- entrepreneur and founder are used interchangeably
- sometime cofounders equal, other times not
- shouldn't outsource founding to lawyers
- relationship between cofounders often frays: stress, changing priorities
- predefine how cofounders leave the business: vesting, drag-along rights, co-sale rights
Most senior = managing director (MD) or general partner (GP)
- final investment decision and sit on company boards
Next senior = principals or directors
- junior deal partners, almost always require support from MD to move a deal through the VC firm
- some power, can't make a decision
Associates = work for deal partners
- scout new deals, due diligence, write internal memos
- cap table = spreadsheet defining economics of the deal
Analysts at the bottom
- crunch numbers and write memos
Venture partners or operating partners
- part-time with varying degrees of deal-making ability
Entrepreneurs in Residence (EIR)
- need to ultimately deal with the MD or GP
- key source of early stage investment and very active in first round of investment: the seed stage
- VCs will invest alongside angels, although not all angels are equal and not all VCs share the same view of angels
Angels usually invest in early rounds but not future rounds
- in difficult financing, angels participation in future rounds come into question: pay-to-play and drag-along rights are designed to help VCs force behaviour on angels (and other VC) in difficult financing
- angels usually high-net worth, although not always
- SEC rules regarding "accredited investors"
Some angels are extremely active: super angels
- some raise a fund similar to a VC fund, known as a micro VC: fiduciary obligations to investors, so while present as angels they're actually VC
Don't assume they're all the same because they're not
- all have own incentives, pressures, experience and sophistication
- don't put yourself in a position where held hostage by angels. They're important, but shouldn't control company. If angel group is small diffuse group, consider setting up special purpose LP controlled by one as vehicle to invest in.
- true friends and family = lottery ticket plus not investor relations meetings all the time
A collection of investors is called a syndicate
- most syndicates have a lead investor; this makes easier to negotiate with one person.
- still need to communicate with all investors though
- insist at least verbally that lead speaks for all investors in the syndicate
An experienced lawyer who understands VC financing is invaluable
- negotiates, focus
- real terms always economics and control
Must have a stable of experienced mentors
Mentor = gratis relationships (karma)
Advisors = paid relationships
How to Raise Money
- goal should be to get several term sheets
- must have mindset that your will succeed, once on the fundraising road
- attitude matters: mindset is that going to be successful. "Do or do not, there is no try".
Determine how much you're raising
The minimum amount of money you need to get to the next major milestone.
- eg: $500,000 seed round: angel investors, seed stage VCs, super angels, microVCs, early stage investors including from VC funds
- eg: $10M: start with larger VC because you'll nee a lead investor who can write a $5M check
Focus on the length of time you want to fund your company to get to the next meaningful milestone
- how long to ship first product?
- with a product, how long to get certain number of users, or specific revenue amount?
- assume no revenue, what is monthly spend (total burn rate) to get to that point?
- eg: 6 months to product with 8 people, you'll spend $100K per person per month for 6 months.
- raise $1M with a 1 year run rate since few months to ramp up
- don't ask for more than you need, because an under subscribed round will impact.
- don't ask for a range: just shows you don't know what you want
Executive summary and presentation
- later stage; maybe business plan or private placement memorandum
- focus on content while making presentation solid
- prototype or demo is desirable
1. Exec summary
- on to three page description of idea, product, team and business
- add substance
- include problem you are solving and why its important to solve
- why product is awesome, why better that what exists, and why the team is right one to pursue it
- and with high level financial data with aggressive but sensible expectations
- 10 - 20 page slide deck
- communicate same information as executive summary, but with visual presentation
- 3 minute presentation at pitch
- 8 minute presentation at accelerator
- 30 minute presentation at VC
- form matters
- less is more: few key things VC cares about. The problem, the size of the opportunity, strength of the team, competition, plan of attack, and current status
- don't prepare business plan for fundraising
- maybe helpful for entrepreneur to write
Private Placement Memoradum (PPM):
- traditional business plan wrapped in legal disclaimers
- not right for early stage
Detailed financial model:
- financial predications 100% wrong
- can't predict revenue, but should be able to manage expenses to plan
- assumptions underlying revenue forecasts
- monthly burn rate
(some firms may use discounted cash-flow analysis to determine value of your business)
- the demo is integral part of showing/ telling the story
- more important than other formal materials for very early stage
- demo tells story about problem product addresses
Due Diligence Materials:
- cap table, contracts, employee agreements, board minutes
- need to be in order prior to starting to pitch
Finding the right VC
- the right emotional connection is a good guide (like dating)
- research, and get a list
- best way is to ask friends and other entrepreneurs
- "give more than you get" on social media and blogs
- if you want money, ask for advice
Finding a lead VC
- can categorise into 3: leaders, followers and everyone else
Goal is to find a lead investor
- put down term sheet, drive financing, most active new investor
- clearly interested and wants to lead
- interested and passes: don't worry about ones who pass
- maybe: seems interested by doesn't step up. Keep warm but won't catalyse investment. Great to add in after with lead
- slow no: never say no, but in react mode. Little resistance but never moves anywhere. These are a no, and not worthwhile
How VCs decide to invest
- previous connection
- intro via other VC
- only seasoned entrepreneurs
- fully responsive
- you should understand quickly whether you're coming through their preferred channel
- recognise who you're dealing with in the firm
Due diligence: read about firm from this process
- ask for intros to other founders they've backed. Look to speak to founders who went through messy situations.
If don't invest, ask for feedback why so important learning experience.
- if yes, next step is VC will issue a term sheet.
Closing the deal
Best way to close the deal is to get multiple term sheets.
1: signing the term sheet
2: signing formal docs and getting the cash
- most all term sheets end in deal closing. Assume term sheet is close, unless smoking guns, unprofessional investor, or something stupid in your process
- term sheet taken by lawyer and processed into 100 plus formal documents. And don't assume that a lawyer complaining means VC knows: could be a dust up between lawyers.
Overview of the Term Sheet
- negotiating hard by VC on every term may be inexperience, or a negotiating tactic
- term sheet is critical. It's a blueprint for future relationship. It's not a letter of intent.
Key concepts: Economics and Control
VCs only really care about economics and control.
- economics refers to return investor will get in liquidity event (sale or IPO) and terms that while impact this
- control refers to mechanics to exercise control over business or veto certain decisions company can make
- when company created, founders receive common stock. When VCs invest, they purchase equity and usually receive preferred stock.
Terms of the Term Sheet
Valuation: multiplying number of shares by the share price
- price per share ultimate measure of what is being paid for equity. Price often referred to as valuation.
Pre-money valuation is what investor valuing company prior to investment
Post-money valuation is pre-money valuation plus to contemplated aggregate investment amount
- verbal discussion around price must understand pre or post valuation: "I assume you mean pre-money"
- employee pool, option pool
- size of option pool taken into account in valuation, thereby lowering actual pre-money valuation
- fight pool size or negotiate pre-money valuation
- should have option budget with all hires you plan on making between now and next funding date. VCs seek to minimise risk of future dilution by making option pool large up front
- an option to buy future share at certain price into future regardless of future price of shares
- in effect artificially inflates valuation as becomes part of allocation of proceeds in liquidation event
- bridge loan: investor will make investment as convertible debt which will convert into equity at upcoming financing. Bridge loan investor gets either discount on price of the equity (up to 20%) or warrants that grant discount up to 20% in return for risk taken
The price number itself is arbitrary (essentially made up). Most investors want to make sure founders have enough of the company going forward to incentivise the founders to build the business. And investors have enough to make return. Most early stage financing tend to be for 20-33% of the company.
Best way to negotiate higher price is to have multiple VCs interested in investing.
In early rounds, VCs will seek lowest price that still leaves equity in founders hands. In later rounds, existing investors will argue for highest price for new investors in order to limit dilution of existing investors.
Incredibly important to pick early investors wisely, since effects process going forward. The more interested investors, the better negotiating position (BATNA).
VCs typically take various factors into valuation:
- stage of the company
- competition from other funding sources
- experience of entrepreneurs and leadership team
- VCs natural entry point
- numbers: accounting, key metrics, headcount, burn rate
- economic climate
Focus on what you can control and get several interested parties.
Comes from Preferred vs Common stock. There are other elements to preferred vs common, but biggest and most visible is liquidation preference.
Impacts how proceeds shared in liquidity event (sale of majority of assets)
- most important when company sold for less then the amount of capital invested.
Liquidation preference grants investor right to get money out first, or ownership (economic terms).
- actual preference
- money returned to particular stock ahead of other stock at a multiple (often 1x) to original purchase price. ie. $1 per share
Participation (in the liquidation preference)
- full participation: participation amount, then share in liquidation proceeds on as-converted basis (converted to common stock)
- capped participation
- no participation
No participation example: an investor at $3M pre, $5M post, 40% and $2M liquidation preference (i.e. 1x non-participating liquidation preference). If liquidity event of $10M can choose between 40% of company ($4M) or $2M (liquidation preference). Investor takes $4M and founder $6M. If $2M liquidity event, after same deal investor can take 40% ($800K) or $2M (liquidation preference). Investor takes $2M and founder 0.
Participating preferred (participation) example: In this scenario, investor gets their liquidation preference, then their stock converts to common stock and they get their ownership % in common stock. This makes a big difference in the upside case (not so much downside because founder still gets 0. With same example but with participation and $10M liquidity event. Investor gets liquidation preference ($2M), plus their ownership 40% of the remaining or $3.2M for total of $5.2M. Founder gets $4.8M.
Liquidation event is an event in which shareholders receive proceeds for their equity including mergers, acquisitions, or change in control.
- IPO is another funding of the company, not liquidation. VCs preferred stock is converted to common stock as part of IPO.
- participation lots of impact at low outcomes, less impact at higher outcomes. However, participation granted to early investors often rolls on at each round. With further rounds, liquidation preferences can either be stacked on top of each other (B gets preference to A) or equivalent in stature (blended preferences). Can have a big impact on economics of company.
- cap on participation will allow investor to participate until their hit their cap. Best case is no participation, then with cap, finally full participation.
- early stage: best for both to have simple liquidation preference and no participation. Professional investors generally want combination of best price plus motivation for management and employees.
Usually relevant in a down round, useful to entrepreneurs
- investors mostly keep participating pro-ratably in future financing (paying) in order to not have their preferred stock converted to common stock.
- causes investor to stand up at time of investment to support company during its life cycle (goal for company and investors)
- typically vest over 4 years for stock or option with one year cliff: 25% after 1 year, remaining 75% per month after that
- founders often get different vesting, back a year or more to start of the company
- key component defines what happens if merger or termination
- key to ensure founder motivated over time: vesting time matters in sense of exit
Employee Option Pool
- or option pool
Essential to include vesting in the employee pool. Usually, 1 year cliff with 25% at 1 year, then monthly thereafter for 4 years.
Amount of the company that is reserved for future issuances
- option often added to pre-money valuation by VC to decrease size of pre-money investors (option pool shuffle).
It is possible to reset the vest for a founder who raises after 4 years, but more likely to have another option grant.
- protects investors if company issues equity at lower valuation that in previous rounds
- full-ratched dilution
- weighted-average dilution
Control Terms of the Term Sheet
Board of Directors
Most important group of people to work with: strategy, recruit, experience. Extremely important to get correct. The board is for the founder. Board members have fiduciary obligation to act in the best interest of the company.
Push for a balanced board: so early me, a VC and an outsider (not a major investor). Not good to give control over to the VC. Best to keep small, and only people you love. Each round will likely appoint a board member.
- process for electing board of directors
Be wary of observers and value-add and numbers of board members
- early company often 5: founder, CEO, VC, 2nd VC, outside board member
- mature company often 7-9
Board reimbursed for out-of-pocket expenses to attend meetings, board shouldn't receive cash compensation on private company.
Things that can't be done without shareholder approval. Veto rights that investors have on certain action by the company. Fairly standardised now.
- change terms of stock owned by VC
- authorise creation of more stock
- issue stock senior to VC
- buy back common stock
- sell the company (critical)
- change size of board of directors
- “material” or “materially” doesn't add anything meaningful
- critical to have investor vote / veto as a single class
- warning: major decisions only, not about operations like hiring or certain contracts
- drag along gives subset of investors ability to force (drag along) all the other investors and founders to do a sale of the company, regardless of their wishes.
Is actually a non-negotiable term: the right to convert preferred stock to common stock (may be “automatic" conversion) - thresholds for conversion important: as an entrepreneur want them lower for greater flexibility whereas investors want them higher for control over timing and terms of an IPO.
- cannot have different conversion terms for different preferred stock.
Other Terms of the Term Sheet
- more of a private equity type concern rather than a venture capital concern based on the return required by the VC fund to move needle
- the larger the investment amount and the lower the expected exit multiple, the more dividend matters.
- ensure dividends must be approved by super majority of shareholders.
- usually non-cumulative.
Offers VC additional downside protection
- company redeems shares over 3 years after x years
- provides VC with an exit, if a going concern but no exit event
- also relates to the year or life cycle the fund is at
- never agree to "adverse change redemption”: redemption if material adverse change, yet this is vague and uncertain.
Conditions Precedent to Financing
Try to avoid conditions precedent to financing. Certainly don't pay for VC legal fees unless deal closed.
"approval by investors partners": means deal terms aren't approved to go ahead
"rights offering to be completed by company": means VC wants all previous investors option to participate
"employment agreement to founders": need to understand feeds and termination rights
Right to VC to information about company, like budgets, financial statements etc.
- could insist on confidentiality
Don't focus on registration rights: the world is good if you're going public
Right of First Refusal (Pro Rata Right)
Right investor has to buy shares in future financing
- define major shareholders who able to participate, and only if play in later rounds
Be careful if the right is far larger than the actual stake (pro rata at 1x, not a multiple). Otherwise, you options are limited.
Define how preferred stock and common stock relate to each other in context of a share vote.
Restriction on Sales
Relates to selling shares when a company is a private company
- a good clause that should be supported by founders, management and investors
Proprietary Information and Inventions Agreement
- make sure everyone who contributes signs a proprietary information and inventions agreement.
- mechanism for investors to make company legally stand by that it owns its IP
If founders sell shares, investors have opportunity to sell proportional amount of their stock
- devote 100% of energy to company
Can't shop a deal around after signing. If negotiating with several terms, need to say to others need the term sheet if they'd like to participate, because cannot consider another firm after signing with the no shop clause.
Always going to be a time when move from "search for investor" to "close the deal"
- should have time limit
Company will indemnify investors and board members to maximum extent possible by law
- have to accept: you should have reasonable and customary directors' and officers' (D&O) insurance policy
- just need to make sure that loophole doesn't occur: "assignment without transfer of the obligation under the agreement"
VC can purchase shares at public price if IPO.
The Capitalisation Table
- term sheet almost always contains a capitalisation table. Cap table summarises who owns what part of the company before and after financing.
Convertible debt often used in seed stage. Convertible debt is a loan (debt) that converts to equity (usually preferred stock) at the next round, usually at a discount.
Arguments for and against convertible debt
Fans argue easier transaction because there is no valuation set, avoiding this part of the negotiation. Fewer rights associated with it to equity because its debt, and less paperwork / legal fees.
Those who think there is a definitive answer yes or no for convertible debt are wrong. Consider a convertible debt deal with a reasonable time horizon as an equity financing and a forced conversion, as well as a floor (not ceiling) on the conversion valuation.
Main driving force of debt over equity round is parties' desire to avoid setting a valuation (idea of legal costs less relevant today).
Terms of convertible debt
The idea of the discount is investors should require more upside (than just the interest rate) for the risk they are taking investing early. Range of discount typically 10 to 30% (20% most common).
The valuation cap (the cap) is an investor-favourable term that puts a ceiling on the conversion price of the debt.
Cap starts to set the price for the future negotiation = the cap becomes an implicit price negotiation (which defeats much of the benefit of the convertible debt).
Allows investor to pay money to get type of stock in the future (exercise the warrant). Similar to options.
Advise against the warrants approach (rather use the discounted approach).
How Venture Capital Funds Work
Structure: management company servicing the 'funds'. Limited Partner vehicle (the fund) serviced by 'General Partner' entity.
VC firms raise money from institutional investors, which invest in the fund according to 'limited partnership agreement' (LPA). VC firm makes a 'capital call' when it requires money (investors legally obligated to send the money, yet this typically takes two weeks).
How VC makes money
Management fees: typically 1.5% to 2.5% which pay for salaries and costs. Commitment period, is the lifetime of the fund when it can make investments (typically first years). Overtime as more funds raised by the firm, the senior managers typically increase salary.
Carried interest: carry is the % of the profit that VCs get after returning their money to their investors. Most VCs receive 20% carry (although may rise to up to 30% if extremely well regarded). In this case, 20% of whats left after returning invested funds +80% of remaining returns to investors.
Firms recycle the managements fees (if successful early on), so management fees a type of prepayment on the carry. A $100M fund should be able to commit $100M in capital.
Reimbursed expenses: VCs generally reimbursed reasonable expenses to attend board meetings.
Additional factors regarding incentives
Firm is a partnership, and proceeds of the carry will not be evenly distributed internally. Can be a source of friction. The GP may also commit in their own fund, up to 5% (traditionally1%).
Commitment period (or investment period): the length of time the VC has for identifying and investing in new companies. After period, cannot invest in new companies but can invest additional money in existing portfolio companies. Zombie VCs are those that have not raised a new fund to invest in new companies: ask when they made their last investment.
Investment term: the length of time the fund can remain active.
The closer to the end of the life of the fund, the more problems that can arise for entrepreneurs.
Reserves: the amount of investment capital that is allocated to each company that a VC invests in. That is, investment after the initial investment. This can have significant impact on incentives of VC if under reserved your business or across portfolio. Cross-fund investing may exist to protect an under reserved fund.
Three key factors regarding financing negotiation:
1. achieving fair and reasonable result
2. maintaining positive personal relationships
3. getting and understanding the deal
A good deal leaves both parties happy.
Pick the things that matter to you, and leave everything else:
- the valuation, stock option pool, liquidation preferences, board and voting controls.
Preparation is the most important thing:
1. Have a plan for key things you want, understand which terms you are willing to concede, and know when you are willing to walk away.
2. Spend time beforehand getting to know whom you're dealing with.
Know your strengths and weaknesses. For example, as a focused entrepreneur may have 'time' to deal. Have a BATNA.
Important to look at negotiation is one play on long multiplay game (because need several financings). Be wary of people taking single game winner take all approach.
Know when to walk away: make sure rational and deliberate decision not one from emotional state.
Negotiating personalities / styles
The Bully (aka UAW negotiator)
- yelling, screaming, forcing issues and threatening
- chill out and have their energy sap
The Nice Car (aka used-car salesman)
- hard to get straight answer
- may need to add bully to move along
The Technocrat (aka pocket protector guy)
- technical nerd
- wears down with details, can cause you to loose focus
The Wimp (aka George McFly)
- soft person, may not be great to work with!
The Curmudgeon (aka Archie Bunker)
- everything you negotiate sucks
- won't yell, but never happy
Best way to gain leverage is to have competing terms sheets from different VCs.
Don't offer terms. This is best coming from the VC.
You need to hire a great lawyer: must understand deal mechanics and your style.
Raising Money the Right Way
Don't ask a VC to sign a NDA: signals naivety.
Get introductions, don't carpet email
No usually does mean no, although over time may make sense to go back (atypical)
After no, don't ask for a referral (referral not worth much after no)
Much harder to be successful as a solo founder
Software patents not relevant
Issues at Different Financing Stages
Don't want to over price early stage, because if can't meet potential will need to dilute later.
The terms at the seed stage will flow through to later round (precedence). So important to obtain balanced terms at this stage so allow for easier negotiation later. Clean earlier financing, very important.
Early investors can help a lot: professional angel investors can help a lot with introductions etc. Don't want early investors to overplay involvement.
- one, two or three committed early investors is good (but more is a party round and has problems for later rounds because either a feeding frenzy or no lead investors which signals problems).
- problem if one large angel investor with expectations widely out of proportion to venture stage, in a position to severely hinder.
Great seed round structure that reflects well:
- convertible debt round, lightweight terms, convertible debt with discount into venture round. No fancy features around pro rata rights
- light preferred seed round. Light preferences: simple liquidation preference, no participation, little to no protective provisions, no complicated board provisions or blocking rights (ie. primary thing seed investors getting in the downside case getting money back, plus some protection their capital structure can't be changed).
Great seed deal configuration:
- several lead angels and rest follows, leads with an active engagement (not necessarily a board seat)
- one or two VC investors at seed stage, VCs actively engaged with the company at a seed level
Terms from first VC led round carry on to future financing. Liquidation preference may
Mid and Late Stages
Two issues: board and voting control. Also, issue with valuation, if VC forced to hold out for larger exit that entrepreneur would have been content with.
Letters of Intent: the Other Term Sheet
Letter of Intent (from potential acquirer).
Legal Things to Know
IP / employee issues
Delaware incorporation is good
Laws relating to accredited investors in the US
File an 83(b) election within 30 days after receiving stock in a company
Section 409A: fair market valuation of stock options
Seed stage: $500K -> $2M
Classic VC institutional stage: $2M -> $20M
Later stage / pre-IPO: $50M+