Term-sheets and Sh*t-terms; Chapter 2: Founder Obligations

Right, so before you start reading this chapter - just to give you a quick recap - we're going to continue with Rahul's story of his AI company where Bad Capital had given him a term sheet with an obnoxious ask. If you don't remember or haven't read the first part - you can read it here - it talks about how to go about the valuation of a company and the dilution for a founder - all of that is the core of a Term-sheet.

Given that Rahul was a first-time founder, he thought the term sheet was just about the valuation and the investment amount, however, as he started reading further, things started getting more confusing.

Chapter 2: Founder Obligations

To Rahul, the path to building his startup seemed very simple and straightforward - you raise money, build and grow your company -> make yourself money and give your investors a return on their investment.

However, if you look at it from an investor's POV - they do want the end result "return on their investment" but they also want to ensure that they are protected in doing so. This table can give you a good perspective on this;

Now, when Rahul looked at the term sheet, two sections stood out to him:

1. Certain obligations he had to meet such as vesting his shares, creating an ESOP pool etc, and,
2. Investors asking for certain rights such as pro-rata, liquidation preference etc.

In this chapter, we're going to cover the obligations, but before that, let's look at the main reason why these obligations are set in place and what precedes them.

PS: This is not the language used in an actual term sheet

Exit

Let's be honest. Anyone and everyone who is involved with a startup is waiting for their "Show me the money!" moment.

The first thing that Rahul noticed after the valuation and investment amount sections, was a clause on Exit.

Let's use an analogy here: Imagine you're a builder, and you need money to construct your dream house. You go to some friends who agree to lend you cash but expect to get their money back with something extra for their trouble.

They're not giving you money forever. They say, "We'll give you five years to build your house and return the money when you sell it for a profit." That's fair, right? - this is the Exit.

A similar logic applies to a startup as well.

With a startup, there are 4 typical ways in which an investor can seek an exit:

1. Company going public - It's a dream for most founders and all investors
2. The company gets acquired and finds a new home
3. Secondary sale - basically a larger investor comes in and buys the shares of an existing investor
4. Buyback by the company - the company itself makes enough money to buy back the shares of its investors

Side note: if the company isn't able to offer an exit after 5 years, what happens then? Well then the investors can enforce a "Drag right" - I'll share more on this in the next chapter :)

The important part of the Exit clause is that it ties in the Vesting and Lock-in obligations that we discuss below.

Vesting

Rahul knew what vesting meant - but he thought it was always for the employees and didn't expect himself as a founder to have a vesting cycle for his own company's shares.

Vesting is a pretty standard clause that is asked for by all investors - but why you may ask?

Well, the answer is simple. Investors want you to work for your company as it builds its worth, and that sounds pretty fair, right? Therefore vesting is relevant to ensure that Rahul remains committed to the company's success over the long term, i.e. he gradually earns his ownership stake.

Investors suggest various vesting schedules, so let's explore some of the scenarios that can play out.

Situation A - Vesting clause from Bad Capital: 7 years with a 2-year cliff and annual vesting

• Cliff Period: The "cliff period" within the vesting schedule is the time during which the founder's ownership doesn't vest at all. If the founder leaves the company before the cliff period ends, they typically don't retain any ownership stake.
• As we saw from the first chapter, Rahul owned 58% post-dilution - so this is what Rahul's vesting looks like
• After completion of 1st year: Cliff period - so nothing
• After completion of 2nd year: Cliff period - so nothing
• After completion of 3rd year: 11.6% (58%/5 years)
• After completion of 4th year: 11.6% - Total ownership 11.6% + 11.6%

So forth till completion - which is basically 58% ownership over a period of 7 years

Now, why is this a sh*t term? Firstly, the standard cliff period is 1 year. Secondly, 7 years is a really long time - as much as we'd say that building a startup isn't a sprint but a marathon, a 7-year vesting schedule can really de-incentivise a founder.

Standard terms; A 1+4 (1-year cliff, 4 years vesting) schedule is pretty standard - now your investor can ask for an annual vesting schedule, however, you can negotiate a quarterly one.

Lock-in

So by including a lock-in term, investors aim to align the interests of the founders with the long-term success of the company. It assures investors that Rahul is committed to building the company for the duration of the lock-in period.

Now, how is this different from the vesting clause that is detailed above for Rahul?

Well, through a lock-in the investors ensure that Rahul stays actively involved in the company's growth and doesn't simply sell his shares shortly after receiving investment and it is directly linked to the exit period or a liquidity event.

Now, when Rahul started the company, a huge part of his motivation was to make money as well. However, given that Bad Capital gave him a 7 year lock-in period, making money just seemed like a distant dream!

In a standard term - this can be included post a 5-year window that we discussed above (similar to the vesting and exit period) and what Rahul can do then is carve out a certain equity amount - say 10% - which is vested in case he requires liquidity!

PS: As a founder, if you want to sell shares, the lead investor will hold ROFR i.e. you have to first ask the lead investor to buy before you ask anyone else (more on this in the next chapter). That's acceptable because they're already invested and have enough context on the company

ESOP pool (Employee Stock Ownership Plan)

Finally Bad Capital put out something good for Rahul. Bad Capital through its term sheet obliged Rahul to set aside a 15% ESOP pool - basically a designated portion of a company's equity that is set aside for the purpose of granting stock options or other forms of equity compensation to employees.

Now this got Rahul pretty curious so to understand it better he called up his BFF and asked the following;

Rahul: How do I create an ESOP pool? Would it show on my Cap Table?

BFF: Creating an ESOP pool involves legal documentation, determining the size and allocation criteria, and obtaining necessary approvals, and yes, it would reflect on your Cap Table.

Rahul: Do I have to use all the shares allocated in the ESOP pool? What if I don't allocate all the shares in the pool right now?

BFF: No, you're not obliged to use all allocated shares immediately; unallocated shares can be retained for future use or reallocated later.

Rahul: When the dilution in the next round happens, would the ESOP pool get diluted as well?

BFF: Yes, during subsequent funding rounds, the ESOP pool would also get diluted proportionately along with existing shareholders.

Rahul: Is the vesting schedule of employee stocks supposed to be the same as my vesting schedule?

BFF: No, the vesting schedule for employee stocks can be different from yours and is typically tailored to align with employee retention goals.

Rahul: Is there any software that I can use to manage my ESOP pool?

BFF: Yes, there are software options like Carta, or Eqvista designed to manage ESOP pools efficiently.

Rahul: Do I have to get investor approval before allocating ESOPs to employees?

BFF: Honestly, depends on the size - there can be certain criteria that can be mentioned in your reserved matters (more on this in the next chapter) which result in you taking some approval - say you want to give an employee 2% in ESOPs

Okay, so this was a pretty basic version of what these terms mean (and our Playbook does a much better job at explaining each term so do reference that), but I hope that you were able to get a little bit of understanding on how they implicate a company and the founder - incase you have any questions around it, don't hesitate in calling a BFF :)

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