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.

Congrats to the whole Brooklyn crew


Dawdle had two inspirations: a terrible experience and a little company in Brooklyn called Etsy.  While lots of people who read this blog know the frustration of eBay and GameSpot and all that, not as many people know about Etsy and what makes it so awesome.

Etsy was founded by Rob Kalin (another NYU '02 grad - woo) and is the world's best marketplace for people to buy and sell things that are handmade.  You'll often see lots of links to Etsy for papercrafts, scarves, perler beads, and other crafts relating to gaming on all the major blogs.  Etsy has been out there to provide a better way for craftswomen and craftsmen to make a living doing what they love.  They have beautiful and interesting ways to browse the store - by color is my favorite.  But it was just because the gals and guys thought that there had to be a better way.  They didn't care about a business plan or anything, they just went with their gut and what felt right.

In June 2007, while on a trip to New York, I randomly dropped by the Etsy offices.  I didn't call ahead or anything, just decided to drop on by.  Mary from Etsy was so awesome - she took me on a tour of the place, showed me Etsy Labs, where people can come by and make things to sell on the site.  I know I looked like a moron, my mouth was wide open in the kind of goofy grin you have when you fall in love for the first time.  It was magical.  It felt real, that someone could go out and decide that this was what they wanted to do, and with a little inspiration and a lot of hard work, that it could be done.  You could go and build a little something for yourself, and for other people, and do it while being good and honest and open and by listening, not commanding.

Dawdle's kind of the anti-Etsy.  We're a database-driven site that is made for people to get in, get what they want, get out, and get on with gaming.  Etsy is for dawdlers - those who want to browse, look around, exult in their surroundings.  I don't think Dawdle could ever work for perler bead coasters of Zelda characters (I have some on my fridge).  But Dawdle would not exist if it were not for Etsy.  Rob's inspiration, the team's success, and Mary's kindness made me realize that, yes, it can be done, and yes, it can be done the right way.

I'm so happy for them that they were able to raise a huge $27 million round from one of the very best VCs in the business.  They deserve every success that they have had, and I just want to stand up and applaud.  Kudos, guys and gals.  You've already changed the world - now the world knows.

Image Source: Joi on Flickr

Quick Value Prop Hit

One of the things that I've had trouble with is succinctly articulating Dawdle's value proposition.  To me, it's this great and robust platform that can be expanded in infinite ways, meeting the needs of whatever the userbase wants.  Turns out that getting excited about the possibilities rather than what's there now just isn't smart. 

Even as we keep building new functionality and thinking about things to add, we need to be able to communicate why we're better *now*.  Right now, Dawdle's the safe and easy way to name your price for all your gaming gear.  We can back that up: Dawdle lets both buyers and sellers name their price using easy drop-down menus that are specific to gaming.  We provide protection to sellers by guaranteeing payment and giving buyers the tools to resolve any issues that may come up on occasion, and backing them up when necessary. 

Sometimes, it can be hard to focus on the great things you have now when, as an executive, your job is to always look forward, think strategically about new entries, new markets, and new partnerships.  But not only can stepping back be good for your mental health, it's good to step back and look at what you've already achieved and how it already is making your customers' lives better.

Vendor responsiveness is a leading indicator of quality

One of the hardest things to juggle when you're running a company is how to deal with your vendors.  As a startup, you're generally dependent on single-source vendors.  Generally, it's good to make sure that you don't become dependent on one, but oftentimes, the switching costs outweigh the benefit of getting out of the relationship.  That means it's critical to pick the right vendor to start with.

We've had issues with cost overruns, delays, lack of communication, incompetence, and just plain old nonperformance.  And this is despite the fact that we used referrals for almost every single vendor.  Frankly, the only vendor we were happy with was a blind RFP we sent for outbound telemarketing through BuyerZone.  In that instance, we went with the first respondent. 

It was clear that 1) they knew their stuff, and 2) they wanted our business.  Don't underestimate a hungry, smaller firm when looking at vendors.  Because they're smaller, they can be more nimble and responsive when you want things done.  Although they may see new things and make mistakes, they're generally aligned with you to make things right and offer concessions.  Larger vendors may have "seen it all," but oftentimes, that institutional knowledge is lost or only comes up when you need to fix things.  Generally, to me, the benefits of institutional knowledge should come from a vendor avoiding mistakes and errors in the first place.

I say this to make a point: when in doubt, responsiveness can be used as a general proxy for aptitude.  Those who have systems in place to respond quickly and intelligently prove that 1) they know their stuff and 2) if they don't, they'll find out and get back to you when they do.  Our [redacted, because he doesn't seem to get that he's on thin ice] seems decent enough, for example, but he only responds when I want to spend money.  If there's no commission available, he's all but unresponsive.  Random emails of "what can I do for you" aren't just useless; they're counterproductive when I tell you what you can do and you don't follow through all the way.  Just saying "I'll look into it" and then not following up unless you're prompted is crap.   Thankfully, he's gotten very little money from us in the past.

So, in addition to checking references and reading proposals and interviewing, look at how quickly those things come.  If you have to ask twice, assume the vendor doesn't need your business.  And if he doesn't need you, then you shouldn't put yourself in a position where you need him.