All investments by angels (and everyone else) in a company are made according to detailed legal documents that specify everything about the relationship among the various parties, the terms of the value exchange, and the various rights and responsibilities of everyone involved. The paperwork can range from three to five pages for a simple, nonconvertible note, to 120 pages or more for a full convertible preferred stock round. Because these are legal documents, both parties—the company and the investor—have their own lawyers, who work together to develop the actual agreements signed by the principals.
The collection of documents that together constitute the investment agreement are typically summarized in a much shorter document (anywhere from one to half a dozen pages, depending on the type of investment) known as the term sheet. Think of the term sheet as a shorthand way of documenting an agreement in principle that will take many pages of legalese to implement. Because it deals specifically with all of the major points of the relationships, it allows both sides to determine quickly whether or not they want to enter into a deal in the first place.
A term sheet is usually (although not always) drafted by the investor and presented to the entrepreneur with a defined date by which it needs to be accepted. If the entrepreneur signs and returns it within that period, then the deal is in motion, and the lawyers for each side go back and forth on the actual documents that will be signed at the closing. Alternatively, the entrepreneur might respond by declining the terms as presented, but indicate that he or she would be receptive to a deal at a higher valuation, or with a larger investment, or fewer board seats, or something else. In that case, the ball is back in the investor's court and they may simply walk away, or come back with a revised term sheet.
The period between when an investor has presented a signed term sheet to an entrepreneur and the expiration date of that offer, is a critical time for everyone. Since the entrepreneur is not bound by anything in the terms until he signs it, he is free to do whatever he wants with it, including taking it to other potential investors and saying, in effect, “Look! Here is a signed term sheet that I've been given by Tom. Dick, would you be interested in matching or beating it? Just so you know, I'm also speaking with Harry, who has expressed interest as well.” While it wouldn't happen in exactly that way, I can guarantee you that the Holy Grail of fundraising from an entrepreneur's perspective is having more than one term sheet from which to choose. And since market competition is one of the main drivers in early-stage finance, one term sheet often brings others who might have been sitting on the fence.
Because of the possibility (if not likelihood) of their term sheet being shopped around to other investors and used as a stalking horse, investors typically try to make the consideration time as short as possible. The ultimate version of this is the ridiculous (and, frankly, offensive) 24-second shot clock that some of the cast members on the TV show Shark Tank pull on entrepreneurs. In most cases, however, investors have several conversations with companies to figure out the range of terms they are likely to accept. They may also send over an unsigned draft of the sheet, which is not binding on them, to get some feedback. But after the real one is delivered with a signature, the company will usually have one to three days to accept or decline the offer.
Once the entrepreneur has signed the term sheet, it is binding—not just legally (for at least some parts of it) but also ethically. If either party backs out of a signed term sheet without a very good reason, word will almost certainly get around, and the action will have long-term repercussions: a hard-to-erase stain on the entrepreneur's or investor's reputation.
After both parties have signed, the lawyers get to work on the full documentation for the round. One lawyer (usually specified in the term sheet) will be responsible for the base drafting, with the other making comments, although in virtually all cases the documents are based on more-or-less standard industry models. The timing of the actual payment of moneys committed during the investment round depends on the nature of the round. In Friends-and-Family rounds, the entrepreneur will probably be able to get funds as they are committed. In a traditional angel round, there will usually be a targeted range that the entrepreneur is trying to reach as well as a minimum amount to close. Once that minimum is reached, a simultaneous closing is held at which the funds are released to the entrepreneur.
In the past, the closing typically involved sending paper back and forth for signatures and using overnight delivery services to send checks to the company's bank. Today there is a trend toward fully electronic/digital closings, in which the requisite documents are electronically signed by all parties and funds are wired directly into the company's bank accounts.
Depositing funds into an escrow account is often required during a large funding round involving several investors, in cases where investors only want to fund if the company can be sure to get all the money it needs to execute its plan. Otherwise, if the money came in as dribs and drabs, the company might get part way down the road, run out of money, and go broke. So investors say, in effect, “Okay, I'll put the money in escrow with your lawyer (or an online platform like Gust), so you know that you'll have my money, but you can't get your hands on it until I know that you will be successful in raising the full amount you say you need.”
Another situation in a round like this is that everyone wants to invest simultaneously with everyone else, but logistically the signatures will be coming in at different times, and there may be changes in the paperwork up until the last minute. So everyone signs the signature pages, and the signatures are held in escrow until everyone gives permission to release, at which time the deal is closed.
In Chapter 10 I discussed the two primary forms that angel investments take: convertible notes and convertible preferred stock.
For several years in the early days of the professional angel world, investors used a very simple form of convertible note that needed little explanation and effectively punted on everything (valuation, conversion, protections, and other provisions) until the next institutional venture round. As angels became smarter and recognized the anomalies in the risk/reward ratio, they insisted on a valuation cap. And then as they got burned in various edge cases (such as an acquisition happening before they converted), they started to add certain limited protections which made the once-simple note a tad more complicated.
In Appendix C I have included the full text of the standard Gust Convertible Note Term Sheet, which you are free to use when you lead your own investments. An electronic version is available online, together with its supporting documents, at http://gust.com/termsheets/.
We developed this based on hard-earned experience, and I personally have used it on several investments that I have led. It is easier and cheaper to negotiate, document, and close than it is to do a full equity round, but it still provides a cap on valuation and some limited protections for investors during the period up to the next financing.
When it comes to a full equity round using convertible preferred stock, the majority of U.S.-based venture capital funds historically have used a standard term sheet model developed over a number of years by all of their law firms working together under the coordination of the National Venture Capital Association. This term sheet, known as the NVCA Model Venture Capital Financing Term Sheet, is a free download, together with the deal documents backing it up, from http://tinyurl.com/NVCAmodel. It is annotated with comments that explain the various company- and investor-favorable terms, as well as those which are generally neutral and agreed upon by both sides.
Professional angels, especially those investing in groups, initially followed the lead of the VCs and used the same documents, which made it much easier to do follow-on investment rounds when VCs would typically join in. The problem is that the NVCA term sheet alone is 17 pages, which in turn expands into 120 pages of additional documentation. Negotiating these documents—with lawyers on both sides of the table—can become expensive, and it is not unusual to see legal fees reaching $50,000 or more for a full convertible preferred round.
As more and more companies began to get funded by angels and as the market changed to make much of the NVCA content seem like overkill for a small investment (such as many pages about registration rights during an initial public offering, which is, frankly, a highly unlikely occurrence), there emerged a need for something easier to use for angel deals. A much shorter and simpler set of documents was therefore developed on a pro-bono basis by attorney Ted Wang of Fenwick and West and is available online, together with its backup documents and annotations/discussion, at www.seriesseed.com. This term sheet is really simple, reducing the 17 pages of the NVCA version to just over one! The challenge with this approach, however, is that it manages this shrinkage by removing all protections for the investor and pushes off the major issues until the next round.
We at Gust therefore took the liberty of coming up with a middle-ground approach that I believe is most useful for serious angel investors who are likely to read this book. Over the course of a year, we worked with lawyers for investors and companies and iterated the result with some of the leading professional angel investor members of New York Angels. Under the guidance of Lori Smith of White and Williams (one of the country's top corporate lawyers who serves on the legal advisory committee of the Angel Capital Association), we started with Ted Wang's bare bones Series Seed documents and added back in the bare minimum of investor protections that sophisticated investors would insist upon.
I've now used this approach with several recent investments that I've led, and it seems to be, as Goldilocks would say, “Just right!” It's thoroughly annotated (by me) and designed to be a middle-of-the-road document, scrupulously balanced between the needs and interests of investors and entrepreneurs. The full term sheet is included in Appendix D, and can be found in an electronic version, along with all of its supporting documents, online at http://gust.com/series-seed/.