Angel Round Term Sheets
Learn how to prepare for an angel round term sheet including:
Most common term sheet structures
Pitfalls and how to avoid them
(27 min)
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Welcome. Today we're going to discuss angel round term sheets, including how do you prepare for an angel round term sheet, what are the most common types of financing structures or instruments and common pitfalls and how to avoid them. The end of this video will also cover some recommended resources for an entrepreneur to prepare for an angel round financing and negotiate a term sheet with a potential investor. Well, I'm very excited. Joining me today are John and Yvon who are partners at Pearson Ferdinand which is one of the top law firms in the country. Both John and Yvon have extensive experience working with founders, entrepreneurs and CEOs to help them negotiate term sheets for angel rounds and other early stage financing rounds.
So John, we'll start with you. You know, you and I have known each other for a long time. You've been practicing law in San Francisco and Silicon Valley for years and you've worked with entrepreneurs and CEOs on many who have many different types of growth businesses. So to start us off, please give us an overview of your experience, your firm's experience, especially as it relates to helping founders and CEOs raise those early round financings and then negotiate their term sheets.
Thanks, Jason. Well, thank you for giving us the opportunity to speak today. It's a real pleasure. You know, I've had the benefit of practicing almost 25 years now working with startups, working with, you know, different investors really from formation to IPO and it's one of the, you know, parts of my practice that I really enjoy. Over that time I've been through a lot of business cycles and what you, you know, come to realize is that there is a investment vehicle for every situation, every company, you know, and and there's not a one-size-fits-all. So that's a little bit of what we're going to talk about is thinking about the context and circumstances when what financing you know what opportunity is is right for you and and that comes with years of experience but also with the ability to work with my great colleagues like Ivonne here.
Great. Thanks John. Well, Ivonne, same question. You know, your background and anything else you want to share as it relates to early round financings and negotiating these early round term sheets.
Yeah, thank you so much for having me. I'm excited to be here. Similar to John, I have been working with early stage founders, investors, for 11 years, not quite 25 years. And yeah, helping founders from everything from formation even pre-formation ideiation, helping founders think through how to structure their companies so that they can be prepared for the raise and put themselves in the best position to raise money all the way through the sale or IPO and and so you know we're helping them with pre-seed seed financings series A B C you know D sometimes financings and bridge rounds we advise on when to raise and what instruments to use during the raise. I've pretty much seen the gamut and am excited to you know always be a resource helping entrepreneurs walk through the process of building their companies, raising money and getting to that exit. So really excited to be here as well.
Thank you. And you know that's a really good point because we're focusing on early round financings but you really as an entrepreneur need to think about not just the current financing you're working on but what happens next right you're either going to get to cash flow break even and be able to self-sustain or you're going to need to be able to raise that next round and working with someone who's got that expertise that's done it all the way through IPO and can advise you is really important. So, I appreciate that. Well, let's get into the topic of this video and I'll ask some questions and you know, one or both of you guys can respond and we'll just kind of take it from there. I think let's start with an easy one to start. How should an entrepreneur prepare for an angel round financing from the legal perspective in general? What are some of the key areas that investors will focus on and just kind of macro level, what should they be thinking about?
Yeah, I mean I guess I can start with that. You know, there obviously a lot of things that go through a founders's mind. They're trying to build their business. They're trying to get their network. You know, they're focused on the technology. Usually, they're technologist first, right? There's something that they're doing either at the university system that they came out of or wherever they worked previously that really excited them. And so, you know, it's all about the idea and the technology in their brain. But when you're thinking from the investor standpoint and the perspective of someone who's going to put their money into your business, the question is really, well, what are they putting their money into? And it has to be more than just sort of the amorphous my idea, it's me, you know, you're sort of supporting me. And so from a legal perspective, what we always focus on is what is the corpus? What is the thing that's being invested in? What is it that an investor is actually going to have at the end of the day and it's really a piece of your business either in the form of equity or debt but that means that there has to be a corporate body and that body, you know, that company needs to have all the rights to your idea. So we always look and say all right have you made sure that your technology is actually owned by the company. Have you entered into proprietary information agreements with your developers? Can they leave and take the technology with them or everything that you've had them do on a handshake is that documented so that the company owns it? All of these things need to be encapsulated really within the body of the company of the entity that you're investing in so that the investor knows well it's not just the amorphous idea in you there's actually something there that I'm investing in.
I do want to make sure we talk about this safe versus the convertible note, those structures a little bit. Which, you know, is one more favorable to the founder, is one more favorable to the angel investor, as an entrepreneur, what should I be thinking about with those two structures that are most commonly used when I raise that angel round of money?
You want to take it or you want me to take it? Yeah, go for it. Okay. So yeah, safes versus convertible notes. Safes are definitely more founder favorable. They're more favorable to the founder. Both are instrument and convertible notes are more favorable to the investor. Mainly because safes are equity instruments and convertible notes are a combination of an equity and a debt instrument. Convertible notes have a loan component where you know it's a loan, it's a note. It has an interest rate, it has a maturity date, and you have to pay it back as a founder. Now, typically investors don't necessarily want the note to be paid back. They would prefer that it be converted into equity at your next financing. But if the company does not have that financing before the maturity date comes then the founder typically amends the note and extends the time with the investor. But they still have to go to the investor proactively and say, "Hey, we need you to extend the amount of time that we have before this note is either due to be repaid or converts into equity."
With a safe, there is no loan aspect. So, there is no interest and there's no maturity date on a safe. Therefore, there's no downside protection to the investor. The safe does not have to be repaid. It only ever just converts into equity. And so that's why it's more founder favorable. And the note, the convertible note is more investor favorable. There's downside protection, meaning the investor is basically a creditor who has to be repaid, you know, in whatever circumstances the company finds itself.
Right. Well, okay. So, let's Oh, go ahead, John. I was just going to say you know one aspect of a safe though that you have to think about and particularly when you have multiple is they have a characteristic which is a post money valuation cap. So if you are exponentially growing the idea with the safe is sort of usually it's the better of one or two either a discount to your next round or a valuation cap if the next round is 100 million but you set the valuation cap at 10 million. Well, guess what? The principal amount of the safe converts at that valuation cap, right? Notes can have that feature, but they typically don't because there is this sort of downside protection to it. So you could see more dilution with respect to a safe depending upon what your growth trajectory is.
And I think the other thing I would add, and correct me if I'm wrong, but in a convertible note, if it doesn't convert to equity and there's a downside scenario, typically what will happen is the company's responsible for paying the note. It's not a personal guarantee by the entrepreneurs. So I always talk in terms of if you're going to raise any capital, what are the milestones that you are going to achieve with that capital that are going to create value, right? And make sure you have one, two, three of those milestones because when you say the bridge to the next round, I like that concept, but I also like the concept of having specific value creation milestones that will then support that next round of valuation. So, I try to advise people, okay, you're going to raise 250,000. What are you going to do specifically with that money? And how is it going to increase the value of your business? And by the way, when you're achieving those three milestones, you know, you should be communicating with investors and letting them know because, before you need to raise that next round and letting them know, hey, we said we were going to do A, B, and C. So far, we've achieved A. Stay tuned. We'll let you know when we achieve B. And by the time you get to needing to raise your money, they've been able to follow your story along the way. But I didn't mean to interrupt there, but I do want to kind of draw out that nuance of not just a bridge, not just what do you think your evaluation will be, but as an investor, I want to see specifically what milestones you're going to achieve.
Yeah. I think that all of these concepts play together. The concept of what are the milestones, waiting until you actually need the money for that milestone as opposed to like John said using it as a sort of constant funding of operations vehicle and being able to articulate that right and that communication with investors. I know that's probably more your expertise, Jason, but that's super important for raising your next round because more than likely your current investors are going to be who you lean on to raise your next round. They might not lead but they will hopefully participate. That's the goal.
Yeah. So I would say number one when it comes to thinking about the safe as you're getting to a higher valuation you want to first of all build your company as much as possible and bootstrap your company in the beginning as much as possible and as long as possible so that you're actually increasing the value of your company as much as possible without giving away any equity without promising equity. You want to bootstrap in the beginning, right? And so that's point number one. You're not raising money on day one. You're bootstrapping on day one. You're raising money on day three or day five. You know, that might be a year down the line. And the goal there is to build as much value in your company as possible because as John said, when you get to that safe round and if you have a valuation cap and you're safe and you're negotiating a $40 million valuation cap, post money valuation cap, that's a pretty high valuation cap, right? You're valuing your company quite highly. Your goal as a founder is to get as high a valuation as you can. The goal of the investor is to get as low a valuation as they can. So this is where you're going to sort of have friction and this is what you're going to negotiate with the investor.
And this here in lies the sneaky part about valuation caps. Yes, safes are not valued rounds. They're not priced rounds, but there is an implicit valuation if there is a valuation cap because you're saying, okay, well, this money is supposed to get me to a $40 million valuation. And so now you're negotiating a valuation cap based on that number. Well, there is an implicit valuation in there. And depending on what the actual cap is, that's definitely going to affect your actual price round, the series A round or the series C round. So you have to be very careful with valuation caps and how you negotiate it and getting to an equilibrium where you're happy as a founder, the investors are happy, you're not getting super over diluted. That also happens.
And I would say this, here's a pitfall. A lot of founders, they negotiate valuation caps without running the numbers through an actual cap table model. And what happens is that like John said, you have a $40 million valuation, but you've actually put a cap at $10 million and you're completely diluted when it converts into that next round, which you're not happy about as a founder. The investors are also not happy about it because they want you to be incentivized to stay with the company and continue building the company. If you don't have any equity in your own company, there's the chance that you could basically just say, "Well, what am I building this for? I'm going to jump ship and go start a different company, go do something else." The investors don't want that. They want you to be excited about your company. So, sometimes if you're overdiluted because you didn't think through that valuation cap, you'll now have to re-up your equity in the price round to actually get you to a point where you have enough equity to stay with the company. I've seen that. I've done that myself many times. You don't want that to happen, right? So you know all of these sort of play with each other and affect each other.
Understanding how the bridge gets you to the next valuation. Understanding how you need to be building your company as much as possible before you actually raise that safe round. And then of course the communication with the investor along the way so that when you get to that round to the safe or to the next round after the safe, that investor's been informed along the way. You don't have to do a huge pitch or convincing session. Six months they already know what's happening. And so they're excited. They're ready. And that's part of fundraising, too, is articulating what you're doing, articulating how you're going to get to where you're going and using the right words and you know there are some buzzwords Jason probably could give you some more of those buzzwords but yeah I think they all play together.
Industry norms around board seats voting rights, what do you see most common in these angel rounds is as being pretty standard? Are angel investors getting a board seat? Are they voting? What kind of information rights do they get in an angel round or anything else that kind of as an entrepreneur doing this for a first time it would be good for me to know?
Yeah typically there's not a board seat. I mean being a board member Jason as you know entails fiduciary obligations and it's not without risk to the person who takes that on and so most angel investors are interested in companies they're interested in the technology. They're not really focused and interested on taking on the sorts of responsibilities that you have as a board member. But they would love to know everything that the board is doing. And so I think it's very typical to have as part of the round a lead investor lead angel get a board observer right and what we call information rights which is basically all the information that does go to the board members goes to the board observer at the same time. They also have a right to consult with the company. That can be important for certain types of funds, venture capital funds that they have that sort of right and that there's regular information. Now, it doesn't have to be in the form of audited financials. That's pretty rare in young companies, but they're going to want to know that there's a financial structure and that the reporting, the financial reporting is consistent and transparent. And so that's the type of information that's usually not really heavily negotiated. It's just sort of assumed and part of the standard package of documentation that you would provide to an investor and should be prepared to provide it to your investor.
Anything else I should watch out for when I'm receiving an investment from an angel, whether they're terms or just other things to be aware of that you guys can think of. I'll just jump in and then I'll let Yvon close out and with her thoughts. But I think you know cash is fungible, investors are not. Know who's investing in your company, right? This is your net worth is your network and your investors are your network and so you want to know that whoever is investing is there to support you and certainly is not going to become someone who is going to become confrontational when your business has to pivot because you're effectively married to this person for the next 5 to seven years and your exit. So, cash is great, but again, not all cash is coming from the same source. And so, really spend the time, as exciting as it might be to get that first term sheet or that first little nod from an investor, step back and think, is this a long-term right fit? Because this is going to be a long-term fit that you're going to have to live with.
That's great advice. I 100% agree with that. That is exactly what I was going to say as well. Not all money is good money. And I have seen it where investors have become problematic for founders and companies. So, you do want to be very careful and know the investor. Have multiple conversations with them. Don't just get excited because they're ready to put $50,000 or $100,000 into your company. Really understand who you're quote unquote getting in bed with because you will have to update them on a regular basis. You know, if they're asking you a million and two questions for a $5,000 investment agreement, that is a sign. And you might want to rethink it or you might want to make sure you're just make sure you're comfortable with it if you're super communicative. And I mean, you should be communicative anyway just in general. But if you're okay with that and you're okay with like the million questions over really small areas that are not very controversial, then, go for it. But it has become issues in the past. Not this not to say that it will be, but just be careful with that.
Otherwise, I would say with the board seats, I agree with what John said. If an investor asks you for a board seat, even though we're saying like, oh, they don't really have the time, sometimes they ask for it. At a safe round, I agree it's not appropriate and you shouldn't be sort of willing to give it away at the safe round. Now I would also say that you don't really want to just kind of I'm just going to pepper through a few points that we didn't really hit on which is, you know, the investor kind of has to earn their board seat, right? If you do decide to give a board seat away, which hopefully you're really kind of only doing that at a priced round anyway, they need to be investing no less than $2 million-ish dollars or more, you know, like no one should be getting a board seat for $500,000. Um so that's what I mean by they need to earn their board seat. So if they're asking for it, you should absolutely push back as a founder.
That said, you really shouldn't be raising a ton of money on safes. So, you kind of also want to watch out how much you rely on the safe to raise your money. You shouldn't have $5 million worth of safes in your company. That you probably have a ton of investors and that's going to cause your cap table to become all unwieldy. The conversion at the price round will be difficult, expensive. You're going to have to get signatures from every single one of those investors. So, you know, those are a couple other things to watch out for. Last thing I'll say with respect to the safe as an instrument if as a founder at all possible, it is possible to raise a safe on just a discount. You don't necessarily have to use the valuation cap. Now, as an investor, they're probably going to push for the valuation cap. But if you're able to raise a safe on a discount alone, that is literally the best instrument or the best setup for a founder is a safe instrument with only a discount. And it's possible. So, just keep that in mind.
No, that's super helpful. I mean, that's something people should think about. And again, they're going to be working with a lawyer to help negotiate this term sheet, but having a better understanding before they going in is really, you know, it's important. Last question before we get into resources for entrepreneurs and I would say let's just try to hit this one from a high level because it could be an entire you know 30 minute call in and of itself but just quickly like what are the differences from if I'm an entrepreneur doing this the first time what's the difference between my friends and family round my angel round and my institutional round. All right let's jump to sort of the conclusion here which is I'm an entrepreneur I'm getting ready to my first angel rounds. You know what resources are available for me just to start learning to get up to speed to be as smart as I can and to do as much as I can on my own right before I eventually will need to work with a lawyer because I'll need someone to help me negotiate my term sheet and I need someone to review everything before I sign.
No, that's super helpful. I mean, that's something people should think about. Um, and and again, you're they're going to be working with a lawyer to help negotiate this term sheet, but having a better understanding before they going in is really, you know, it's important. Last question before we get into resources for entrepreneurs and I would say let's just try to hit this one from a high level because it's could be an entire you know 30 minute call in and of itself but just quickly like what are the differences from if I'm I'm an entrepreneur doing this the first time what's the difference between my friends and family round my angel round and my institutional round all right let's jump to sort of the conclusion here which is I'm an entrepreneur I'm getting ready to my first angel rounds. You know what resources are available for me just to start learning to get up to speed to be as smart as I can and to do as much as I can on my own uh right before I eventually will need to work with a lawyer because I'll need someone to help me negotiate my term sheet and I need someone to review everything before I sign it. Um but what um what resources are out there? What would you re would you guys recommend?
I mean online there's there are a lot of uh different online resources. A good place to start is Y Combinator and you know looking at their website particularly if you're interested in safes or safe terms or if you just kind of want to understand the general market and watch you know videos as to how people have raised funds um in the past. That's always a good source. you know there there are websites like startup resources there's the national venture capital you know association you can basically Google search and and you know look through it but I I always say the resources are your your your fellow entrepreneurs I mean the the best resources is the person who's done the round just before you or you know has the experience and if you're in a university system you know they'll oftentimes have incubators and associations that are that are um you know tied to the university, tied to the alumni network. So all of those are great resources. I always think that sort of the the network of who you know who's gone before you is always going to be the best, you know, best resource.
Great. I don't know if you have anything to add to that, Ivon, but my next and last question is if an entrepreneur, you know, does all that and they're getting traction, they're getting have an interested investor and they want help, who should they contact at your firm? Should how do how do they do that if they're ready to make that step?
They can contact either either my myself or Ivonne. Um I think we provided some uh uh contact information here but uh you know uh P it's Pearson Ferdinand we're on our website and um you know we have a number of other colleagues in other cities so it's you know while I'm in Palo Alto and Ivon is in New York we we operate you know throughout the United States we're fully remote and cover you know cover all areas uh you know in uh in the United date. So, uh happy happy to uh speak with anyone um you know at any point.
Great. I will we'll share that information uh that you guys provided up on the screen so people can contact you. I I just want to say thank you so much for taking the time here. This is a you know a tricky subject especially if you're doing it you know as a founder CEO entrepreneur for the first time and this has been really helpful. So, thank you guys again and um we'll wrap it up here.
Thank you.
Thank you. Pleasure to be here.
Right. Take care.
