more options later and it's quite simple. What they're
actually saying is, "I don't want you to come back and dilute me later when
you could dilute yourself now instead". How thoughtful!

In a perfect world, this would have no effect on you. In the real world, it
sometimes causes people to create option pools that are too big/small, since
it's a confusing topic and it can be really hard to predict exactly what you
need in advance! How people then act in those situations differs massively,
but only affects things on the margin (e.g. perhaps the founder will issue a
slightly more generous equity package to a new employee because "I have this
whole option pool to spend").

tl:dr; this should have very little effect on you as an employee, but if your
company's option pool came out of the pre, then the founders probably wasted
valuable time and energy figuring this out with an investor who shouldn't have
asked to structure it this way in the first place. Unfortunately, like many
terms in financing (see the rest of Sam's post), this is too often the case.
Fortunately, it will have little impact on the company or your experience, so
don't worry about it :)

~~~
vosper
My company is fairly open about our financial state and investment situation
so I'm trying to learn as much as I can while I have the opportunity.
Understanding things like this helps me to ask the right questions, so I
appreciate you and earbitscom taking the time to respond.

------
mindcrime
_All founders equity shall be subject to a repurchase right which also
reflects a standard 4 year vesting schedule._

If we were taking outside money tomorrow, this would be a point of contention.
I understand the idea behind a vesting schedule for founders (the investors
don't want you to walk away two days after they invest), and I might
grudgingly agree to something like that. But no way would I ever agree to make
100% of my founder equity subject to vesting or repurchase. The bottom line
is, I've spend 2+ years working on this company, and without the work I (and
the other co-founders) have put in, there is no company, no valuation, no
nothing. I'm not going to put all of that equity at risk just to make an
investor feel good. If we're all supposed to "be in this together" and have
aligned interests, they would have to accept that we've already earned the
right to a significant portion of the company.

~~~
tptacek
I would never join (as a founder) a team that did not have 100% vesting.
People quit, unpredictably. Vesting protects founders.

~~~
mindcrime
_I would never join (as a founder) a team that did not have 100% vesting.
People quit, unpredictably. Vesting protects founders._

I'm fine with the basic idea of vesting, and you're right, it does protect the
founders (from each other) to some extent. What I have an issue with, is a
scenario where you work, as a founder for, say, 3 years, and then take outside
investment money, and the investor demands 100% of your founder equity be
subject to vesting and/or a "zero price" buyback clause. I would never, ever
take that deal. A lot of things can happen, and there is value which has
already been created by the 3 years that was put in.. as a founder, I'd expect
to retain _some_ percentage of my equity based on that. The exact details
would, of course, have to be negotiated.

~~~
Silhouette
_A lot of things can happen, and there is value which has already been created
by the 3 years that was put in.._

Indeed. I'm surprised to see so many people here think that a 100% lock-in is
reasonable. That effectively sets a zero value on the work done to date, while
at the same time presuming that a company is established enough to be worth
serious investment, which is paradoxical.

I don't see how this really protects founders to a useful degree either, at
least not for very long. While some degree of vesting creates an incentive for
everyone to stay on board and do their best to make the project a success for
everyone, it doesn't need 100% of the money involved to do that. Even if it
did, there wouldn't be 100% lock-in after presumably no more than a year, and
then you're back to having a significant chunk of equity that isn't locked in
anyway. So again, the argument that a 100% initial lock-in and 4 year vesting
period are both necessary seems to contradict the idea that you start
releasing a significant fraction of the locked equity after only one year.

~~~
tptacek
100% 4 year vesting is a day-1 requirement, but how much of vesting resets on
a new round is obviously a negotiated point.

------
jdh
> Option pool

I see the point that this is just a price negotiation. However, I don't
understand why the form of presentation is so important to people. If you get
a standard term sheet that says $2M investment at a $6M pre-money valuation
and a 15% pool, it takes about 2 minutes to do the math to see this would be
the same as a term sheet that said $2M on a $4.8M pre-money valuation, with
the 15% pool coming in and diluting all parties after. The discussion on this
thread seems to lean toward the idea that the latter term sheet is more
founder friendly. I wouldn't see the latter term sheet as more founder-
friendly, I would see them as equal.

Why do VCs continue to write term sheets the standard way? After all, if they
thought entrepreneurs would really prefer the latter term sheet, it would
obviously be in their interest to write it that way, and VCs are not dumb. I
think they think that entrepreneurs prefer it the standard way, they like a
cosmetically higher pre-money number, and I suspect they are generally right.
I don't think on this matter they expect they are fooling the naive
entrepreneur: this is pretty basic, and I doubt many would want to go into
business with someone who couldn't grok this.

Now, diluting after but keeping the $6M pre-money... now that's founder
friendly! Who doesn't like higher valuations! I suspect this is what a lot of
people mean by founder friendly.

> Lawyers

As a founder I disliked this clause, I didn't understand why I had to pay the
VCs legal bills. The major bummer on this is that VCs have less incentive to
really grind down the amount if the company is paying, I agree with that.

But I have seen a lot of entrepreneurs grind on this particular term, and I
think it's nuts to make this a point of principle.

VC's annual W-2 compensation is the management fee minus expenses. In the
traditional customary structure of company pays, the deal expense comes out of
the invested capital and doesn't impact annual compensation.

When you grind your VC on this point, you are saying this: listen you jerk, I
am going to make you pay this out of your personal paycheck this year. And I'm
going to make you go back to your partners and explain why, rather than
customary deal terms, his partners have to eat their share of this bill
personally.

Now, maybe it ought to be that way, I don't know -- I'm more with the other
commenters that say what's the difference, just ask them to add $25K to the
round size and scale up the pre-money accordingly and call it a day.

But running a business deciding what battles to fight or not.

As a founder, you can work valiantly to ensure that $25K of your $5M round
comes directly out of the pocket of the guy who is going to be your partner in
building the business for the next 5 years, instead of the family offices and
endowments that are his investors, where it is customarily paid, but I think
there are other points of negotiation you'd get more leverage out of pushing.
Ask the VC to gross up the round size by the attorney's fees and use whatever
leverage you have on more important points.

Incidentally, "company pays" can be a reasonable structure for angel investors
as well as VCs: Say you have a $1M round with all angels, and for some reason
your deal can't use one of the free open source docs out there. If there is a
need for a lawyer (let's say you are raising from US investors but it's not an
American company and they might reasonably want to understand any risks
associated with this): if your lead investor is putting in $200K and then 16
other individuals are each putting in $50K, it's not reasonable for the lead
to be out of pocket on the cost personally, and splitting the bill 17 ways
makes no sense either, it would be much more sensible for the company to pay,
and if need be the round be made slightly bigger. The same principle could
apply to institutional rounds with multiple investors involved.

~~~
Robin_Message
Hang on, if that's the rationale for it, aren't VCs essentially defrauding
their own investors by forcing portfolio companies to pay what is really the
VC's expense out of the money that's just been invested in them?

~~~
aaronbrethorst
How is it fraud if it's a negotiated and agreed-upon term? IMHO, it's really
just called 'being a dick'.

~~~
Robin_Message
Fraud against the _VC's_ own investors – they are spending money on lawyers
for a deal, which is logically an expense of the deal, but accounting for it
as a productive investment, for which they receive commission.

------
ajju
What is the level of acceptance for (a) post-money option pools and (b)
investors paying their legal fees amongst firms versus enlightened angels? I
know Spark Capital publicly adopted (b).

If I asked for these terms from a firm today, would I get laughed out of the
door? (Not that that should stop one from asking).

------
earbitscom
Great. We agree to these terms. Thanks, Sam. Welcome to Team Earbits.

------
sdoowpilihp
Three pages in total, and all in fairly plain english. The simplicity of this
term sheet speaks volumes of the confidence the investor has in their
investments. I wonder if there is a correlation between the complexity of an
early stage investor's term sheet and their over all success?

------
danielpal
On the "pay investors legal fee's", I was recently very shocked of how many
things investors want their Portfolio companies to pay for them.

For instance, if investor is required to travel for Board Meetings they will
require company to pay for it. Also some investors will make companies do
regular financial audits with a firm of their choosing and force the company
to again pay for it.

My biggest questions is, were does the 2% annual fee that investors charge
their LP's go? I know some firms have on-site staff to help their companies
with recruiting, PR etc, but most don't.

~~~
vampirechicken
It is customary for companies to pay the travel expenses of all of their board
members. That's not out of the ordinary.

~~~
staunch
Neither is paying their legal fees out of the ordinary. Doesn't necessarily
make it right. I don't think there's any good reason a company _should_ pay
board members travel expenses.

~~~
jusben1369
This is an odd kind of adversarial stance to take with your Board. Not all of
your board members are necessarily VC's either. You might have a solid advisor
on your board.

~~~
shimms
Not to mention that your most solid advisor could be one of your VC's too ;)

------
jacquesm
That's pretty good stuff.

I'd suggest adding an acceleration clause removing the repurchase right upon
founder termination by the company if that hasn't been dealt with elsewhere.
Four years is a long time.

~~~
kogir
> Four years is a long time.

Perhaps that's exactly why it's there. If you can't commit for four years,
should you really be founding that specific company? Maybe a different idea,
or a different team that you are willing to commit 4+ years to would be a
better choice.

------
salimmadjd
>No option pool. Taking the option pool out of the pre-money valuation (ie,
diluting only founders and not investors for future hires) is just a way to
artificially manipulate valuation. New hires benefit everyone and should
dilute everyone.

This is my favorite part. For example if you have an early exits and don't use
the pool the founder still is diluted for shares never optioned.

~~~
andrewfong
A side benefit of removing the pool is simplifying the math. A common way for
investors and lawyers to model the fixed option pool is to use an Excel
spreadsheet with circular references, which results in unstable numbers and
all sorts of confusion later.

Or to frame it more generally, complexity increases transaction costs.

~~~
nissimk
It's more complicated than that. Complexity is almost always more risky for
the founders than the investors because of information asymmetry. Because the
investors do a lot of deals, they understand all of the implications and side
effects of each term. The founders, even with good advisers and attorneys will
likely have trouble understanding the implications of complex terms. This is a
classic wall street scam where the bank presents complex terms in the guise of
sophisticated banking but it's really just a sneaky way to screw the customer.
It's always good to reduce the complexity in agreements because valuing
options is very difficult without experience.

~~~
harryh
If you don't understand the complexities of an option pool (either pre or post
money) you are dumb and have no business starting a company.

------
morganwilde
OK, what does this mean exactly - "All founders equityshall be subject to a
repurchase right"? Sorry if this is supposed to be obvious, but this is the
first term-sheet I've encountered.

~~~
danielweber
I've seen that used as a club against people.

A: "I want to sell to a third party."

Company: "We have a repurchase right."

A: "Well, I'm selling for $10 a share."

Company: "We don't think that's the right price."

A: "What do you think is the right price?"

Company: "We would need to hire an auditor to determine that, and you would
have to pay for him."

~~~
jacquesm
A repurchase right is a right of first refusal at a given price, if you can
get a better price then you should normally be free to do so.

Auditors for independent valuation should only come in to play when there is
no price, for instance, when a block of shares is offered to existing
shareholders or the company and they can't agree on a valuation.

Drag along / tag along clauses definitely can complicate this.

~~~
gyardley
A repurchase right can mean different things - you'd need to go to the
specific language to really determine what it means.

In the case of Sam Altman's founder-friendly term sheet, what you're
describing is covered by the 'ROFR/Co-Sale Agreement' section.

The repurchase right here refers to what happens if a founder leaves before
their four-year vesting schedule is up - the company has the right to
repurchase their unvested stock, almost certainly (although his term sheet
doesn't specify) at the original near-zero issue price.

Since founders typically own 100% of their stock for tax purposes (hold it for
a year, only have to pay long-term instead of short-term capital gains), the
only way companies can subject founders to a vesting schedule is to have the
option of buying the unvested portion back.

~~~
jacquesm
It all depends on who causes the leave, if the founder causes the leave I have
no problem with such a repurchase right, but if the company causes the founder
to leave (and this does happen) then the company should lose their repurchase
right. Subtle stuff this.

~~~
gyardley
Sure, absolutely.

The standard mechanism for this is accelerated vesting - I think Nivi wrote
the definitive bit on it, here:

<http://venturehacks.com/articles/acceleration-termination>

------
timberlane
Sam,

Thank you very much for sharing this. Two questions:

1) Without an option pool, how do you prevent founders from issuing more
options to themselves?

2) On the other side, do the Participation rights include the right to
purchase into the option pool when it is created? i.e. is creating the option
pool a "offering of new securities".

~~~
mikeyouse
I'm not Sam, but I have some insight;

1) The Board has to approve all new shares, so founders would have to go to a
vote in order to give themselves a new chunk.

2) There won't be an option pool created. The participation clause is in
relation to new rounds of funding. As new money comes on board, new shares
will be added and the pro-rata participation means that Sam will be able to
invest alongside the new round to maintain his percentage of ownership.

------
saddino
Love this. Would consider myself super lucky to have someone as founder-
friendly as Sam as an investor.

------
beambot
The liquidation preference reads like a 1x participating preferred statement:
"We have the RIGHT to get back our capital AND then everything is split pro
rata."

Shouldn't liquidation preference clauses read more like: "We have the OPTION
to get back our capital OR ELSE everything is split pro rata."?

Also... can you explain the dividend clause? I understand the preference
(preferred dividends get paid first), but what is the significance of 8% (8%
of what)?

~~~
sama
No, after the liquidation preference, everything is split among common
holders.

~~~
shimms
To be clear for those who aren't following the salient detail here - the
preferred stock does not convert to common if the liquidation preference is
exercised. The investor gets up to their money back (1x preference), and no
more.

If they choose to participate pro-rated they convert to common first, and
participate equally with everyone, without the preference.

The investor would chose to convert to common when the sale price is greater
than the post-money valuation of the deal. On this basis their pro-rated
participation will be greater than the amount invested.

If the sale price is less than the post-money valuation of the deal, they
would be sensible to keep their preferred stock, and exercise their 1x
preference, meaning they get their original amount back 100 cents on the
dollar. The remaining is then split between the common shareholders
proportionally (in effect without the dilution from the investor that
exercised their preference).

Mark Suster (@msuster) from GRP put together a good spreadsheet [1] that shows
the preference effect on sale, including preferred non-participating stock and
preferred-participating (PP) stock (essentially double dipping into sale
proceeds).

Brad Feld (@bfeld) from Foundry Group has a good write up of the different
types of participation on his blog [2].

[1]: [http://www.docstoc.com/docs/47831420/Venture-Capital-
Valuati...](http://www.docstoc.com/docs/47831420/Venture-Capital-Valuation-
Spreadsheet) [2]: [http://www.feld.com/wp/archives/2005/01/term-sheet-
liquidati...](http://www.feld.com/wp/archives/2005/01/term-sheet-liquidation-
preference.html)

------
klochner
> There is a 1x liquidation preference, but I’m willing to forgo even that and
> buy common shares (and sometimes do, although it has implications on the
> strike price for employee options so most founders don’t want it).

+1 for that - common shares mean non-founding employees have to pay through
the nose if they want to exercise early.

------
JacobIrwin
Does anyone have a .docx-version I can customize (as my company was not
Incorporated in Delaware... I tried brute, without success:
[https://dl.dropboxusercontent.com/u/20673425/misc/founder-
fr...](https://dl.dropboxusercontent.com/u/20673425/misc/founder-friendly_pdf-
docx_yikes.docx)

~~~
JacobIrwin
I found this site: <http://www.pdfonline.com/pdf-to-word-converter/>, which
got it the pdf into rtf format. Then I used Word to open the rtf and saved it
to a docx (without any conversion/formatting issues alert)...

Then, for yall, I uploaded the docx in my public dropbox folder:
[https://dl.dropboxusercontent.com/u/20673425/sharing_dont_de...](https://dl.dropboxusercontent.com/u/20673425/sharing_dont_delete/founder-
friendly_term_sheet_new.docx)

------
jdevonport
This is truly excellent, I've had some such nasty stuff come up in term sheets
and it just creates animosity straight away between founders and investors.

If I ever get the chance to invest back into another startup one day I
wouldn't think twice to use a straight forward term sheet like this.

------
giis
I understand its founder-friendly term sheet.But Is this fair enough term
sheet for both founder and inverstor?.

------
enemtin
A three page term sheet? Wow.

