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Last Fall, i signed up for Brad Feld and Jason Mendelson’s excellent Venture Deals course. They provide a useful introduction to the steps, players and dynamics of raising a round of venture financing.

Some useful external links:

• Private Company Financing Trends: H1 2018
• Pre-Seed Funding Report 2010-12

Outline:

• Week 1: Introduction
• Week 2: How to Raise Money
• Week 3: Cap tables and convertible debt
• Week 4: Term sheets - economics and control
• Week 5: Term sheets - part two
• Week 6: Negotiations
• Week 7: Acquisitions and Letters of Intent

Week 1: Introduction

• Over the last 30-40 years, venture deals haven’t changed that much. Brad and Jason started blogs that detailed what all the terms meant. They then converted that into a book covering the whole life-cycle of doing a deal.
• Most of these dynamics are known to lawyers and venture-capitalists, and the motivation was to expose founders to these.

The Players

• Founders
• VC Firms
  • Always deal with partner-level person.
  • Associates and people below partners don’t have the power to make a deal happen.
  • primarily investing other peoples’ money
• Angels
  • investing their own money
  • often are people who have done these deals before, and are invaluable sources of advice for not only financing but also generally running your startup.
• Syndicate
  • a group of angels and/or VCs who are investing
  • key to identify a lead-investor who can herd all the other cats to agree on terms.
• Lawyers
  • get references from people who have been in the industry a long time
  • have lawyers advice you on how and when to go back to the VCs
• Advisors and mentors
  • mentors: do this for professional karma.
    • very important to have a good mentor network
  • advisors: want to get paid in some form (money, more usually equity)
• At what point should a company open a dialogue with an investor?
  • never too early to talk
  • Jason spends a good chunk of his time talking to entrepreneurs, many of whom he’ll never fund
  • go early, go often, get their experience
• How do VCs make money?
  • they have Limited Partners (LPs) like pension funds, institutional investors who give money
  • the VC partners keep 20% of profits, along with some management fees. Standard is 2/20: 2% of fund for fees, 20% of profits.
• You said be careful about giving money to advisors, but what about equity?
  • Don’t spend cash on advisors
  • Equity should have vesting (2-4 years) and small amounts like 0.25% at most.

How VCs make Money

• simple job: get money from LPs and return a lot more money to them
• VC makes money by:
  • annual fee
    • of 2%, paid annually on capital under management for first 5 years and after that on cost-basis of managements.
    • typically this accrues to 15% of fund over its whole life
    • pays for salary, office space
    • there is a concept of recylcing the fee
  • carry:
    • 20% of profits.
  • expenses:
    • travel, hotels are charged back to the companies invested in
  • recycling:
    • if a company gets sold, then some of the proceeds are reinvested in the fund to make it whole from the management-fees that were removed.
    • why? the more capital invested, the higher the likelihood of great outcomes
• incentives and motivations
  • in some firms, all four partners are equal. So all profits are shared.
  • in other firms, individual partners get paid based on their own investments. There can be seniority rules, etc.
  • an investor who has been very successful may get more lattitude to make risky deals
  • or partner is not performing well, and his/her ability to make follow on investments gets curtailed
• Large percentage of VC firms make very little money. Why?
  • you have to look over time. For early-stage VCs, these take 5-10 years.
  • every firm tries to adjust how it is measured to appear to be in the top-quartile, which is of course a tad illogical. Not everyone can be above-average!
  • numbers are fairly opaque. Lot of it is not publicly reported.
  • no question there are many firms or funds that don’t return capital.
    • funds raised in 1999-2000, raised at peak of dot-com bubble failed.
    • many returned 10 cents on the dollar. Management fee was paid but no upside. Implication if no successful fund: its LPs don’t fund the next one.
• As an entrepreneur, what is the best way to judge a VC firm’s track record?
  • look for history and tenure of individual partners. Some firms are dynamic with lots of churn.
  • can also ask when the last fund they raised was. If the firm hasn’t raised the fund in at least 5 years, then likely means it is having difficulty convincing LPs to give them funds.

Week 2: How to Raise Money

• Attitude matters: do or not do, there is no try.
• Raise money to get to the next milestone. Min amount should frame a “successful fundraise”. Don’t give a range 3-5 million. Present a specific number.
• Documents:
  • Business plans are not needed. Good for planning, but not for presenting.
  • Need:
    • executive summary 3-5 page doc: what you’re building, why, where is the biz going.
    • Ppt 10-20 slides. Goes into more details.
    • The Executive Summary is the tell part, and the PPT is the Show part.
  • Prototype and proof-of-concept is important: not important for the functionality but more important to engage with the VC and entrepreneur, to show how they respond to feedback.
  • Transparency: be open about strengths and weaknesses. Guide the VC, don’t force them to find it.
  • Don’t lie about anything: investors will not want to deal after this. “We aspire to have” is different from “we have”.
  • Financial plan:
    • Revenues: in truth, revenue projections are wrong for so early-stage businesses! VC doesn’t care, but cares whether you understand the economics, and the gross-margins etc.
    • Can control: expenses. Expense model matters.
    • Ask: can the building become a big business?
      • 1 million dollar business growing 10-20% a year is a good business but not one VCs are interested in.
      • Raising a million dollars and making a 100 million in revenue, and 20 million in profit → probably delusional
      • I.e. do you have a good sense of the economic model
  • How does one know to raise money or bootstrap?
    • Defer raising capital as long as you can!
    • Raising money !== success. Self-funding is great, when finally raising money your business will be further along giving you better terms. Finding the Right VC:
• Like Dating: if on first-date, want to hang out more, are inspired and feel you will learn more. Will last longer than average marriage.
  • Find out from others how does the vc react when going gets tough. Are they hard to work with, or do they roll their sleeves up.
    • Ask the VC for intros to CEOs, including those who failed
• Getting first meeting:
  • Hard one. Do the research. More entrepreneurs do great on strategising about your business, but don’t research which VCs to talk to (look up on TechCrunch, do other research)
  • Send a proper email. Tailor it to that person, not a generic link to your deck.
• What is Lead VC?
  • Very important. Having a professional, reputable and can close deal quickly and find other VCs to join in.
• What are the other steps from intro to closing the deal?
  • Different for each venture firm.
  • At every interaction, want to feel better about the entrepreneur. If not -> no.
  • Fast No’s, slow Yes’s.
  • Other firms: may need to talk to Associates, present on Monday Partner meetings, etc.
  • Ask the VC: what is your process? How does it work?
• Getting deals to close?
  • Get multiple offers. Creating competition is fastest way to get them to go fast.
  • Try to create some competition, don’t lie: I’ve spoken to Z and Y a few times and they seem interested.
• If you do have multiple firms: how much to share? VC names, terms
  • Etiquette: don’t tell the VC anything. Other VCs have said they don’t want to reveal terms. Otherwise, VCs could collude.
  • Caveat: if this VC has done co-investments multiple times, then maybe.
• Timeline on the process?
  • After agreed upon term-sheet: is [week, never). Usually 1-2 months.
  • Full time job, hard to run business at same time.

Common mistakes raising money

• NDA: don’t ask a vc to sign one. Never.
  • Signals naivety: VCs cannot sign because they have all these docs in different forms to keep track of
  • Doesn’t really protect the early-stage entrepreneur.
  • Useful to know how the VC does treat this info, but NDA wont protect you.
• First meeting:
  • Comes from some intro, or proactive outreach from VC
  • Carpet-bombing the VC: mistake!
  • Focus on getting intros, can be via email.
  • If VC says “No”, then “no usually means no”. Over time, after some fundraising rounds can later become a “yes”.
    • Don’t ask for referral, if VC has said “no”. Because first thing the referred-person will ask if the first-vc is investing, and if not, then the referral is not worth much
      • Exception: the space is not something the first-vc will invest in, but has a relationship with the founder or the other-vc, and so can make a credible referral.
• After “no”, after how much time can the VC give feedback?
  • Some VCs don’t want to, because they haven’t spent much time on it, or don’t want to risk the relationship
  • If VC has spent quite some time and you have a relationship with, then ask.
• Solo founders
  • There are some success-cases, but much harder especially to raise early-stage venture.
  • Mostly 1-4 founders and usually 2-3 founders. It’s so much work, and very useful to have more founders to bounce ideas off.
  • Many investors are scared to invest, because of what will happen if the one founder doesn’t work out
  • Some seemingly so-called founders have other less publicly visible founders also there. Good to have this firepower.
• Patents?
  • Don’t care as early-stage software investor
  • Some companies do have patents, but not driving factor.
  • Important for hardware or biotech
• Do you absolutely recommend not emailing without intro?
  • Emailing without connection is not helpful.
  • Do stuff that causes VC to have a relationship. Comment on the blogs. Become part of the community they have. That opens up an opportunity to talk to them.

Financing Stages

• To what extent do terms and conditions in seed round, constrain future rounds?
  • A lot!
  • Most important to focus on: precedence.
  • Terms from seed-stage flow to next rounds. If seed stage conditions are standard, then easier to follow that on in the next round.
  • Onerous investor-friendly conditions can hamper future rounds
  • Seed stage investors can either help you find more investors, or can be devils and hinder future funding
• Can you share an example where poor terms hurt in seed round?
  • Companies that have raised money from lots of VCs in seed rounds. Instead of one or two investors, you have many investors committed (“party rounds”) but not deeply committed.
  • For next round, if the series-A sees a VC has invested in the earlier round, then it begs the question, well why are they not investing in this round?
    • Sometimes the entrepreneur actively didn’t want the initial VCs, and had a tougher negotiation because those initial investors did want to participate
  • Sometimes the large angel has wildly out-of-context expectations for the terms of the next round, and they can hinder the next round
• What is the structure of a good seed round?
  • Two types of rounds
    • Convertible debt: terms are lightweight with a discount into the next round. No fancy pro-rata rights etc.
    • Light preferred: A preferred financing with light preferences, simple liquidation, no participation, simple protection, no complicated board structures or blocking rights. In the downside case, they get money back and protection that their capital structure cannot be changed.
      • Layering more terms, mean a multi-way negotiation which could include the early investors.
• That is terms-side, what about people-side? What configuration of people is good?
  • Party-rounds:
    • Success case: everyone does well and everyone wants to continue
    • Middle scenario: some angels want to continue, others don’t
    • Downside scenario: no one wants to continue, need to find new investors
    • Entrepreneurs not happy with investors (didn’t help much)
  • Good:
    • Bunch of angel investors, several are leads (deeply involved) and rest are followers
    • VC-investment with one or two VCs

How VC funds work

• Structure of the firm:
  • GP: partners who work together. Have investors who are LPs. LPs and GPs both invest in the fund entity. The VC group may be multiple funds (over the years).
  • GPs own the management company as well
  • LPs put in most money. Historically, 99% but now may be 95-99%.
  • GPs get a management fee.
• Why so many entities?
  • Each fund doesn’t have the same investors. For various reasons, LPs may not have funds or not interested in continuing with this VC firm.
  • Most VCs increase the size of their fund over time, and have new investors coming in.
  • Might have different partners in the GP over time.
  • Money for a fund doesn’t come in at once, simply a commitment. VCs make a capital call when investing in any company.
  • Structure is tax-efficient, and allows for capture of the commitment
  • LP/GP structure is well understood for the dynamics of all the parties.
• VC firm fundraising
  • Humble. Needed 90 meetings Jan-March with institutional investors. Via intros, cold calls: endowments, funds of funds, etc.
    • Out of 90, got 20 immediate Nos. Before meeting ended, or shortly thereafter.
    • Remaining 70, ended up with 20 LP investors. Took till March, April and May to get all commitments. And took till September to close.
• Should entrepreneur care about the LP-base?
  • Health and long-term longevity of the VC matters. Having some LPs committed over time matters.
  • Figured could handle 10 investments per year.
  • Entrepreneur wants the firm to be in business and don’t want the senior partner fund-raising all the time. Took Brad 7 months!
  • Second fund took 2 months, but still easier.

VC Reserves

• Amount of money the VC will save for future investments. Putting some into series-A, means they secretly commit more for future rounds.
• Should entrepreneurs think about this?
  • Ask the VC! How much they do reserve, and how have they done?
  • Mismanaging reserves is really bad for the VC. In dot-com bust, many firms needed more but so many funds had not reserved well so couldn’t help many of their portfolio companies.
  • Is an art, and takes some luck
  • The VC firm discusses reserves across portfolio every quarter
• Entrepreneur should set good expectations about future rounds
  • Very important to discuss this with the VC. Need to understand/share how the business will grow in the next few years. 5 million today, and in 2-3 years will need between X-Y more money.
• Does that mean: sometimes will not invest entire fund?
  • Technically yes: 100 million dollar fund, will usually be within 5-10%. And need to ask LPs for more permission to go over.
  • Many funds have to decide: management fees to take salary, or keep in reserve. Some firms decide “we’re going out of biz so take management fee”.

Week 3: Cap tables and convertible debt

Cap Table

• Ledger of who owns company. Who can vote, and how much power they have. No VC invests unless they know existing shareholders.
  • Lawyers will issue an “opinion”: insurance table that cap table is correct. Lawyers should be informed whenever options or warrants are given out
• Entrepreneurs often mess up
  • Debt provider gets warrant
  • Angel investor gets in…?
• Is there a way to get them off the captable?
  • Offer to buy their shares
  • Sneaky: Ask them to do massively diluted financing, but dilutes all shareholders, and regrant new options to others
• Why is there no standardised captable?
  • Lawyers like to build

Cash Flow

• When could VCs have cash flow problems?
  • VCs need to invest in companies and pay salaries
  • Can generate by: asking for capital from LPs, or sell companies
  • 100 million fund could call in 100 million in capital. Will avoid calling all of that in order to account for unexpected scenarios. So, usually 75-80 million to actually invest.
  • If fund is not successful, then cash flow issues can trickle down to companies

Dangers of Convertible Debt

• It is debt, not equity. Can be used in ways that are more aggressive in terms of negotiation.
• Two examples
  • Financing where Brad was leading first equity round. Company had raised $0.5 million of convertible debt. Half debt from one person. Debt holder had lot of leverage upon equity financing.
    • Were doing a relatively small financing of $2 million. Didn’t want half of it to go to debt holders.
    • This big holder could compel the whole debt-holding to do what he wanted
    • Debt holder didn’t like terms while Brad thought they were doing a good deal. Debt holder thought he should get more equity, while Brad felt that relative to entrepreneurs he was already getting too much. Founders got squeezed.
    • This debt holder essentially had a blocking right to financing, and used that right to hold up the financing. Finally, entrepreneurs gave some of their shares. The valuation didn’t matter to debt-holder, because his debt was converting; he wanted more equity.
  • Company was insolvent. Had debt plus no money. Founders hadn’t paid attention to paying payroll taxes. Creditors came after founders personally to pay some taxes. In case of equity, creditors couldn’t have done that.

Convertible Debt

• Very popular in mid-late 90s, and now back
• A loan
• Unlike a bank loan, expect to convert to preferred stock at a predetermined price or a discount to price other person is paying
• In old days, a financing cost $50k, while convertible debt cost $5k.
• Now, series-A deal for $25k while cdebt at $15k
• Now, entrepreneurs want to delay the valuation
  • E.g. want to get a 20% discount on the next valuation
• Cap:
  • Start company of 2-5 million dollars, but entrepreneur thinks its probably worth 10 million dollars.
  • Debt-holder says i get 20% discount, with some valuation-cap. Protects the debt-holder.
    • But, there is now a piece of paper that says the max valuation is X. This anchors the valuation, and kind of sets the next round.
    • The cap is a passive way of setting valuation
• Is 20% discount standard? Or are there ways to make a step function?
  • VCs don’t like cdebt. They like the valuation.
  • Money doesn’t last like 6-9 months.
• What is a bigger sticking point: the discount or the cap?
  • Cap!
  • Implicit valuation discussion

Convertible Debt Mechanics

• When do notes convert to preferred stock?
  • Automatic: occurs when something has happened like financing or certain time has passed. An investor in such a note is investing in company and wants to eventually be an equity holder.
  • Voluntary: occur when terms are not satisfied. If money is spent, and business needs more capital, then calling the note doesn’t make sense. Will either work to convert to equity, or rollover the note to extend term or conditions to give more time to automatically convert.
  • Terms are typically written to define both cases.
• Calling note
  • Entrepreneur may pay back money
    • Raise financing at higher valuation, and terms let the entrepreneur either convert or pay it off.
    • Company becomes cash-flow positive. If not triggering automatic conditions, can offer to pay debt back to not lose equity.
    • Entrepreneur wants to pay note back, because doesn’t want dilution. Might be paying interest, but actual note will get paid back rather than converting.
    • Often note conditions don’t contemplate these conditions, so these can lead to problems when notes come due.
• Given note, expecting big Series-A, but Google comes to acquire company?
  • Used to be case, where no conditions handled what to happen in the acquisition
  • But entrepreneur pays back the note. So, these investors just get the interest and principal back, rather than participating in the acquisition’s upside.
  • Now, is common to have terms like getting 2x note value, or getting conversion at pre-determined valuation.
    • E.g. we get note back with interest, or note converts at post-money valuation of $5 million dollars. So, selling at $20 million means investors get 4x money back so better aligned than just getting interest+principal back.
• Are the voluntary changes at the sole discretion of the entrepreneur?
  • Depends on how note conditions are written.
    • E.g. note written in a manner what should happen when note is cash-flow is positive. Entrepreneur decided to payback at interest+principal.
      • A few years later sold at $50 million. So, the investors didn’t feel great about it.
      • Entrepreneur may have said that investors invested early and didn’t agree on terms of later valuations.
• When a note does become due, and company has insufficient capital to pay back?
  • Rarely, no recourse like personal guarantee or collateral.
  • Could be in situation when note is due and business is not performing, the note holders may close business. More often, the holders roll over (extend the term).
  • With raising equity, it is well defined what should happen in this situation. When raising debt, this gets more complicated and one has to negotiate what may happen.
• Lets imagine one is in the middle of raising the next round, and the automatic provisions kick in, then can you just pay the note off?
  • Depends on the liquidity, and the dynamics of the automatic conversion matter.
  • A lot of new investors may not want you to pay off the debt. New seed investors don’t want their money to paying off debt, so prefer converting to equity.

Interest rates and convertible debt

• Interest rates always explicitly defined in the note, and generally have no real correlation from what a bank rate or fed funds may give.
• Generally, will be between 8-10 and sometimes 12% based on whether imputed on monthly or yearly basis. They get a bit of return that translates into discount on financing. Not worth fighting the rate unless rate is 18-20%. There are laws about how high it can be – usually not above 28%.
  • Maybe entrepreneur can say you get a great deal on valuation so what about 0% approx?
  • Not right way to think about it. The investors don’t have control over how long the note is out, and so this is a good way to give them a return since you are using it to presumably create more value in your company.

Early stage deals

• Often see cdebt at beginning of life.
• And often later in life, as a bridge-financing to the next round of equity financing. May have situation where one has raised money and made some progress or market dynamics make fund raising tough, so oftentimes existing investors may not do an inside round but prefer doing bridge-financing.
  • Common cliche is that this bridge financing is with an expectation to next venture financing. Otherwise is called peer or plank-to-nowhere financing

How are terms different in early versus later financing?

• Similar in structure, but more aggressive terms: bigger discounts, or more warrants, or bigger multiple on the exit (instead of 2x, you’ll see 3/4/5x). Existing investors are not financing but preserving as much upside as they can to give you capital to get you to the next round.

Warrants

• A type of financial instrument allowing investor sometime in the future to pay some money and get some shares. Setting price today but giving investor time in future to exercise the stock. Similar to option, but different characteristics.
  • Options usually to employees, not always.
• Giving investors some equity characteristics on the debt. Giving discount.
  • Could give 20% discount. If pre-money of $5 million valuation, 20% discount means investors money converts at $4 million pre-money.
  • Or, could give warrants that represent 20% of money that they put in the round -> get equivalent of 20% discount.
    • Tricky things: could be penny warrants. More valuable, stocks almost free. Or warrants can be exercisable at the price of next round.
    • Often negotiated in terms of exercisable price, and amount that is convertible. Relatively easy to figure out equivalent between discount and warrant amount.
    • Sometimes investors ask for discounts and warrants. Like participating preferred: like investor asking for double of what they would normally get.
• Why ask for warrant, rather than discount?
  • Allows investors to invest more money in company. Others like the construct better, because a future financing at a lower price, the warrant has different characteristics.
• Which is better for entrepreneur?
  • Your goal should be a simple cap table. A discount is better, because investor gets more shares than new investors. With warrants, its an extra thing on the captable with exercise-price and terms to keep track of.
• Other terms in convertible-notes worth noting?
  • Mostly happens in context of investors trying to make the note look like equity
  • A pro-rata right allows investors to invest in the round as well as the note.
    • Or a super-pro-rata right, a certain percent of the financing.
    • Pro-rata right is not a struggle, but giving someone a right to a certain percentage of the financing is bad.
  • Liquidation-preference. By definition, a note has a liquidation preference because note converts to equity.
    • Sometimes will put participating-preference in the note. This complicates things.
    • This is overreaching, should push back.
• Are notes/warrants transferable in general?
  • Depends. Most notes require consent to be transfered. Most convertible debt is not invisibly transferable.
  • In warrants, the standards are to be transferable. Good to pay attention to, but usually the amount is a relatively small % of the company, not a material ownership.

Week 4: Term Sheets: Economics and Control

• Term Sheets have two points that matter: control and economics
  • Control: who is on board of directors, voting rights called protective provisions,
  • Economics: valuation, liquidation preferences
  • Rest: registration rights, choice of law, etc. matter much less
• How finalized is a term sheet?
  • VC feels “deal is deal” and so shouldn’t change unless due diligence brings something up
• Price:
  • Nuance around pre-money versus post-money, or options in valuation or outside
  • Pre versus post money
    • VC says “ill put in 2 million at 5 million valuation”. Big difference between post versus pre money valuation
    • As part of deal, VC may put in option-pool in pre-money part of valuation, leaving founders with even less.
    • Other factors like warrants. Rare in early stage, except for debt financing that converts. These warrants may have a strike price that converts at a particular price (similar to options).
    • Think of “post money” as the final value and subtract all other elements (VC money, option pool, warrants) to get your share.
  • How is Price even arrived at?
    • It’s arbitrary. Made up. Investors want to ensure entrepreneurs are invested enough. Most financings are for 20-30% of the company.
    • Best to get multiple investors interested bidding to get the price up
    • Make significant progress to get product out, get revenue, to get higher pre-money valuation
  • If there are 2 different investors, one gives a higher price but other is better to work with
    • Entrepreneur needs to make a judgement
  • How can entrepreneur have an educated opinion on value of company?
    • Many investors will try to extract a number, but its their responsibility to give you a number
    • But having an independent view will avoid your anchoring on some number an investor gives out
    • Talk to other entrepreneurs to understand similar valuations. Collect multiple data points and get first-person data.
• Liquidation Preference
  • Investor will invest as “preferred stock”, not “common”.
  • Consider “2 million on 3 million pre, and 5 million post”. Investor owns 40% and has liquidation preference of 2 million dollars. I.e. get choice of 2 million dollars or 40% fractional ownership, in a transaction. So, (upside case) if sold for 10 million dollars, then i take the 40% ownership. But (downside case) if sold for 2 million dollars, then investor takes the 2 million preference and entrepreneur gets nothing.
  • Two types of liquidation preferences:
    • Participating preferred. Here, investor gets their investment back and then convert to common stock. Didn’t matter in downside case above, but makes big difference in upside case.
      • Later rounds tend to get included in “participating preferred” as well, which severely changes the economics for founders. Imagine raised $25M and sold to get 60% of company for $100M. The $25M would come off the top, and only get $75M for splitting.
      • Can be “capped participation”. A participating-preferred with 3x-cap. Means, participate until they get 3X return.
        • These leads to a “dead zone”, where investor has no incentive to increase the amount of the sale
  • How common is participating-preferred?
    • Much more prevalent earlier. Seen as founder-hostile. Tend to see only at high-valuations.
    • If early-stage investor models it out, then economics don’t make sense because later-stage investors will also get it.
    • Foundry Group keeps deal simple, never does participating-preferred.
  • What defines liquidation-event?
    • Defined in legal docs. Usually: sale of company, sale of majority of company (change of control) but not usually in case of financing, going public.
  • How often does one see 1x versus 2x versus 5x liquidation preference?
    • 1x-pref means no participation
    • Three concepts:
      • There is liquidation preference: get money back or get percent ownership
      • OR there is participation. This can be 1x and then flip into common.
      • OR there is cap. How many multiples do you get participation for and then flip to common.
  • Entrepreneurs often focus on price. Higher price with participating may be worse than lower price.
• Employee Stock Option Pool
  • Vesting:
    • 1% of company. Example: VP of eng.
    • 1 year cliff. Then monthly for a full 4 year vest.
    • Founders also have vesting. May not have 1 year cliff, since working already for some time.
  • Changing from CEO role to CTO, stock doesn’t change for the founder
  • Acquisition: will try to lock you.
    • Standard that being fired as part of acquisition, then all stock accelerates to full vesting.
  • From 10-30% of company. Need to be able to hire with correct incentives.
  • Example: raise $1M and work 4 years, and then need to raise more money. What happens to stock?
    • Depends. Some VCs will want you to reverse stock. Other VCs will give new Option Grant to you.
  • How to determine size of option-pool?
    • Need to identify next set of hires. Look at standard compensation reports. Then make matrix of VPs, Engineers, Office Managers, and plug into model.
  • Does pool come from pre-money or post-money valuation?
    • Traditionally, from pre-money.
• Anti-Dilution
  • Concept: If i invest, and you do something that i don’t approve (raise money at lower price, or issue unapproved options), i am rewarded by owning more of company.
  • 3 ways to calculate
    • $5M pre-money and you issue stock to father and i am diluted then you shouldn’t be able to do that. Clause says i get made whole and rest of company is diluted.
  • Full ratchet
    • If you sell me stock at 10 cents and you later sell for 1 cent, then i get the 1 cent price.
    • Sometimes, if disagreeing on price, maybe you think $10M pre-money and i say $5M pre-money and i say let’s agree to $10M but if next round is lower then comes out of your share, not mine.
    • “Weighted average” anti-dilution: not going to just look at the price. Accounts for price and how much stock issued at that lower price to determine extent of damage done.
  • Not controversial issue
    • So, if VC is arguing for a ratchet, then you are probably working on the East Coast.
  • How long do terms last for?
    • Entire life of company.
    • If series A deal at $1/share, then series B at $5/share, then series C at $3/share, then founders and series A are diluted.
• Board of Directors
  • Role: most important group for setting strategy, recruit, network, bring experience. Most trusted advisory group. BUT could be very disruptive. May take lot of preparatory time. Could force sale on you.
  • Buy book Startup Boards by Brad Feld.
  • Early Stage: Me, VC, outsider. Outsider is non-major investor. Don’t give control to VCs.
    • After multiple rounds, major investor often gets board-seat.
  • What about VCs bringing Associates as Observers?
    • They should be helping you. Got to keep in mind that it is to serve you.
  • Fiduciary duties?
    • By law, have to act in best interests of company, not their own investors.
    • Usually, well aligned.
    • But if not going well, or if pivoted and in conflict with another company of the investor. Avoid loyalty conflicts.
  • How many people on board? And how much say does founder have?
    • Like smaller boards.
    • 5-person board can have 2-founders and outsider nominated by CEO.
      • How to deal with 3-founders? Can we make one an observer?
  • Right time to build board?
    • If you can attract people, then on day one
    • CEOs should be selfish, and get help
• Protective Provisions
  • Used to take days and weeks to negotiate. Now standardized.
  • List of things companies cannot do without shareholder approval
  • 8-10 things:
    • Sale of stock
    • Issue stock better than what other investors hold
    • Sell IP
  • What are warning signs when VCs ask for more?
    • No hiring of senior staff without approval
    • Issue contracts greater than $5k
    • Ensure day-to-day operations are not affected
• Drag Along Agreements
  • Scary for founder.
  • Many flavors.
    • If no longer with company, rest of common stock holders get to vote your stock.
      • This is best for company. No one should have veto rights on letting the company do its business.
    • Do these apply to preferred-stock holders?
      • No!
      • Another website says:
        • include provisions that this can only happen after common shareholders have all made money
        • Or with super-majority of common shareholder vote
• Conversion
  • Always have right to convert preferred to common stock
  • In liquidation preferences, may say i just get my money back and no right to more money.
  • Only other time it is used. Say 52% of common, if you are holding up some deal. So, can convert my share to common so i can vote with the remainder of the common.
  • How is ratio of conversion determined?
    • Usually 1:1.
    • Can change if a stock-split happens
    • Or anti-dilution occurs.
• Dividends
  • Typically, like an interest rate on money invested. Language like “8% of invested money on annual invested”
  • In term sheet, typically, non-cumulative.
  • Do see in larger private-equity deals, but rarely in VC-deals
  • Value in one edge case:
    • Investor invests at high-price, but acquired at less-high price. Everyone makes money including founder, except for last investor who just recoups money.
• Redemption Rights
  • Allow investor to force redemption of equity by company
  • VC firms have limited life. 10 year funds with optional extensions of 1-2 years.
  • Near end of life of fund, there is desire or pressure to liquidate
    • May want to force an exit via sale or IPO or re-purchase shares
    • Hard to force transaction to happen
    • If successful, greed kicks in and wants to grow company and not exercise the right
    • If not, then no point in forcing money to be paid for a company that has no money
    • Usually after 5-6 years, where firm has right of redemption
  • Founder can usually push back on this
  • Usually, when exercised, the company offers very little money for the shares.

Week 5: Term Sheets, part two

• Conditions precedent to Financing Investor can always not sign at last minute
  • Examples for due diligence
    • “Operating plan”: vague
    • Outstanding litigation
    • Outside control of founder: investor needing approval from investing committee at firm
  • Long list means investor not very serious
  • How much push back is acceptable?
    • Term sheet typically has no-shop agreement, where founder cannot end the deal, but investor doesn’t feel same level of commitment
    • One term sheet, may have no leverage to push back
    • Otherwise if multiple term sheets, then push back
• Assigning Shares
  • Can transfer shares between related entities under the VC firm
• Information Rights
  • Access to financial statements, books, records, etc
  • Two situations
    • Small investors ($10k, $25k in seed rounds). Doesn’t make sense to give same rights as major investors
    • Many VCs may be invested in small amounts in competitor companies. Makes sense to limit. How?
  • Protections to prevent investing in competitor?
    • Difficult to agree on this. Founders and investors both want to avoid a lawsuit. Better to do diligence on investor, and avoid them.
    • Can still apply protections like Confidentiality
• Registration Rights
  • “Don’t matter” — yeah, right
  • 3-4 pages of term sheet
  • Rules of engagement during IPO. Often only the case in some future event.
  • Likelihood of needing to deal with it is low, because IPO
  • Even in IPO, negotiation is different with underwriter (investment bank)
  • Then, you have secondaries, where existing investors can sell shares (not the company itself)
  • Finally, there is often language that says what rights investors have to force a negotiation. Practically, its hard for investors to exercise these rights in absence of cooperation from companies or underwriters
  • Why in term sheet?
    • Been there a while, so gotten big to incorporate edge cases that were encountered over the years
    • “Piggy back” rights
    • Effort by investor to capture edge cases
    • Actual validity and circumstance is rare
    • For fun: have lawyer push back on these, but you’ll look goofy and undermine yourself in the negotiation
    • Flipside: investor will bury some random tidbit that bites you
• Right of First Refusal
  • “Pro rata right”
  • Investor can invest in next round of funding
  • Ability to invest amount to maintain same % ownership
  • Seems reasonable for founder. Can there be trouble?
    • Generally, we want to encourage investor to have this
    • But important they have right on just pro-rata, and not on larger amount. E.g. investor having 5% can ask for first-refusal on 20%. Not good. Limits options with other investors
    • Keep it simple. 1x.
• Voting Rights
  • Fairly standard
  • Determine how preferred and common stock interact in terms of control
  • Exceptional situations
    • Certain classes of shares (e.g. facebook, snapchat) control voting rights
• Restrictions on Sales
  • Be a bummer if VC sells to VC’s father
  • Need company’s permission to sell
  • Generally have co-sale agreement that if someone is going to sell, others can tag along with them
• Intellectual Property
  • Critical to keep close control and ownership
  • Best way is to ensure all workers (employees, contractors, friends) write invention agreement that everything they work on belongs to company
  • Must ensure there is no interaction with their previous work or side-projects
  • Simple 2-3 page agreement they must file
  • How about co-founders who have left?
    • Really important for all to sell
    • Negotiate when you are weak, not when strong, on techcrunch-coverage to ensure other party cannot get leverage
  • Friend has a quick problem to do?
    • Someone just did the simple thing and put it on github
    • In this case, likely nothing will happen
    • Friend could integrate code, raise $10 million in funding, and guy comes back for their cut
    • Let’s say guy says i’ll charge $10k, still need agreement to ensure exclusivity of ownership
  • Co-sale agreement
    • Simple, straightforward, rarely negotiated
    • Agreement between common and founder
    • Imagine if CEO finds a friend who agrees to buy shares
    • Gives VCs right to also sell
    • So, CEO only can sell their pro-rata %
    • A way to control the cap table
    • Way to get liquidity for other folks
    • How often do these show up?
      • Rarely, but does happen
  • Founders
    • VCs want founders to be solely focussed on company
    • Restricts activities
    • Founders can get distracted
    • What kinds of activities are okay, and not allowed?
      • Strong on community, charitable, education
      • Good on sitting on others’ boards
      • Not happy spending a day a week helping another startup in the area
  • IPO Shares Purchase
    • Came out in dot-com era
    • VC firms were able to buy shares already invested in to run up the price, and then sell their insider-shares
    • Mendelsen would like to make these extinct
  • No-shop Agreement
    • Term-sheet is the engagement, so want to ensure you do not share to other VCs
    • Cannot go talk to other VCs
    • If VC is paying lawyers and doing diligence, then want protection on that cost and time
    • Came in during 2000.
    • How does this work operationally?
      • You give me term-sheet with no-shop
      • You tell others that you got a term-sheet from VC1, but before you sign, you get other VCs to give their term-sheets in
    • How much time is there?
      • No more than a week?
      • Usually between 45-90 days
    • How do i be honourable to the no-shop?
      • Tell the dream-VC who came in the next day to go away
      • OR tell the lead-VC you really want to bring the other VC in
      • OR tell VC to suck it, and risk getting sued – e.g. bad coverage for VC in techcrunch, and also risk reputation
  • Indemnification agreement
    • VC wants to minimize risk of being on board-of-directors
    • I.e. if customer sues company, or another shareholder does
    • Then company will use its resources to protect from lawsuits
    • Is this standard, or need to negotiate?
      • All VCs and board-members have it?
    • Why is this necessary, if fund structure is LLC?
      • Yes, VC’s investors do indemnify VC, but company indemnify’s the VC’s investors

Week 6: Negotiations

• What matters in negotiations
  • When an entrepreneur enters a negotiations, what are the priorities?
    • Two things matter: economics, and control. Choose which matters more.
    • Many things in term sheet don’t affect these.
  • “You never make money on terms”
    • Good VC cliche. Most VCs are after huge upside, not modest outcome.
    • As an investor, focussing on strategic upside is better.
    • Many VCs focus on specific things:
      • Economics: lowest entry point
      • Control: want to protect against problems when company not working
  • How should a VC prepare?
    • Understand person who you are negotiating with. Learn style, priorities of other person
  • Some examples that went well:
    • BitDoor. Keith Smith was CEO. His previous company had a rapid rise and rapid fall – and had bad dynamics with investors.
      • He was focussed on key things about control dynamics
      • Brad Feld’s offer was an email with a few bullet points that focussed on control and economics. Feld tried to focus on control parts, and there was minimal economics changes.
    • Entrepreneur didn’t know what they wanted, and Feld didn’t understand either.
      • Feld got to know partners over 2-3 months, but was at surface level.
      • Presented entrepreneur with detailed term sheet. Her lawyer (was mediocre) and went after random terms that didn’t really matter.
      • This was tedious. Long time, lot of back-and-forth. 2-3 days would elapse as entrepreneur thought about what was important.
      • Towards end, entrepreneur reopened earlier agreements and requested changes around control-provisions that were important to Feld because it was a seed deal.
      • Feld backed out. And voluntarily paid the legal fees of entrepreneur.
      • Q. Jason had said: Want meeting to be better than last. How did this fit into that?
        • Feld: very few cases where got to agreement on term sheet and didn’t close financing.
        • • Game theory
  • Mathematical underpinning to these decisions, over time.
  • Key concepts:
    • Prisoner’s dilemma: 2 potentially guilty people. Both asked if other person is guilty.
      • 3 scenarios: both silent, A says B guilty and B says nothing, and both say other is guilty.
      • Scenario 1: If both silent -> medium punishment
      • Scenario 2: high punishment, no punishment for other person
      • Scenario 3: both get high punishment
      • Outcomes different, based on intensity of punishments
      • How about playing once, versus many times?
        • This is a single play game
        • A multi-play game is like a company. A negotiation with an investor is part of a multi-play game (e.g. later financings, or salary adjustments)
    • How to practice negotiation prior to negotiating with VCs
      • See Getting to Yes book
      • Also, recognize you are constantly negotiating with family members, partner, etc.
      • How do you deal with confrontation? Do you back away, run to it, get more or less rational?
• Negotiation styles
  • Bully VC persona
    • This is the Best Deal you’ll ever get! You MUST do this. Hell no, i’m not changing that!
  • Nice guy VC
    • Everything will be awesome on all we work on
  • Technocrat VC
    • Show me 5-year projections, and gross margins
  • The Wimp VC
    • I really wanna do this deal, please let me in, c’mon just do me a favor
  • Curmudgeon VC
    • Last 72 times i invested in a company like this it failed. Maybe you’re different, probably not though
  • Even in a VC firm, different archetypes can exist
    • Recognize that these people are showing an aspirational image. They want you to think this is who they are.
• When to walk away
  • How to recognize a bad deal, where you just walk away
    • Only use when things are bad, and important to know what your alternative is. Best Alternative To Negotiated Agreement.
    • If you come back voluntarily, you have lost all leverage.
  • Always define your hard line
  • Most important to have multiple options: other investors, or term sheets on the table
  • Bad case: one lead investor and 2-3 others who could have been lead investors, but you’ve already introduced them to each other.
    • Now, if you walk away from the lead investor, but you are in a hard place.
  • Most important to be direct, and non-emotional.
    • If you have decided not to do something, then articulate it directly to the investor
    • Lead VC asked for overreaching conditions, CEO pushed back. Lead VC came back saying he needed terms for himself, if not for other investors. CEO reached out to the others.
• Getting to an agreement
  • Building leverage
    • Have multiple options. 2-4 terms sheets. Timing matters a lot. Work hard to have stuff happen in parallel.
    • Cannot force VCs on your tempo.
    • What about: entrepreneur giving VC a term-sheet?
      • Only effective at seed-level
      • Let other party set terms
      • Can seem naive. Puts artificial pressure on VC.
  • Getting deal to closure
    • Keep things at high-level. Do not negotiate line-by-line. Get to closure in matter of days.
    • Keep lawyer on hand for drafting language, but keep negotiation about business decisions
    • Once lawyers get engaged, make sure to be involved the business decisions.
    • Keep a defined time line (30-45 days) with clear deadline. Can even be done in a weekend – so work is finite, but there is a recognized process.
    • Reputations of a lawyer are fairly easy to figure out
  • Running multiple options in parallel, how do you prevent over committing yourself
    • Common mistake: not enough attention on pushing forward. Attention is on generating options.
• Things to do/not to do in negotiations
  • Going term-by-term, line-by-line
    • Not effective
    • Go out of order. Don’t want other person to control it
    • Think what matters to you
    • Must be willing to give
  • Using market conditions as influence
    • Common mistake
    • Market terms evolve, and are situation specific.
    • This is hollow
    • Counterpoint: not market. Here are 5 examples why we didn’t do in other places.
  • Ethics
    • Don’t ever lie
    • Don’t assume other party is honest or not. Do research. Find who is always stretching, or changing terms.
  • Can terms be revisited
    • If clean and constructive relationship with VC, then can surface issues that are not working help. Can be addressed in future financings.
    • In acquisition, good relationships with boards/VCs, then can revisit to make that deal happen
• Legal basics part 1
  • Mistakes on IP
    • A rat’s nest. Defining what it is and how it works.
    • People think about patents.
    • Must clearly define that the company owns everything you and multipl partners worked on.
    • Mere fact of having idea has no or little value
  • Employment issues
    • Roles and responsibilities. Full time or part time.
    • Must ensure new employee or contractor is really working for you. And no link to any previous employer.
  • Starting company. State to incorporate.
    • Delaware has well defined corporate law that investors and lawyers understand.
    • California or Texas often has many companies.
• Legal basics part 2
  • Are some investors better than others from legal view?
    • Must be accredited investor.
    • Exemptions and exceptions exist. Must work with lawyer to ensure investors are fine.
    • SEC protects small investors.
    • Rescission rights (“just joking, want money back”)
  • 83B election
    • Lawyer should do automatically. You need to sign and mail it somewhere. Only have 30 days to do this.
    • When issuing stock, that locks in the cost-basis for the stock. Means you only have to pay capital-gains tax on top of that.
    • In absence of this, on each vesting, need to value stock and pay tax.
  • 409A
    • Total employment guarantees for accounts
    • Need to value common stock to grant options
    • Previously, board could set the value
    • Now, must be done with some rules. Safest way is for a 3rd party do it – write a 50-80 page doc, and justify the valuation.
    • Have one-year safe harbor. So, once a year or anytime a material change in company happens (financing, etc.)
    • For acquisitions, this rep is important. Buyer says you are responsible for pricing options correctly.
  • If startup has raid a modest amount of money, can they value it themselves?
    • If you hit success case, then the old valuation could be deemed invalid and would have to re-price the stock options granted earlier.
    • Penalty is paid by options-holder. So bad for employees.
    • Good hygiene here is valuable.

Week 7: Acquisition/LOI (letter of intent)

• Structure of an LOI
  • Couple of pages
  • Usually focussed on price
    • But not always simple number, and can have components
    • Can have escrow, perf incentives
    • Can be cash, or stock in acquirer
    • Can have earn-out rewards after a year
  • Typical process
    • Different reasons: sometimes sudden, sometimes slow evolution. Sometimes competitive, sometimes single buyer. May shop company around, or want to work with just one company
    • Stage
      • Dance leading up to negotiation
      • Negotiating LOI
      • Going from LOI to agreement (lawyers). More heavyweight than financing.
  • What actions can a company take to make this happen?
    • Recognize that likely you are going to be acquired
    • Always be open to any inquiries
    • Actively develop relationships with potential acquisitions
    • Do not completely ignore it
  • Getting capital structure right
    • Doing annual audits
    • And general financial hygiene
    • All good for acquisition
• Asset Deals vs Stock Deals
  • Stock Deal (pie deal)
    • Buyer purchases entire company. Becomes part of buyer’s company.
  • Asset Deal (banana deal)
    • Company exists standalone. Asset is bought.
    • Changes legal structure of responsibility for liabilities
    • Acquirer prefers this
      • Liability
      • Ease
      • Can pick and choose assets that acquirer wants
      • Easier to do asset transaction than stock transaction
  • Tax implications
    • Most sellers want to do stock deal, and buyers want to do asset deal
    • Now, many are doing stock deal because its cleaner overall
  • Companies with lots of physical assets with environmental liabilities saw lots of Asset Deals
    • When primary assets are IP, then more stock deals
    • If more consolidated position with founders, then mostly Asset Tx
• Form of Consideration
  • Cash, or Stock, or….
  • If private company is giving stock, they should be able to give you financial statements for you to value them
  • can get common or preferred stock
  • 409A valuation can tell you the fair-market-value of the company for different classes of stocks
  • For public companies, stock is closer to cash, but usually has vesting builtin.
  • Can offer: 5% of company
    • Key question: is that pre-money or post money!
  • Must have point-of-view on how well the company is doing!
• Assumption of Stock Options
  • Can be assumed by acquirer or not
  • Depends on whether stock options have value or not. For sale, below liquidation preference, only investors would get money.
  • Open question: how should acceleration work?
  • If buyer is not buying out options, then could accelerate
  • If options have value:
    • Buyers view existing option plan, as retention mechanism
    • Buyer may substitute a retention pool, instead of option-plan
  • Some entrepreneurs really want options to accelerate, as way to reward employees
    • Decision also includes investors
    • Some investors are dogmatic to want
• Reps, Warranties, and Indemnification
  • Representations and warranties
    • What company is saying are true about variety of things
    • Show up in LOI, because want to define what is being discussed at high-level
    • Good way to tease out how buyer is going to be thinking about reps and warranties
  • Will make Rep that:
    • Rep that you own all IP
    • Capital structure is true
    • Will disclose any legal issues and make Rep that these are all of the legal issues pending
    • Make Rep that employees have signed a confidentiality agreement
  • What is indemnification
    • Specific statement of taking responsibility for anything not true in Reps and Warranties
    • Big difference between something being true, and having knowledge of it matters
  • Vast majority of this is pro-forma (i.e. in every transaction)
    • Spectrum: some reps and warranties are very lightweight, seller friendly
      • And some are very heavy, buyer friendly
    • Any complicated problem downstream does get affected by all reps and warranties that you have
• Escrow (or holdback)
  • Used for addressing breaches of reps and warranties
  • Amount of consideration held back to satisfy any potential breaches.
  • Typical 10-20% and held for 1-2 years
  • Typical claims against escrow:
    • Any sort of legal disclosure. Rights to all IP. No legal issues outside disclosures. Licensed all software correctly.
    • First recourse is to go against escrow.
    • Often seller involved with buyer’s company, and can work with buyer to mitigate this
  • Deals tend to totally clean, or a complete mess.
    • Hard to predict on the frontend of the deal
  • In vast majority, the escrow gets paid out fully to sellers
  • Escrow almost always held by third-party company, but not always
• Confidentiality Agreement/NDA
  • Buyer-and-seller sign mutual NDA
  • In both’s interests, due to exchanging sensitive info
  • Even fact of talking to each other, is very important
    • For private-private tx, the buyer may not want their competitors to learn about this
    • For public-private tx, formal laws about what to disclose or not
  • If buyer gives NDA, then should be mutual NDA both ways
• Employees/Acquisition
  • May get new consideration, or new job
  • Consideration:
    • Stock options: accelerate or not
    • Carve out for employee incentive
  • As founder should have a point-of-view on how you want to treat employees
  • What is the dynamic, when this is negotiated too late in process?
    • From buyer’s perspective: waiting later in the process, can mean this becomes another negotiating point
  • Or, starting too early can also be a mistake
  • For senior execs in company, buyer will want them to sign up as a condition of the deal
    • Multiple negotiations, including with employees
  • At lower levels, buyer wants them to sign releases etc.
  • Disclosing to employees depends on openness, confidentiality, leaks
  • Experience is most default to smaller number of people getting to know, and everyone much later in process
  • Your reputation matters for multi-run game
• Conditions to Close
  • Often language in LOI, these conditions can be used by a buyer to walk away
  • Usually no recourse for seller
  • Often, will signal things that are important to them
    • Vague: “Successful completion of due diligence”
    • Specfic: “Getting consent from 95% of shareholders”
  • Usually show seriousness
  • Level of specificity defines seriousness, that buyer has thought carefully of what needs to be done
• No Shop
  • Cannot shop company to another acquirer for 30-60 days
  • Implication: cannot talk to potential acquirer, whether proactive reachout or other party reached out to you
  • When there are multiple parties bidding, this indicates going to single conversation
  • If violated, often good reason for buyer to walk away
  • Is sometimes negotiable, but should work to get to the point where you’ve done work to build conviction on your side and the buyer’s side to go ahead with the acquisition
    • So sign LOI when both sides are actually serious
    • Companies that regularly do deals, will come through
    • Most deals that fail to close is from lack of support on buyers side
  • Best alternative is to have good business where you can just continue, if deal fails through
• Transaction Fees
  • Having a great lawyer is important
  • Have involved all along process
  • Fees have to do with lawyering
  • Just accept it
  • Build relationship with lawyer before acquisition
  • Sense of scale
    • Low end for small deal. Maybe $25-50k
    • Typical deal. $50-100k or $150k
    • For 100s of millions, may cost $250-500k
  • Buyer will push fees to seller
  • Can have a breakup fee, which buyer doesn’t like, but can be negotiated with multiple buyers
• Shareholder Representative
  • If things go bad after acquisition happens
  • After consummating acquisition, designated person is responsible for reps, etc.
  • When something goes wrong (e.g. claim on escrow, lawsuit against earn out), buyer has legal team responsible but seller no longer exists
  • Used to be this person was an investor
    • But this was lot of work, and time, for free
  • Now: a company is created Shareholder Representative Services that places the role for a fee
• Registration Rights/Acquisition
  • Getting stock from the public company that bought you
  • Stock is registered or unregistered
  • If registered, then free to trade
  • If unregistered, then need to file a registration statement prior to selling, or certain amount of time needs to pass when it becomes registered automatically
  • In agreement, may need to say they will try to get registered
    • But not directly in buyer’s control due to process set by SEC