In many ways, reading between the lines of venture investment termsheets allow us a tiny window into the life cycle of a startup. In these termsheets, VC’s tried to anticipate all that could happen (financially) to a start up from down rounds, mergers, IPO’s, asset sales, founder complications, to future conflicts of interests. Its as if the term sheet was borne of thousands of man hours of scenerio planning to account for all things that could happen and to protect the VC’s from negative outcomes (read losing money). Of course, by just reading them, it is hard to extrapolate the various scenerios which VC’s are thinking of.

In the past year though, no one has done more to shed light into these issues than the blog conversations between Tom Evslin, Fred Wilson, and Brad Feld . The latest between Brad and Tom on founder vesting should strike a nerve for all entrepenuer, especially the younger ones without the track record or leverage when negotiating.

The title of this post is certainly a little facetious . Most entrepeneurs do not lose blood and not too often tears (the drama involved is rarely for the weak of stomach and sensitive type). But certainly a few grey hairs, dark circles, and ulcers later, I’ve come to conclusion that money does trump the many things entrepeneurs bring to the table. We get common they get preferred. They get participating we get non. They get liquidation preferrences, we get nice hand shakes. (more from me here on liquidation preferences)The list goes on and on. (BTW I just thought of another inequity, why is the employee pool allocated pre-investment rather than post? hmm . . this deserves another post maybe by Mr. Daley who is an expert on this topic )

When it comes to founder vesting, this is where the line must be drawn and the MBA take out their notes from negotiations class and get some ROI from their education. The “standard” terms Brad talks about is not standard. . .

Under the standard terms which Brad describes, founders’ stock and options vest over a period of four years. So, if a founder leaves before two years are up, only one-quarter of her stock and/or options are vested. The value of the remaining three-quarters is essentially reallocated among all the remaining stockholders.

Its not standard not because its not common but that its not standard because WE as sellers of equity cant let it become a standard. Once it does, the value of founder equity has no where else to go but down. At the very least founders vesting should be pro-rata based on time. 2 year service time with 4 year vesting schedule should equate 1/2 of share vested. There is no other morally justifiable way to talk about this. Otherwise, this makes the whole concept of “pre-money” valuation even more of a farce than it is now. With all the financial instruments VC’s embeds into a termsheet, the pre-money valuation is much much much lower than the face value. (dont get charmed by a high pre-money valuation)

I understand the concept of founder vesting and is not against it in many circumstances. Many times its for the entrepreneur’s own protection. For example, a group of 3 founder starts a company. If one decides to leave 6 month into the venture to start something else, he/she obviously does not deserve to have the same equity share as the rest and some mechanism needs to be set during incorporation to put a vesting schedule to all founders to prevent the above situation. Even more common, 3 founders works partime after work to start a company. 2 decides to quit their job to commit fulltime. The 3rd stays at his old job. The 3rd does not deserves the same amount of equity than the 2 who are taking much bigger risks. A vesting schedule solves/attempts to solve these issues somewhat and create a fair mutual understanding BEFORE the issue surfaces. . . this not only prevents conflict but might also save a startup.

That said, I’m pretty dead against “cliffs” for founders, especially for companies over 1 year old that have started hiring employees. Think of it this way. If series C VC’s asks series B VC’s to vest and/or cliff their equity stake when round C is raised, all hell will break lose. So why as someone who “bought” their series “pre-A” shares through “blood, sweat, tears” should agree to the same terms VC’s themselves would not agree to? Well, its cause Money is Worth More Than Sweat, Blood & Tears. Cliffing is just adding injury to insult.

Given the reality of the situation, this is what I recommend entrepreneurs do. Start vesting the moment the “product” is being designed/scoped. The biz plan, biz model, powerpoint are all nice and great but its not a real business, its a project. But when the product is being realized, you’ve got something that the VC’s want and cant take away. So 9 month after product design/development you raised your seed, ask for vesting to start 9 month ago. Most VC’s are so high level, they can copy your biz model/plan but they cannot reproduce your PRD’s unless they find another entrepreneur, and by that time, they might as well invest in you. And fight off the cliff, its simply not fair.

Also remember this. When the VC’s wants to hire a more seasoned executive to run the company, they are looking for ways they dont have to pay this guy equity out of their own pocket (ie dilution). The quickest and most common way to not pay is to get rid of the founder, so in effect his or her equity goes to this new executive. Ths is a fact of life. VC’s are baking this into their plan the moment they invest in your venture - when they are thinking of all the senior executive they want/need to hire, in the back of their head they are already trying to figure out how many are going to be paid by kicking out the founders and how many are going to be paid through colletive dillution (and when too).

When ventures are not going well, VC makes money in 2 ways. 1) adding some value and help the company grow and 2) get more % of the company, ideally free. Every VC will try 1, and keep 2 as an option of last resort. (read about carveouts, a related topic, here). VC’s are financiers first and foremost. This is how financiers make money.