Brian Halligan had a great post up last week about the lessons learned from raising a mezzanine round of financing. It’s really interesting, but perhaps only applicable to a more limited set of entrepreneurs. However, there was one gem of a small section in there with a more widely acceptable takeaway:
“It turns out that the terms from your Series A are most often cut and pasted into your later round deals. When you compromise on terms in the early stages, you will have to pay the price in the later stages. You generally don’t start from scratch and rehash the terms.”
As a seed stage investor here at NextView seeing our companies progress down fundraising paths, I think it’s extremely important to highlight that terms in early rounds do set precedent for terms going forward. And that’s not just for Series A deals; this phenomenon starts even from a Seed round.
One could cite that the reason for this behavior is pure laziness, as Brian alludes to in a “cut and paste” mentality of later investors. But the more meaningful reason that early financing terms endure into future rounds is that negotiation away from terms already in place are just that – negotiation. In other words, new investors must use their leverage in the discussions to proactively change those pre-existing terms rather than focus on price, new terms relevant only to this deal, or other aspects of this specific round where they have an interest in influencing (like syndicate composition or allocation). And even when that’s possible given the situation, the old terms provide an anchoring point for all new terms to be referenced against, so they don’t end up straying too far except if there’s a real meaningful reason for them to differ.
Given that this phenomenon is fairly pervasive, I think that there a number of takeaways for entrepreneurs who are raising early rounds of capital:
- While valuation is the most salient point in a deal and certainly important, terms matter quite a bit and A LOT more than most entrepreneurs pay attention to. Terms don’t start as in-your-face numerical figures… but they do end up that way when it comes time to exit.
- Earliest terms matter most, even and especially in the seed round, because they set not only the base literal structure, but also the “tone” for future financings. Once there is punitive-looking round, the more likely the company will be a punching-bag on terms in subsequent rounds moving forward. In contrast, valuation always has room to move up.
- Terms precedent is one solid reason (among others like founder-investor alignment) that entrepreneurs should have bias towards priced equity round vs. convertible notes in seed financings. While the intent of notes is often to delay setting a valuation until context is more crisp, kicking the can on terms can be dangerous. It’s preferable to set them early as possible when investors are most accommodating as in seed round (because they too have incentive for clean terms without bells & whistles which could eventually hurt them as well).
Yes, early terms endure. It makes sense then for everyone involved with early financings to consider not just the deal at hand, but also what it means for the future.