How Venture Works: Term Sheets and Napkins.
Tags: Startup, Venture Capital, Fundraising

I remember when I started my first company, I really didn’t understand how financings worked, and why they were the way they were. Over the last 7 years and 300 deals I have done, I have some concept of why venture works the way it does, and some concept of why. I’m not going to claim to understand everything. However, I figured every few weeks, I could take a concept that is generally accepted in Venture Capital and actually break down what it means. I might even have a story behind it.

My Dad is a VC (Tim Draper) and my Grandfather is a VC (Bill Draper) and his Dad was a VC (William H. Draper II). I’m not sure how many VCs can actually claim that they are 4th generation, this outlook influences my understanding of the industry.

I remember when I was a teenager, sitting in my Dad’s office as he would look through term sheets — he would point at terms in contracts that were supposed to mean something to me: Prorata, Preference, Board Seats… He would point and explain each point to me, I would nod along and repeat the terms back to him as he cited them. Teenagers are so good at short term memorization.

To this day, my dad’s teachings stick in my head. However, I didn’t have context. I didn’t understand what constitutes a deal. I didn’t understand what a good exit felt like, or really what made a great partnership. What I truly did not understand was why it was so complicated. Why do investors try to protect themselves from entrepreneurs with such intense terms?

Venture capital was founded on napkins. My grandfather is the most charming man anyone could ever meet, always dressed immaculately. He’s 90 now and still sharper than everyone. He was around for the beginning of Venture Capital, and he has some amazing knowledge bombs to drop on people.

He used to have to cruise up and down “The Orchards” of Silicon Valley trying to find a building that said “technology” on it. He would go inside and explain to the founders what Venture Capital was, and then describe the value add:

“Well, you put in the blood sweat and tears, and I’m putting up the money, so why don’t we go 50/50?”

This is what a term sheet used to be. It used to be written on the back of a napkin, in ink, forged by the investor and founder in blood. Well not blood, but you can imagine it being a Huckleberry Finn type contract. Now we have 3x preferences, prorata, the annexation of Puerto Rico (Watch the Little Giants to understand the reference) and board seats. The industry got more competitive, and decided to create more standards and protections. It became about protection rather than parallel partnership.

The “Light Bulb” moment for me came a couple years ago when Henry Ward, the founder of Carta came to speak at Boost VC with a presentation. His goal was to give the founders the knowledge around early stage contracts, so they at least understood what was worth negotiating for.

I think it was during his 3rd slide it was a line graph, and he said,

“In the case of early stage investing, you are negotiating for an ‘ok’ exit.” (Paraphrase) Basically for the 5 years, 2–4x exit.

If the exit is $0, none of the terms matter. Because everyone gets zero.

If the exit is $10B, no one cares as long as they own their number of shares.

At the end of the day, it’s about control and protections and it’s about an average outcome. In an industry truly driven by power law though, investors shouldn’t care as much about complex terms created by lawyers to continue to be relevant. They should care about aligning incentives with founders for the long term.

This is a macro level thought. So it’s important to understand that our lawyer is important to the Boost VC process. Our term sheets are not written on napkins and we have had experiences where we learned to need a specific term. But at the end of the day, the returns of the Boost VC will be driven by 10000x wins, and whether their shares were common, preferred, or alien, they will end up making the investors money.