Terms sheets for teambuilding
Have you ever woke up at nights troubled with one specific nightmare: your most valuable team member (developer, designer, marketer, etc.) have left you in the wind and you’re facing a perspective of losing everything being invested in your startup so far? This practice will help you stop worrying and reduce your risks considerably.
We all are used to thinking of terms sheets as of paperwork that you get down to when investors start coming. But I’ve been negotiating my terms sheet with a US-based startup as an early-hire recently. And this is what every founder and early-hire should be aware of:
For a founder term sheet is not only about cash and equity. It’s about managing risks and motivating talents to stick around.
Imagine, you’re asking someone very special to work for you. You offer a good market rate, because you know this person is going to deliver best results. But it’s not only about money (though, let’s face it — for most founders it’s first and foremost about it). However, you also invest you time, energy, and efforts, but in a couple of months a person says “Thanks for the ride” and jumps from the train. This leaves you frustrated as hell while your whole venture skids to a halt. Is there a way to prevent it?
Not entirely prevent, but terms sheet might help you considerably to mitigate the risk of being left abruptly by an important team member. Split the compensation into 2 part: cash and deferred cash and negotiate the actual proportion in the compensation rate.
This way you’ll be motivation your early hire to stick around long enough up to the time you’ll be actually raising from the investors (presumably, by the time you have a product and paying customers).
How to structure a deal
By introducing deferred cash you basically say to your early hire that they will be paid some chunk of their compensation rate in future — let’s say, only and when you raise your seed round. This approach lets you motivate the hire. But, on the other hand it also raises employee’s risks considerably. What if you don’t raise at all? Therefore, there must be additional perk for a person to sign up to this deal. This “perk” is usually manifested itself through the risk factor multiplicator: you basically say, if you agree to this compensation, you will get more in case the event in future happens.
Let’s say a person asks for $30/hour. You, in return , offer to pay $20/h in cash. But in deferred cash you can’t plain and simple offer to pay additional $10/h when you raise your seed round. You have to add a risk factor to it (for instance, 1.5) and say: “When I raise my round I will pay you additional $15/hour — this way your market rate will be $35/hour”. And vice versa, it you offer to through in $10 in deferred cash, the employee will discount it to actual $6,6/hour, that if they ask for $30 overall is definitely not good enough.
If you feel that the employee is way too valuable but you can’t afford to pay more right now, try to through in equity too.
This way the early hire compensation rate will be consisting of 3 parts: cash, deferred cash and equity. With equity — as far as I’ve seen it, the most widely used agreement with employees is based on Safe note principles introduced by YC in 2013 (better, though, aim for 2018-version of post-money Safe). Like in Safe agreement with an investor you offer an employee to agree to a certain company valuation and the fact that their market rate will be partly paid with company’s shares. As equity also presumes even higher risks than deferred cash (because the event when an employee will be compensated fully moves even further in future — to the time when company is bough out or goes through the public offering) the risk factor should be higher too (probably 2,5 or 3). The leading assumption here, however — is the fact that the equity value will grow with the time. Meaning, if you’re offering to pay $10 in equity now you may easily translate this into $20 in a year and $30 in 2 years (depending on the growth rate you’re betting on).
How to look at the terms sheet as an early hire
Let’s face it: every hire wants to be paid by cash, plain and simple. It’s a zero risk deal and there are virtually no downsides in it. But very few startups can actually offer this type of commitment (aside from perhaps very time-bound small and hugely important tasks — like, creating a logo). Does it mean you should turn down the deal straight away? Or do you agree to any terms founders might offer? Actually, for you as an early hire, terms sheet is a perfect way to evaluate the level of trust you’re eager to invest in this particular product and this particular team. Do you believe that this have some legs? Do you believe this team will actually raise something? Being an early hire you have to put yourself in VC’s shoos while negotiating your terms sheet.
Dig deeper into the team, not the product (presumably, this team is hiring you to actually help with the product, so you’ll have some level of control over this part). But most importantly, what about the founders? Do you trust them? Do they have domain expertise and experience in raising?
For me personally, the smart way to do it — is to start thinking along the following lines: “They are hiring me for my skills and abilities that I have proved — during the trial period or showing letters of reference, or showing my previous project, whatever. They don’t hire me for skills that I might brag about but have not proved to them in any particular way (like, for me being a good friend or a terrific baker, or an unbeatable Minecraft player). So how much do I trust these people on their skills that they have not proved to me in any way — like, their ability to raise a round, their ability to manage a fast growing venture, their ability to actually bring customers?”
If you answer these questions honestly and admit that your level of trust is not 100%, then, probably 50/50 split between cash and deferred cash doesn’t sound like a reasonable deal. Aim for less risk with more cash. However, if the startup you’re dealing with is being built by your closest friends, you have known these people for years and you have a deep and unshakable trust in their skills to lift the whole machine in the air — it makes a perfect sense to prove it with signing up terms sheet with more equity than cash deal.
Weighing up the trust
Anyhow, both parties are evaluating the level of trust they are eager to invest in this deal and low risk — high risk compensation tools ratio should be a mathematical representation of this level. If you don’t have Safe notes or deferred cash agreements as a wide spread practice in your environment — you can always come up with it as a founder or an early hire. There are plenty of templates in the web, though for the Safe notes you should probably refer to YC website as the most reliable source on this topic. To me, the experience I’m going through right now is very insightful.
I’ve been hiring people before but I have never thought of using terms sheet, deferred cash and equity as a risk mitigation tool and negotiation ground with valuable parts of my team. In practice, it is actually a great way to make deals between two parties more fair and transparent.
It drives founders to be more explicit with their milestones and objectives, drawing a manageable plan with achievable goals while telling the team when, how, on what condition and how much they are going to raise. It also drives early hires to evaluate the level of trust they’re investing in the venture and motivate them to stick around long enough for founders to get their product and hopefully — product-market fit.