An Analysis of the YC "Open Sourced" Documents By A Former VC Investment Professional and Current First Time CEO


I thought it would be useful to do a quick rundown of the recently (re)released YC documents for a first time angel round.  I come from the perspective of someone who looked at these documents for later stage venture capital, but given the nature of the documents, it turns out that my experience is pretty applicable to these documents.  Others may disagree, but this is just one person's perspective.

This is a note to the entrepreneurs out there – in particular the first time ones. I'm only analyzing the term sheet, because this is where the negotiations happen in a business sense. The other documents are legal documents that essentially turn the term sheet into appropriate legalese. You'll want to make sure you read your legal documents to make sure they conform to the term sheet, but you really shouldn't be negotiating the legal documents in a friendly transaction. Also, I'll refer to the entrepreneur as "she" and the angel investor as "he" to make things a little bit easier for the pronouns.

First and foremost, this term sheet is for Series AA preferred stock. It is not a term sheet for convertible notes.  Let me do a quick paragraph on convertible notes and their place before we get into the term sheet itself.

Many, if not most, angels will use convertible notes as the initial investment in the company, with a conversion into Series A (or the first venture round). Often this conversion is done at a discount or the notes come attached with warrants into the Series A or common stock. The benefit of a convertible note arrangement is that it pushes off the valuation discussion until later. This can be beneficial for the first time entrepreneur or the busy angel investor, as it eliminates a source of friction.

In contrast to convertible notes, the YC documents have a pre-money valuation, share price, and the whole nine. The Series AA preferred stock instrument is more similar to a standard venture capital instrument than the convertible notes used by most angels or the exchangeable share structure suggested by Basil Peters. Again, however, the use of a preferred instrument mandates that a valuation discussion must occur. I refer you to Venture Hacks for all the help you can use in negotiations for the valuation discussion.

Liquidation preference – the YC term sheet has a 1.0x liquidation preference. This means the investor gets their money out before the pro-rata distribution for the common stock.

Edit: As pointed out by gojomo, this is not participating preferred.  It's just regular convertible preferred, meaning that the investor can choose to either get his preference or to convert to common and get a pro-rata share.  This is a pro-company term.

Simplified Example of what would happen if it was participating preferred: Series AA is for $10,000 with a $90,000 pre-money, so you're at a $100,000 post money. The company sells for a million dollars. (Woo hoo!) The first $10,000 comes off the top to the Series AA investor. The remaining $990,000 is split amongst the equity holders according to the "as converted" percentages of ownership.  Participating preferred can be thought of as a "double dip".

A liquidation preference is standard in VC investments; it is not inherent in a convertible note, although the notes will generally convert into Series A or B or whatever, which should have a liquidation preference in a standard VC investment transaction.

Conversion – the AA converts 1:1 into common stock. Given the liquidation preference, why would an investor ever want to convert? Simple. If the company is worth more than the post-money of the Series AA, the investor will get more money than just a return of their initial investment.  The Series AA investor wants to convert, because only then will they make money.  Preference is downside protection (at least it used to be before the advent of participating preferred).  Also, conversion usually happens right before an IPO (or sale of the company) to make things much easier for the public offering. If you're going to have an IPO, ostensibly the investor has a big win, especially at the AA stage. Nothing to be worried about here.

Voting rights – no special voting rights for the Series AA. The investor gets the share of votes that they would have on an "as-converted" basis. In short, the founders would still control the company and the investor is coming along for the ride (this is good for you). Well, except for one major exception…

Protective provision – you ain't selling your company unless the investor says so. The other provisions are there to make sure the founders (who ostensibly still hold a majority of the "as converted" common) can't screw over the Series AA investor by diluting him. That's pretty fair and makes sense. However, the last protective provision says that if the founders want to sell, but the investor thinks it's too early, the investor can block a sale.  (I'm assuming that the Series AA has only one investor, who would, of course, meet the 50% threshold by a whole 'nother 50%.)

If your investor is Paul Graham, he'll be a good guy and go along with whatever the founders decide. If it's someone with less experience, or fewer investments, he may not go along. This, to me, is the term that may cause the first time entrepreneur some pause. In my opinion, the forced non-sale is something only a unsophisticated angel investor would do. However, these documents leave that possibility out there. Know thine investor's motivations and exit profile.

Pro rata – this allows the Series AA investor to maintain their percentage ownership of the company throughout any subsequent rounds. The Series AA investor cannot dictate the terms of subsequent rounds, or have special terms, but they do have the right to participate with any new investors at the same terms as those new investors get in the future. This is pretty standard and should make intuitive sense.

Information rights – you have to tell your investor what's going on. These documents allow you to provide unaudited financial statements, which your accountant should be able to generate. The statements you have to provide (as outlined in the Investor Rights Agreement) are the balance sheet, income statement, and statement of cash flows for your company. If you're doing your own books, you should be able to generate the financial statements yourself in QuickBooks pretty easily.

Other matters – the investor, and you, have to hold onto your shares for 180 days following a public offering. No quick flips immediately after the IPO. This is pretty standard. You know the story of how Mark Cuban bought every single S&P put he could after he sold to Yahoo? Same general idea; you have a holding period long enough that it makes it highly unlikely that you're pulling the wool over anyone's eyes. I know – you IPO'd, you want your money. It's OK; I'm sure you can wait. Besides, the Private Client Group at the investment bank doing your IPO will be happy to give you advice on how to diversify your portfolio for a small percentage of your net worth.

Loose ends (not a term in the term sheet) – as outlined in the Stock Purchase Agreement, the company says that they aren't infringing on anyone else's intellectual property, that they own that they say they own, they're not violating their corporate charter, and that they've filed all required tax forms and paid whatever applicable taxes they have to pay. Essentially, that the company has not broken the law before the investor puts his money in the company. The investor says that he's an Accredited Investor and his investment does not trigger any large SEC filing action beyond the standard Regulation D filing.

There is one difference in these documents versus a standard VC round – the company does not have to pay the investor's legal fees. As crazy as it sounds, it is standard for the proceeds of the VC investment to go, in part, to paying the VC firm's legal expenses. As Venture Hacks says, you should negotiate a cap, but it's not worth fighting to remove this term from your Series A or B. Thankfully, the Series AA docs know that cash is precious and the investor would rather have his money go to salaries or equipment than $650/hour lawyers.

Sachin Agarwal is the co-founder and Chief Executive of Dawdle, an online marketplace for new and used video games, systems, and accessories based in Chicago, Illinois. Prior to Dawdle, he was an investment professional at Ascension Health Ventures, a healthcare-focused venture capital firm in St. Louis, Missouri. Prior to AHV, Sachin was with Jefferies Broadview in Waltham, Massachusetts, where he advised companies in the digital media, open source software, and healthcare IT spaces. Sachin is not an attorney. While he is licensed as a financial advisor, he is not your financial advisor and this is not investment advice.