📗 Venture Deals

Venture Deals, by Brad Feld & Jason Mendelson

According to my VC homies, this is the Bible to learn about the different players involved in VC-backed companies, their incentives along the journey of a company, the different types of financing and key terms of deals to know about, and a few war stories to learn from.

This did indeed feel about as long as the Bible to get through. It’s basically a textbook – some areas are very dense and technical. I must confess I skipped a few bits. For instance, I didn’t digest Chapter 11’s long list of typical “financial covenents” – actions the company should/shouldn’t take – in the context of a Venture Debt contract. Knowing these exist, and the Bible is on my bedside should I ever need to consult them, will suffice.

But overall I learned a lot of interesting things, which I think will help me better understand deal dynamics in the future, whether that’s as an employee, entrepreneur, funder, or news reader watching from afar.

Here are my notes / the key things I want to remember. Headings are the chapter title names.

The Players

  • Growing trends of groups of VCs/angels getting together forming a syndicate (“party rounds”)
  • In this situation should insist on having a lead investor represent the syndicate so you don’t have to negotiate the terms with everyone

Fundraising Prep

  • You should be a C-corp not an LLC or S corp (“pass through tax entities”)
  • For due dil should have certifs of incorporation, bylaws, all board minutes, financials, cap table
  • Critical to be able to “demonstrate a clear, documented chain of titles for all of its IP”. Deals fall through a lot because of that

How to Raise Money

  • Should know how much you want to raise and ask for that number
  • “Lead investors” typically putting in at least 50% of the new money in a round. You should focus your search on lead
  • Bear in mind amount you look to raise will shut out some funds as lead investor (eg raising $7m but max first check a seed stage VC writes is $3m)
  • Business plans, detailed financial models, etc not useful for raising at early stage. They’re always wrong. Focus on stories + demos. But may be useful as exercise for internal planning

Term Sheet

  • Critical. “Blueprint for your future relationship with your investor

Economic Terms

  • Dictate the return investors will get
  • Fully diluted shares are the total number of common shares of a company that will be outstanding after all possible sources of conversion, such as convertible bonds and employee stock options, are exercised.
  • Size of the employee options pool affects valuation even more than liquidity prefs.
    • e.g raising $5m at $20m pre-money. There is a 10% options pool but VC wants to raise it to 20% in the deal. The extra 10% comes out of the pre-money valuation (it comes out of the “previous investors” share of the company), resulting in valuation of $18m
    • VCs often push for large options pool to avoid future dilution. Should come ready with plan of why you need options pool of a given size
  • Warrants – a right for an investor to purchase a certain number of shares at a predefined price for a certain number of years. Similar to vested options
    • Rare at early stage and add a lot of complexity. Present in bridge loans / convertible debt (see later)
  • Liquidation preference (e.g “Series A preferred” stock)
    • Nx liquidity preference, the investor gets their money back N times before any other shareholders get any proceeds from share of sales (often “common stock”)
    • this means the common stock can end up with nothing if there is a sale at below the valuation at which investors bought shares with liquidity prefs
      • “Liquidation preference overhang” – the amount that needs to be returned to satisfy the liquidity preference
    • Stacked – series B investors get preference first, then series A. New “class” of stock is issued with each round
    • Preferred stock holders can convert their stock to common at any time (1-way convert)
      • If the company is a success they will convert as greater earnings from common stock
      • Liquidity prefs are mostly downside protection
  • Participation (e.g “Series A preferred participating” stock)
    • “Participating” in the proceeds after having received the return from the liquidity preference
    • No participation. You only get back the liquidity preference multiple. If outcome for common stock is better you convert
    • Full participation. The equivalent of having both the liquidity preference return & common stock
    • Capped participation. You get your liquidity pref return and returns from the common stock up to Nx their original investment amount. Again if valuation is high enough that you hit the cap you convert to common
    • So these are mostly for downside protection too
  • Pay to play provision
    • Investors must keep investing pro-ratably in future financings (paying) in order to not have their preferred stock converted to common stock (playing)
  • Antidilution
    • To protect investors if there is a down round
    • “Full-ratchet antidilution”: the conversion price for investors who went in in the higher round is reduced to that of the next (down) round
    • “Weighted-average antidilution”: factors in the size of these rounds too
    • [There is more technical detail here that I kinda skipped / didn’t understand fully…]

Control Terms

  • “Mechanisms that allow investors either to affirmatively exercise control over the business or to veto certain decisions the company can make”
  • Protective provisions
    • Veto rights for investors
    • Typically long provision clauses, should be careful that things are specific there
    • Really try to have all investors in the same class of votes
  • Drag along agreement
    • Preferred investors “drag along” common shareholders with their votes
    • New clause for founder stock that says that if they leave, their stock votes in same proportion as common stock voted. Helps ensure founder can’t sabotage from the outside?

Other Terms

  • Dividends
    • Typically not a focus for early stage deals but they do exist
    • Can matter in downside case
    • Voted on by board so focus on good board control
  • Redemption rights
    • “Allow the investors to sell their shares back to the company for a guaranteed return”
    • Really avoid the “adverse change redemption” which is vague and can be used against you
    • Again voted on by board
  • Right of first refusal / “pro rata right”
    • In new round, major investors allowed to buy again at new price
  • No-shop agreement
    • Can’t solicit other firms
    • Insist on an end-period for it, eg 30 days, so you aren’t locked if doesn’t go through

Convertible Debt / Notes

  • Loan (with usual interest rate & principal to repay), but when the company raises a future equity round, the money loaned via the convertible debt converts into the stock the company sells in the equity round
  • Often used for mid-late stage, and as “bridge rounds” ahead of a bigger financing
  • Discount & valuation cap
    • Convertible debt issuer will often get a discount compared to new equity buyers in the next round (which the latter group might not find fair and can cause issues in the deal)
    • Valuation cap: issuer’s conversion price capped at X
    • Warrants are sometimes issues instead of discounts
  • Major pros: you don’t need to set valuation and faster to do the deal / lower legal fees
  • Major con: messier cap table, new investors might not like having issuer with lower entry price
  • Advice
    • Also set an expiry time period for participating in next equity deal & a “floor” valuation cap (not just ceiling)
    • If you’re raising equity and you have a convertible loan, don’t disclose the valuation cap, it becomes a ceiling on your valuation in negotiations
  • YC and 500 Startups have similar but simplified instruments – the safe (simple agreement for future equity) and KISS respectively
  • [Skipped some of the detailed terms on conversion mechanics & warrants]

Cap Table

  • Gets messier with convertible note. Who’s ownership is diluted by the issuance of the shares on conversion of the notes, and by how much?
  • 3 methods to decide: pre-money method, percentage-ownership method, dollars-invested method.
  • [Skipped detail]

Crowdfunding

  • Equity crowdfunding
    • e.g AngelList
    • JOBS act (Jumpstart Our Business Startups) in 2012 defines regulation around this
    • You can avoid SEC requirement of registering a security if you:
      • Only allow accredited investors ($200k+/year income or $1M+ net worth)
      • Don’t do “general sollicitation” (advertising/publicly promoting)

Venture Debt

  • Loan designed specifically for early-stage, high-growth companies with VC backing (not available if you don’t have VC backing)
  • They use the VC as validation of risk profile
  • Doesn’t require you to generate cash flow like more traditional debt
  • Specialised players like Silicon Valley Bank
  • [Skipped detail on terms]

How VC Funds Work

  • Different companies set up within the VC “umbrella”
  • There is a secondary market for LP stakes
  • Management fees 1.5-2.5% of the fund size per year during the commitment period (typically 5 years, and overall fund period being 10 years)
  • Carried interest earned after LP money has been returned. Typically 20%
  • VCs often recycle management fee – put it to work as investment
  • “Walking dead” VCs – are done with their investment period and haven’t raised new fund but are still trying to make deals. Be careful as can take time your time
  • The closer the fund is to the end of its life the more pressure there might be to exit or sell shares in another round
  • Reserves
    • VC funds keep reserves for each company they invest into to help them for later rounds
    • Often there is a side fund for later stage deals in the best performing companies “select” or “opportunity” funds
  • Departing partners. There is often a “key person” clause – if that person leaves LPs can suspend the fund or even shut it down
  • Corporate venture capital (CVC). Incentive is not always returns but also insights into your tech, locking out a competitor, etc
  • Clawbacks. If VCs have taken their carry as fund progresses but then need to return it because hadn’t returned original investment

Negotiation Tactics

  • Start of negotiation pick a few things that really matter to you. e.g focus on valuation, stock option pool, liquidity prefs, board, and voting controls.
  • Ask other side of the table what their top 3 things are as well, can help push back on other things
  • (Obvious) Best negotiation is to have lots of interest
  • Use negotiating period to understand what the VC is like. You will work with them for a long time so look for red flags
  • Never make the offer first, no reason to, run risk of aiming too low. Listen more than you talk

Raising Money the Right Way

  • Don’t ask for NDAs. Most VCs won’t sign them and means they can’t try to bring others along

Issues at Different Financing Stages

  • Precedent is super important for terms so if (as the entrepreneur) you get a bad deal at seed stage can be a big issue later.
    • Conversely if you get great terms, eg very high valuation, that you can’t sustain later, you risk diluting your original investors a lot (who believed in you at the start)
  • Later stage deals more likely that you go far with an investor only to find they don’t have internal approval to do the deal (at earlier stages term sheet should always arrive if the other partners have agreed)
  • Place a cap early on on % of directors who can be VCs as opposed to independent directors
  • If board getting too big can set up executive committee which the board consults

Letters of Intent / Acquisitions

  • From potential acquirers. Typically non-binding
  • Also known as Indication of Interest (IOI) or Memorandum of Understanding (MOU)
  • Big negotiation points are management retention pool, working capital, and earn-outs
  • Escrow (also known as holdback): around 10% of deal size to satisfy any issues post-financing that were not disclosed in the agreement
  • Earnout is a contractual provision stating that the seller of a business is to obtain additional compensation in the future if the business achieves certain financial goals, which are usually stated as a percentage of gross sales or earnings.
  • Working capital. Didn’t fully understand this, I think it’s the acquired company that needs to provide it
  • Asset deals (as opposed to stock deals)
    • Bad case. Buyers only buying specific assets they want
    • Company actually hasn’t been sold and needs to be wound down etc
  • For unvested options in the target company, can either vest everyone’s options on acquisition or only issue stock to people who were already vested. Pros and cons to each approach (eg unfair to those who vested over a long time)
  • Representations and warranties. Writing facts about the business that you write with “to the best of your knowledge”
  • Breakup fee. Can be asked if seller worried the buyer is fishing for information

Legal Things Every Entrepreneur Should Know

  • IP. Be super careful about who you share your IP with, people can make claims that they were involved in coming up with it later
  • Patents. 20 year monopoly on using an invention. Must file within first 12 months of discovery.
  • Employment issues. The most common source of lawsuits. Know good employment lawyer for hairy situation e.g someone asking for big severance
  • Section 409A. IRS law about options needing to be issued at “fair market value”. Carta recently launched a business line to value the company for this reason. Big 4 also do it.
  • 83b elections. A notification a recipiant of RSU (restricted stock units) sends the IRS. You’re asking the IRS to tax you on the equity at date of grant rather than date of vest. Must be filed within 30 days.
  • Consultants vs employees. Many legal issues can arise if you’re not paying cash to full-time employees in early days, so people are employed as consultants, but contract needs specific things for that not to be a breach of employment law.

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