Predictability Is a Big Innovation When It Comes to VC Term Sheets

Venture capitalists are renowned for their relentless pursuit of innovation and high-risk ventures. Yet, when it comes to the contracts governing their deals with startups, there’s a surprising paradox — they have a strong preference for predictability.

A new study by Robert Bartlett, a professor of finance (by courtesy) at Stanford Graduate School of Business and a professor at Stanford Law School, shows how the National Venture Capital Association’s (NVCA) model for contracts, introduced in 2003, has become almost ubiquitous. In examining nearly 5,000 funding agreements negotiated between VCs and startups over nearly two decades, he found that 85% of contracts in 2022 followed this standardized format, compared to less than 3% in 2004.

“This is consistent with a long-standing theme: Investors don’t want to be spending extra on legal fees so as to optimize their use of capital,” Bartlett says. “With interest rates and inflation high, there will be even more of a focus on anything which can reduce both the time and friction involved in making investments — and using standard financial documents is one of them.”

Bartlett found that after the venture capital industry exploded in the late 1990s and early 2000s, the legal services industry played a crucial role in reducing variations in VC contracts and streamlining the investment process. In 2003, the general counsel of Charles River Ventures gathered around two dozen attorneys to create what came to be collectively known as the NVCA model documents. They included a standard term sheet — the document outlining the key terms and conditions of a potential investment, the starting point for negotiations between VCs and startups — and related financing agreements. These were made freely available on the NVCA website.

Adopting common standards was appealing to VCs, who historically have pushed for lower drafting fees from their law firms. According to Bartlett’s study, by 2022, all of the most influential law firms that handle the bulk of VC contracts had implemented a company-wide rule favoring the use of the NVCA model. “The idea was to get rid of some of the lower-level negotiations that happen after the term sheet, to make the contracting process smoother for everyone involved,” he says.

Balancing Consistency and Complexity

The NVCA model assumed that startups would be incorporated in Delaware. Accordingly, there was a rapid shift toward VC-backed companies in that state. In 2004, less than 60% of charters in Bartlett’s sample were filed in Delaware; in 2022, all of them were.

While standardization brings efficiency, Bartlett highlights two potential risks. “One concern is the ossification of the standard — when it becomes fixed and resistant to change. You don’t want to standardize the wrong model,” he points out, stressing the importance of selecting a flexible template capable of evolution.

Another potential drawback is the challenge of adequately representing startup founders’ interests. “It’s always been the intention that these documents reflect a middle-ground position between founders and investors, but it’s very hard to get founder representation among the lawyers managing the NVCA forms,” Bartlett says. “There needs to be some self-policing in the legal sector to maintain a fair balance between startups and VCs.”

His study also delves into the evolution of Series A financing, revealing increased complexity in how startups organize their early-stage funding. Notably, the prevalence of “series seed” preferred stock in contracts rose from virtually zero in 2004 to nearly two-thirds of the sample in 2022. Similarly, the use of “shadow” Series A preferred stock increased from 12% in 2004 to approximately 60% in 2022, reflecting the rising use of seed and pre-seed convertible notes before startups secure VC funding.

Bartlett also investigated claims that startup founders have increasingly negotiated for more generous governance rights, such as creating high-vote common stock to ensure they can keep control. “The last decade witnessed a founder-friendly environment, allowing speculation that entrepreneurs negotiated better deals, including high-vote, low-vote dual-class scenarios,” he says. Despite such speculation, Bartlett found little evidence that founders have succeeded in securing high-vote stock, at least among the early-stage startups in his sample.

Nevertheless, he says the success of the NVCA model in getting companies to use a common template is an important example of how organized, industry-led efforts can encourage standardization. Bartlett concludes that there’s not much incremental value in having a diversity of contracts for investment. Predictability isn’t necessarily an obstacle to ideation or growth; as he writes, “contract standardization itself is also a process of innovation.”