One of the most significant milestones for founders is raising their first round of institutional capital from outside investors—otherwise known as Series A funding. When you reach this stage, your startup is likely generating steady revenue but it’s probably not turning a profit. This round of funding, therefore, is an opportunity to accelerate your company’s growth.
Until now, you’ve likely had little-to-no experience negotiating equity financing term sheets. So, while VCs and other investors already know term sheets inside and out, you don’t—yet—which can put you at a disadvantage. But navigating through a Series A term sheet doesn’t have to be overwhelming and when you’re armed with the right information and expectations, it’s not.
At Atrium, we’ve helped our clients raise over $1B in over 100 equity financings—reviewing hundreds of term sheets in the process. In this post, we’ve outlined the basics of raising a Series A round, how it’s different from your previous rounds and rounds to come, and the common components and terms you’ll need to understand to negotiate a fair Series A agreement.
First things first: The basics of Series A funding
For most companies, a Series A round is the company’s first equity round of funding. Unlike any seed rounds, which are typically raised using convertible securities, such as SAFEs and/or convertible notes, and usually include a broader range of investors, from angels to institutional seed funds, your Series A instead focuses on a small number of VCs who contribute funding in exchange for shares of preferred stock.
Generally speaking, you’ll have one lead investor in your Series A round who will invest most of the total amount of the round, with some room for other investors, including your current seed investors who might want to invest more money in the company. The length of time you’ll spend raising money will also vary—some businesses receive term sheets before they’ve even begun raising in earnest, while others can spend months having meetings with VCs.
In your Series A round, investors look for more than an innovative idea and want to see growth from your seed stage, as well as a business model that can translate into a profit-generating business. Investors typically want you to take the funds they’ve invested in your company to continue to develop your product and grow your customer base.
Every Series A funding looks different for every founder—no two Series A rounds will ever look alike. So, you’re not going to find a cookie-cutter formula to base yours on, nor should you. Series A rounds in the biotech industry look completely different than one for a B2C company.
And remember, despite any perceptions about Series A rounds, it’s important to recognize that this financing and the ease (or difficulty) with which you raise it are not a direct reflection of your company; it’s simply the first round of institutional fund money coming into your company.
Setting the right precedent
Once you’ve made it to your Series A and found an interested VC, you’re going to receive your first Series A term sheet.
This may feel like a huge accomplishment—and it is—but the process has only begun, not completed. So, now what?
In your seed round, it’s very likely that you got away with a one- or two-page term sheet. However, with a Series A term sheet, you should expect something along the lines of six or seven pages that incorporates more detail.
An important thing to keep in mind is that the terms negotiated in your Series A tend to be the baseline from which the terms of subsequent rounds of funding will be negotiated. A solid foundation in your Series A will likely facilitate a smoother process in your next financing round.
Avoid the temptation of agreeing to nonstandard terms in your Series A in an effort to hurry the process along, telling yourself that you’ll cut that term at the next round. It can complicate future funding and you might find investors asking for similar terms or reluctant to drop any previous less-than-ideal terms.
The good news is that as you continue to go through more rounds of funding, later term sheets tend to become less complex and the investors in each round of fundraising you go through will have different expectations.
The more you know: Series A key terms
You’re going to come across a lot of important terms in your Series A term sheet, which means that understanding all of their implications is essential to negotiating. The following is a brief outline of some common terms and standards you can expect to see in this round of funding.
Liquidation preference: A liquidation preference is the right of the investors to receive a specified amount of money (before common stockholders) in the event of a sale or other liquidation event, typically expressed in terms of a multiple of the original amount they invested.
When the startup fundraising environment is good, as in recent years, 1x non-participating is the norm in early-stage venture capital financings. The “1x” is the liquidation preference multiple. This determines the amount of the investors’ original investment that must be returned before the common stockholders receive any portion of the liquidation proceeds.
Non-participating means the investors are entitled to receive either (1) the liquidation preference amount or (2) the amount they would receive if they converted their preferred stock to common stock (in other words sharing pro rata with common stockholders), not both. Liquidation preference is downside protection—in the case of a successful exit, the investors will choose to share the liquidation proceeds pro rata with the common stockholders, but in a downside scenario, the investors will opt for the liquidation preference to protect their original investment amount.
Dividends: A dividend is a distribution by the company, usually in cash out of its profits, from the company to stockholders. For early-stage startups, declaring or paying dividends is rare because it requires the company to be profitable and also because profits, if any, are typically reinvested in the business to fuel growth and product development. However, that doesn’t prevent investors from negotiating dividends in Series A term sheets.
Most commonly, we see dividends for Series A Preferred Stock structured as a “when, as and if declared” by the board dividend. This means that no dividend is paid unless and until a company’s board of directors decides to pay one.
Despite the fact that dividends are rarely paid, we often see term sheets that call for a stated dividend, usually 6-8% of the series of preferred stock’s original issue price, payable prior to any Common Stock dividend.
Available option pool: Term sheets usually call for a percentage of your company’s post-money capitalization to be included in the pre-money valuation and available to grant to service providers. By including the available option pool in the pre-money valuation, only your company’s existing stockholders, before the financing, are diluted by the increase of the pool in conjunction with the financing.
Typically, we see the available pool set at a range of figures around 10% in the term sheet, and this can vary based upon a number of factors including how long the amount being raised in the financing is intended to last the company and how much hiring you anticipate after the closing of the financing.
The two main issues we see regarding the available option pool are (1) the investor asking for too high of an available option pool and (2) the effect of raising less than a fully committed round since this results in avoidable dilution.
Protective provisions: Protective provisions are a negotiated set of actions that your company cannot take without the consent of the holders of a certain percentage (usually a simple majority) of shares of Series A. The actions restricted by the protective provisions typically include those that could negatively impact the Series A or significantly impact your company.
Depending on how much of the round the lead investor is taking and the dollar amount of convertible securities, such as SAFEs and/or convertible notes, that are converting into the round, the lead investor may negotiate for a higher threshold than a simple majority.
It is helpful to have an accurate pro forma capitalization table when negotiating the term sheet as this will allow you to determine which investors will be needed in order to take an action covered by the protective provisions.
Board composition: At a high level, your board of directors is responsible for the management and oversight of your company. For most early-stage startups, rather than have formal, regularly scheduled board meetings, the initial board (usually the founders) make decisions as needed and document such decisions as actions by unanimous written consent.
At the Series A stage, investors may push you to implement a board structure that is neutral or investor favorable. However, in our experience, founders typically retain control of the board at Series A, with the lead investor having the ability to designate one board seat. Any term sheet that has the founders losing control of the board at the Series A stage (or earlier) should be approached with caution.
What to expect once your term sheet is signed
Well, now it’s time to sprint to the finish line. Your next steps typically include legal due diligence, document drafting and negotiation, disclosure schedules, signature collection, and, finally, closing. On average we see this entire process taking about 37 days from term sheet execution to closing.
A final note: Whether you’re researching ahead of time – and are perfecting your pitch – or already deep in negotiating your Series A funding, always remember that your number one goal should be getting a clean deal—not striving for perfection. Even if you don’t get everything the way you want it, there’s far more to building a successful and profitable business than your Series A negotiations.