Innovation@work: Understanding the Series Seed Term Sheet
By: Kristin Mendoza
One of the most pressing issues for new businesses is trying to raise capital to launch their business. Using the founders’ own resources (aka bootstrapping) is a necessary first step generally followed by asking for support from friends and family. If, however, you are lucky enough to have your business idea capture the attention of a private investor (such as an angel investor or venture capitalist), you may quickly find yourself launched into a conversation about a seed round of financing.
Here’s a short summary of what you need to know:
In a typical Series Seed round of financing, a startup is looking to raise $1 million or less to complete the development of its MVP (minimum viable product) and to roll it out to pilot users with the hopes of establishing product traction. In some cases, the Series Seed round will be followed by a Series A and other rounds designed to expand the startup team, roll out a more polished product and to scale the business. In other cases, the Series Seed round may be the only financing round that a startup needs. Either way, Series Seed investors are coming into the startup at a very early stage in its development and are taking on substantial risk with their investment. For that reason, the startup should expect that investment dollars come with some strings attached which will be reflected in any term sheet that the startup receives.
Common Series Seed terms include:
Preferred stock is a class of stock with certain preferences and rights that are superior to the rights of the common stock that is issued to the founders. Series Seed will generally be issued as preferred stock.
This is the order of payments made to various classes of stockholders in the event that the business is liquidated and there is cash available for distribution to the stockholders. In the Series Seed round, the liquidation preference will generally require that cash from liquidated assets be used to first return the Series Seed investors’ initial investment. Any remaining cash can then be distributed to the founders and other common stockholders.
Sometimes called a Right of First Refusal and Participation Right, Pre-emptive Right is the right of existing investors to purchase more shares in a future round of funding. This right is important to the Series Seed investor because they generally expect that the startup will have future funding rounds where the customary venture capital terms will come into play (e.g., dividend preference, anti-dilution protection, co-sale rights, registration rights, etc.). While they are investing comparatively smaller dollars in the Series Seed round, these investors want the benefit of receiving greater investor protections should they decide to invest additional money into the startup.
This right requires the existing Series Seed stock to be given the same preferences as the next round of financing if those new investors in the new round do, in fact, receive greater investor protections than the Series Seed stock.
Basic financial reporting is required to be provided to the Series Seed investors on a periodic basis (generally, quarterly).
Series Seed investors may have the right to appoint at least one member to the startup’s board of directors.
This is generally a requirement that the startup obtain majority consent of the investors before engaging in certain actions or transactions, such as selling the business, altering the investor protections associated with preferred stock or closing the business. In the Series Seed round, the list of actions and transactions is generally limited to extraordinary events such as those noted previously. Investors in later rounds generally require consent for additional actions, such as increasing executive compensation and incurring indebtedness beyond certain dollar thresholds.
Once the term sheet is negotiated, the parties will move on to the investment documents. There is currently a movement in the investor community to try to “standardize” the Series Seed terms and documentation. As a result, there are now four sets of “open source” equity seed financing documents:
- TechStars Model Seed Funding Documents
- Y Combinator Series AA Equity Financing Documents
- Founders Institute Plain Preferred Term Sheet
- Series Seed Financing Documents drafted by Fenwick & West
The terms of these four sets of financing documents vary to some degree but all were drafted with the goal of reducing the time and cost in raising capital in these early stage rounds. While the “one size fits all” aspect of these form documents has its appeal, not every startup is the same and these forms may still require customization to fit a particular startup’s needs.
If nothing else, these open source forms are a good educational resource for entrepreneurs to understand the terms of Series Seed rounds so they can raise issues early in negotiation, documentation and closing can move along more quickly, and the entrepreneur can return focus to the critical task of product development and launch.