Venture Deals by Brad Feld & Jason Mendelson
When we meet people who say they are “trying to raise money,” “testing the waters,” or “exploring different options,” this not only is a turnoff but also often shows they’ve not had much success. Start with an attitude of presuming success. If you don’t, investors will smell this uncertainty on you; it’ll permeate your words and actions.
Focus on a length of time you want to fund your company to get to the next meaningful milestone.
Just make sure you have enough cash to get to a clear point of demonstrable success.
We always recommend stating that you are raising a specific number.
Realize that whatever you send a VC is often both your first and last impression, so make it count.
In the executive summary, include the problem you are solving and why it’s important to solve. Explain why your product is awesome, why it’s better than what currently exists, and why your team is the right one to pursue it. End with some high-level financial data to show that you have aggressive but sensible expectations about how your business will perform over time.
“Less is more” when it comes to an investor presentation. There are only a few key things most VCs look at to understand and get excited about a deal: the problem you are solving, the size of the opportunity, the strength of the team, the level of competition or competitive advantage that you have, your plan of attack, and current status. Summary financials, use of proceeds, and milestones are also important. Most good investor presentations can be done in 10 slides or fewer.
The discipline of writing down what you are thinking, your hypotheses about your business, and what you believe will happen is still very useful.
The only thing that we know about financial predictions of startups is that 100 percent of them are wrong.
You can’t predict your revenue with any level of precision, but you should be able to manage your expenses exactly to plan.
We believe the demo, a prototype, or an alpha is far more important than a business plan or financial model for a very early-stage company.
Never forget the simple notion that if you want money, ask for advice.
The “slow no” is the hardest to figure out. These VCs never actually say no, but are completely in react mode. They’ll occasionally respond when you reach out to them, but there is no perceived forward motion on their part. You always feel like you are pushing on a rope—there’s a little resistance but nothing ever really moves anywhere. We recommend you think of these VCs as a “no” and don’t continue to spend time with them.
While the VC firm goes through its diligence process on you, we suggest you return the favor and ask for things like introductions to other founders they’ve backed.
Anything other than a straight participating preferred security, such as multiple preferences, is just greedy on the part of VCs and should be a red flag to you about the investor.
In a pay-to-play provision, investors must keep participating pro-ratably in future financings (paying) in order to not have their preferred stock converted to common stock (playing) in the company.
The pay-to-play provision impacts the economics of the deal by reducing liquidation preferences for the nonparticipating investors. It also impacts the control of the deal since it reshuffles the future preferred shareholder base by ensuring that only the committed investors continue to have preferred stock and the corresponding rights that go along with preferred stock.
Make sure that you understand the future funding dynamics of your VC partner and treat them accordingly.
What you want to avoid is a pay-to-play scenario where your VC has the right to force a recapitalization of the company (e.g., a financing at a $0 pre-money valuation, or something suitably low) if fellow investors don’t play into a new round.
Conversion to common for lack of follow-on investment is appropriate.
Consider alternative strategies such as allowing you to purchase your unvested stock at the same price as the financing if you leave the company, protecting your position for a termination “without cause,” or treating your vesting as a clawback with an Internal Revenue Code Section 83(b) election so you can lock in long-term capital gains tax rates early on.
Once stock is vested, a holder may exercise the option by paying the purchase price to the company. In other words, if you have an option for 1,000 shares of stock at $0.10 a share, you can pay $100 to the company (after all the shares have vested) and own the stock outright.
We advise you not to get hung up in trying to eliminate antidilution provisions. Instead, focus on minimizing their impact and building value in your company after the financing so they don’t ever come into play.
Regardless of the actual thresholds, it’s important to never allow investors to negotiate different automatic conversion terms for different series of preferred stock.
We strongly recommend that you equalize the automatic conversion threshold among all series of stock at each financing.
Understand what the norms are for new IPOs before you dig your heels in on conversion terms.
Obviously, the dividend could drive additional dilution if it is paid out in stock, so this is the one case in which it is important not to get head-faked by the investor, where the dividend becomes another form of anti-dilution protection—one that is automatic and simply linked to the passage of time.
The thing to care about here is ensuring that dividends have to be approved by a majority—or even a supermajority—of your board of directors.
We recommend you never agree to the following term that has recently crept into term sheets: Adverse Change Redemption.
As with dividends, just make sure you have maximum protection around your board, or all classes of preferred shareholders voting in aggregate, and not just the majority of a random class of shareholder declaring these.
Try to avoid conditions precedent to financing as much as possible. Again, the best Plan A has the strongest Plan B standing behind it. Your prospective VC should be willing to move quickly and snap up your deal on acceptable terms by the time the VC gets to a term sheet. At a minimum, do not agree to pay for the VC’s legal fees unless the deal is completed (with a possible carve-out for you canceling the deal).
When signing a term sheet, always ask your VC whether the terms have been approved by the partnership or if there is another approval step in the process. Be cautious of agreeing to go forward exclusively with a VC in situations where you still have additional approval steps in their partnership process.
It’s probably wise to understand and negotiate the form of employment agreement early in the process. You’ll want to try to do this before you sign a term sheet and accept a no-shop clause.
Insist on spelling out key terms prior to a signed term sheet if it has a no-shop clause in it. A VC who won’t spell out key employment terms at the beginning is a big red flag.
Insist on a strict confidentiality clause to accompany your information rights.
Don’t focus much energy on registration rights. This is more about upside. The world is good if you’re going public.
A more important thing to watch for is a multiple on the purchase rights (e.g., the “[X] times” listed). This is often referred to as a super pro rata right and is an excessive ask, especially early in the financing life cycle of a company.
ROFR on common is a good thing for the company and should be supported by the founders, management, and investors. Controlling the share ownership in a private company is important, especially as the Securities and Exchange Commission (SEC) takes a closer look at various private shareholder rules—both regarding ownership and stock sales. The ROFR on common gives the company the ability to at least know what is going on and make decisions in the context of the various proposals.
A proprietary information and inventions agreement clause is good for the company. You should have all employees, including founders, sign something like this before you do an outside venture financing. If someone on the team needs a specific carve-out for work in progress that is unrelated to the business, you and your investors should be willing to grant it.
Your chances of eliminating the co-sale agreement clause may be zero, but there’s no reason not to ask for a floor to it. If you or your cofounders want to sell a small amount of stock to buy a house, why should a VC hold it up? A right of first refusal on the purchase with a bona fide outside offer’s valuation as the purchase price is one thing. An effective exclusion is something entirely different.
The entrepreneur should bound the no-shop agreement by a time period—usually 45 to 60 days is plenty, although you can occasionally get a VC to agree to a 30-day no-shop agreement.
As an entrepreneur, you should also ask that the no-shop clause expire immediately if the VC terminates the process. Also, consider asking for a carve-out for acquisitions. Frequently financings and acquisitions follow each other around. Even if you’re not looking to be acquired, you don’t want handcuffs on conversations about an acquisition just because a VC is negotiating with you about a financing.
You should have reasonable and customary D&O insurance for yourself as much as for your VCs. While the indemnification clause is good corporate hygiene, make sure you follow it up with an appropriate insurance policy.
Don’t let the loophole “assignment without transfer of the obligation under the agreements” occur. You need to make sure that anyone who is on the receiving end of a transfer abides by the same rules and conditions that the original purchasers of the stock signed up for.
To attract seed-stage investors, consider a convertible debt deal with two additional features: a reasonable time horizon on an equity financing and a forced conversion if that horizon isn’t met, as well as a floor, not a ceiling, on the conversion valuation.
If you are an entrepreneur, check out what the applicable federal rates (AFRs) are to see the lowest legally allowable interest rates; bump them up just a little bit (for volatility), and suggest whatever that number is.
We can’t opine more strongly that all warrants should expire at a merger unless they are exercised just prior to the transaction. In other words, the warrant holder must decide to either exercise or give up the warrants if the company is acquired. Acquiring companies hate buying companies that have warrants that survive a merger and allow the warrant holder to buy equity in the acquirer.
In no case should an entrepreneur let an investor double dip and receive both a discount and warrants.
VC’s will charge all reasonable expenses associated with board meetings to the company they are visiting.
One important thing to understand about your prospective investor’s fund is how old the fund is. The closer the fund is to its end of life, the more problematic things can become for you in terms of investor pressure for liquidity (in which your interests and the investor’s might not be aligned), or an investor requirement to distribute shares in your company to LPs, which could be horrible for you if the firm has a large number of LPs who then become direct shareholders.
You should understand how much capital the firm reserves for follow-on investments per company, or in the case of your company in particular. If you think your company is likely to need multiple rounds of financing, you want to make sure the VC has plenty of “dry powder” in reserve for your company so you don’t end up in contentious situations down the road in which your investor has no more money left to invest and is then at odds with you or with future investors.
CVCs often look for more control, such as a first right of refusal on an acquisition (something you should never, ever give).
A performance warrant is an option for the strategic partner to buy stock in your company (usually common stock) at a set price (often the most recent financing round price). Unlike a regular warrant, the performance warrant is issued only when the strategic investor accomplishes predetermined performance goals. In this situation, if they perform, you reward them with the performance warrant. If they don’t perform, they still received their equity in exchange for their investment, but they didn’t get the extra equity they were looking for.
There are only three things that matter when negotiating a financing: achieving a good and fair result, not killing your personal relationship getting there, and understanding the deal that you are striking.
You can learn a lot about the person you are negotiating with by what that individual focuses on.
When you are going to negotiate your financing (or anything, really), have a plan. Have key things that you want, understand which terms you are willing to concede, and know when you are willing to walk away. If you try to determine this during the negotiation, your emotions are likely to get the best of you and you’ll make mistakes. Always have a plan.
Game theory is a mathematical theory that deals with strategies for maximizing gains and minimizing losses within prescribed constraints, such as the rules of a card game. Game theory is widely applied in the solution of various decision-making problems, such as those of military strategy and business policy. Game theory states that there are rules underlying situations that affect how these situations will be played out. These rules are independent of the humans involved and will predict and change how humans interact within the constructs of the situation. Knowing what these invisible rules are is of major importance when entering into any type of negotiation.
One successful negotiating tactic is to ask VCs up front, before the term sheet shows up, what the three most important terms are in a financing for them. You should know and be prepared to articulate your top three wants as well. This conversation can set the stage for how you think about negotiating down the road, and it can be helpful to you when you are in the heat of a negotiation. If the VCs are pounding hard on a point that is not one of their stated top three, it’s much easier to call them out on that fact and note that they are getting most or all of their main points.
Don’t ever forget that a good tactic is to change your game plan suddenly to keep the other side on their toes.
Having a solid Plan B (and a Plan C, and a Plan D . . .) is one of your most effective weapons during the negotiation process. It’s helpful to be reasonably transparent about that fact to all prospective investors. While it’s a good practice to withhold some information, such as the names of the other potential investors with whom you’re speaking since there is no reason to enable two VCs to talk about your deal behind your back, telling investors that you have legitimate interest from other firms will serve you very well in terms of speeding the process along and improving your end result.
If you can get VCs to approve a financing around the same time, you’re in a much stronger position than if you have one term sheet in hand that you are trying to use to generate additional term sheets.
Don’t ever show your actual term sheets to other investors. Never disclose whom you are talking to.
Never provide a term sheet to a VC, especially with a price attached, since if you do you’ve just capped what you can expect to get in the deal. You are always in a stronger position to react to what the VC offers, especially when you have multiple options. However, once you’ve gotten a term sheet, you should work hard to control the pace of the ensuing negotiation.
In general, once you are a skilled negotiator, going in order is more effective, as you won’t reveal which points matter most to you. Often, experienced negotiators will try to get agreement on a point-by-point basis in order to prevent the other party from looking holistically at the process and determining whether a fair deal is being achieved.
You can’t lose a deal point if you don’t open your mouth.
Don’t concede points. Listen and let the other party know that you’ll consider their position after you hear all of their comments to the document.
There are ways to mitigate issues of board and voting control, such as placing a cap (early on) on the number or percentage of directors who can be VCs as opposed to independent directors, preemptively offering observer rights to any director who is dethroned, or establishing an executive committee of the board that can meet whenever and wherever you’d like without everyone else around the table.
By the time someone is offering you a lot of money to buy your company, you should have good counsel or advisers or independent board members to help you navigate the terms. The structure of the deal is very important. You should be willing to stand behind your representations and warrantees with a reasonable 12- to 18-month escrow at a minimum. If you can’t, you look like you’re hiding something. Management retention pool, working capital, and earn-outs are just negotiation points around the certainty and price of a deal.
As long as most of your reps and warranties are qualified by a phrase like “to the extent currently known . . .,” you should have no problem signing them. Arguing against them is a big red flag to investors or buyers.
Once buyers are in a significant legal and due diligence process with you, they are as emotionally and financially committed to a deal as you are (and in many cases, their reputation is on the line, too).
As with no-shops with VCs, no-shops with potential buyers should also have an automatic out if the buyer terminates the process.
We decided never to be shareholder reps again, as we see no upside in taking on this responsibility.
When entering a contractual relationship, consider that all good contracts minimize current and future transaction costs.
We suggest that you negotiate a detailed merger letter of intent (LOI) before signing it in order to avoid too much negotiation ambiguity while drafting the definitive documents. As you have more negotiating power during the LOI stage, what would take two hours to negotiate now could save you tens of hours later. In short, you are defining the relationship up front so that you don’t have to run up huge costs, both in time and money, figuring out who has which rights and who receives what consideration.
You don’t own the code unless you get whoever wrote the code to sign a document saying that the code was “work for hire.” Those exact words are critical.
Make sure that everyone you hire is an at-will employee. Without these specific words in the offer letter, you can end up dealing with state employment laws (which vary from state to state) that determine whether you can fire someone.
Every entrepreneur should know at least one good employment lawyer.
Delaware is common because corporate law for Delaware is well defined and generally business friendly, and most lawyers in the United States are adept at dealing with Delaware law. If you are planning on ultimately having an initial public offering (IPO), most investment bankers will insist on your being incorporated in Delaware before they will take you public. More importantly, lots of obvious things that are difficult or not permitted in some states, such as faxed signature pages or rapid response to requests for changes in corporate documents, are standard activities in Delaware.
The only two disadvantages of being incorporated in Delaware are that you will have to pay some extra (but very modest) taxes and potentially comply with two sets of corporate laws. For instance, if you are located in California and are a Delaware corporation, you’ll have to comply with Delaware law and some of California law, too, despite being a Delaware corporation.
If you are not going to raise any VC or angel money, an S Corp is the best structure as it has all the tax benefits and flexibility of a partnership—specifically a single tax structure versus the potential for the double tax structure of a C Corp—while retaining the liability protection of a C Corp.
Often, an LLC (limited liability company) will substitute for an S Corp (it has similar dynamics), although it much harder to effectively grant equity to employees. Instead of stock options, LLCs use membership units, which few employees have experience with. In addition, stock options have better and more clearly defined tax dynamics. LLCs work well for companies with a limited number of owners. They don’t work as well when the ownership starts to be spread among multiple people.
If you are going to raise VC or angel money, a C Corp is the best (and often required) structure. In a VC-/angel-backed company, you’ll almost always end up with multiple classes of stock, which are not permitted in an S Corp. Since a VC-/angel-backed company is expected to lose money for a while (in most cases that’s the expectation for why you are raising money in the first place) the double taxation issues will be deferred. In addition, it’s unlikely that you will be distributing money out of a VC-/angel-backed company when you become profitable.
Nonaccredited investors can force you to buy back their shares for at least their purchase price anytime they want, despite how your company is doing. This right of rescission is a very real thing that we see from time to time.
If you don’t file an 83(b) election within 30 days after receiving your stock in a company, you will almost always lose capital gains treatment of your stock when you sell it.