B20 – Let’s Order Venture Deal #41

Have you ever organized a dinner at a restaurant with friends and you all are in the mood for a bottle of wine?

All of a sudden there is subdued, organized chaos. Each person looks at the menu calmly and pretends to read it like these names on there are recognizable, only to pass it to the next person. And now…that next person is you–and well, you did organize the dinner. So, you decide it’s time to put on the big kid’s shoes and order for the table despite knowing very little about wine.

What do you do? Ask what color the group prefers? Pick a trendy region you really “love” but only because that’s based on what you heard or the last bottle you drank? (I mean, all wine from a region is the same right) Do you ask what meal people are having to try and pair the wine with that to help narrow the options?

(Although I’m told by former tasting director of Wine and Spirits Magazine Philippe Newlin you should start with the wine and then pair food with that wine, not the other way around…Sure, as long as you’re pouring some awesome wine you’re sharing with us, I’ll nod in agreement to whatever wine-related thing you say)

But seriously the waiter is here now, so what do you do?

Maybe try to impress your friends and casually proceed to order, mispronouncing an Italian vineyard or if foresight is on your side and you prefer not to butcher the foreign language, you pick that number printed next to the name, “Yes, we’ll have #41 on the list”…and naturally you made sure #41 was neither the cheapest nor remotely close to the most expensive.

Sound familiar?

Please tell me I’m not the only one guilty of this…

But hey, everyone was looking to you to get the wine, and you did…without knowing much of anything, you suavely stepped up and procured vino for the table. Now the group can sit at ease, going back to what they were doing, knowing the wine will be coming and you handled it. Chaos averted. Let’s hope it works out…

This same situation applies to venture deals.

You manifested your vision converting your passion and effort into an MVP and a team to get it there. Things are looking up. It’s time to take off those bootstraps and move on up, the funds are running out. Time to raise capital.

Your team is there working; quietly, anxiously waiting for you to pull in funding so they can continue to do what they do best with a sigh of relief and momentary job stability.

You step-up and start fundraising. But who do you go to? Well I know this VC fund is really prestigious. I know that Silicon Valley is a great region to go to. Here’s a list of VC’s, this one emailed me back, let’s go with that one.

Money is money right? It’s just a number in your bank account.

Nothing could be further from the truth. Money comes with strings. Good and bad. These strings can rip away the company from you and it can pull you and your startup to new levels with access to key advisers, industry experts, and exclusive introductions. These strings also define how your company will act going forward and how much (or little) you will make in an exit. They matter…a lot.

The strings are the deal terms with which the other side is attached to the venture capitalists.

Further, not all deals are the same deals. It’s hard enough as it is to create a successful company, don’t screw it up with a misstep here.

You have created a perfect setting to eat a wonderful dinner with friends, don’t mess it all up by picking a lousy bottle of wine.

Learn your wines. Learn your deal terms.

There’s no better place to start than with Brad Feld’s Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist

When dealing with investors, especially VCs, it is crucial to understand who you are dealing with, their preferences, how to market to them, what you want out of the deal, and to make sure you understand what type of deal you are getting. From getting investor money to selling the company, these principles apply at all stages.

Two key things that matter in the deal: money and power
- VCs usually own less than 50% of the company but have provisions that give them control over major decisions
Players: entrepreneur, VC, Angel Investor, Lawyer, and Mentor
- Lawyers: they work for you, so ultimately you direct and control them
  - They are a reflection of you, don’t let VCs pick one for you
  - Typically they cap their fees in advance of the deal because if they take you on, should be because they think the deal will go through
    - So insist on lower cap of fees, if unwilling, question it
  - Investors: they know the co-founder relationship often frays, so they include provisions to allow it to be a very clean break if someone does leave
  - VC: as entrepreneur find out who you’re working with and insist on developing a relationship with a MD or GP as well
    - Managing direct/general partner: make final investing decisions and sit on board
    - Principles/Director: some power, but no final decision
    - Associate: work for partners, usually 2 years then go to get MBA, start own company, etc
    - Analyst: crunch numbers and write memos—recent grads
  - Angels: could consider making them all a part of a special purpose LLC with 1 assigned as key decision maker so don’t have to chase down 75 signatures for something
  - Syndicate: many VCs (or other investors) teaming up with “lead investors” usually 2 people that make decisions all investors agree upon
    - Even thought they are the leaders, make sure to communicate to all people invested
  - Mentors: no fee (vs. advisor which is a fee), want to help
    - No reason not to give a small success fee if they help raise money…except illegal
  - How to raise money
    - Have mindset when raising money that you will succeed (when not if)
      - No “trying to test the waters” exploring different options, etc
    - Figure out how much money you need to raise (a figure not a range) you can always raise more later
    - Models: will be wrong, but only thing you can control is your burn rate (expenses), so really it is “how much time does this buy you?” not when will you become cash flow positive
    - Give yourself a time cushion to get to a clear point of demonstrable success
      - But not more than need, because if “closer” to goal, more people likely to invest to put it over the top than going, oh you have a long way to go
    - Tools: know your audience/investors preferences
      - Short description: elevator pitch
        
        1-3 paragraphs to describe the product, team, and business very directly
      - Executive summary: focus on content 1-3 pages
        
        First impression, more you can put in there, more looks like thought it out
        
        What problem are you solving, why is it important, why product is awesome, why you are THE team to do it, include high level financial analysis to show aggressive yet sensible expectations of company
      - PPM: time consuming and expensive, could be a sign wasting money
      - Prototype: toy example, people like playing with things
        
        It’s expected to have bugs, be under featured, etc
        
        Use it as part of story
      - Power point: 10-20 slides usually presenting executive summary
        
        form/presentation matters especially with consumer facing product
      - Business plan: sometimes not read and ignored, 30 pages like a 10k
    - First contact: short description in body + exec summary attached
    - What VCs care about: in 10 or fewer slides
      - Problem you are solving
      - Size of opportunity
      - Strength of team
      - Level of competition/competitive advantage
      - Plan of attack
      - Current Status
        
        Add summary financials, milestones, and use of proceeds
      - When close deal: get term sheet, but also when receive cash
        
        Control your lawyer and make sure he knows which points are most important to fight for
      - Detailed financial modeling
        
        Know it will be wrong
        
        Investors are pleased when company earns revenue sooner
        
        Expense side is key, also insight into what you think/know about the industry
        
        You should be able to manage expenses exactly as planned
        
        Care about
        
        Know their style, talk to other companies they invested in, learn about their mistakes and how handled (fire CEO, etc)
        
        Research them via social media, follow them, post on wall (give before get)
        
        When want to ask for money, first ask for advice
        
        Assumptions for revenue (can talk in person, no need for spreadsheet)
        
        Monthly burn rate of the company
  - Make sure to lag increase in spending behind expected growth rate
    - Such as change in headcount
- Research VC
  - Find lead VC
    - Don’t worry about “no’s”
    - Worry about “slow no’s”: don’t seem uninterested, but doesn’t move things forward ever, just move on from them
    - Be careful of a VC that’s hotly interested in you, then cools, just move on
    - If VC passes on you, politely ask for feedback in why didn’t invest
  - Term Sheet: critical blueprint of how interaction will go
    - Two things VCs care about: economics and control
    - Way a VC handles terms negotiation indicates how he will be as a board member, etc
    - Founders: Get common Stock
    - VCs: preferred stock from equity purchase
      - Seed round, Series A, Series B, etc
    - Economic Terms of the Term Sheet
      - Prices: hive multiple Vcs interested and figure out BATNA
        
        Don’t take valuation seriously, sometimes VCs play tricks with pre/post money, so if ever unsure, have them “spell it out”
        
        Premoney: value of company without new investments
        
        Postmoney: value of company with new investments
      - Fully diluted: assume exercising of all option/employee pools
        
        If large pool size premoney, equivalent to removing its value from old investors and giving more to newer investors
        
        Can fight pool size, negotiate on pre-money valuation, or pool gets bigger post-money
        
        Have detailed pool option with you at negotiation
      - Warrants: investor can buy “x” shares for “y” years at predetermined price
        
        Very complicated, try to get them to agree to a lower valuation without it
      - Bridge loan: new round financing, 1 investor gives money for convertible deb which converts when round gets financed, because took risk so gets discount on equity or warrants that grant discount
      - If no new investors, might have a flat or down round
      - Criteria investors look at
        
        Early on: entrepreneur’s experience, money being raised, perception of opportunity
        
        Later on: more on historical performance
        
        Both: how competitive you get VCs to be about your company, VC’s natural entry point, numbers, current economic climate
      - Liquidation preference: proceeds are shared in “liquidating event”
        
        Transfer of ownership or sale of substantially all assets (not IPO)
        
        Explains money returned to a particular series of stock ahead of other series at a certain multiple
        
        Full participation, capped, and none
        
        Big impact on low cash out and subsequent rounds
        
        Full participation: as converted: assume converted all to common stock
        
        Capped: share until reach multiple, then stops
        
        Stacked preference: series B gets before A
        
        Blended: pro-rata proportion
        
        Best early on to have simple liquidation and no participation because future rounds are what previously got plus some
        
        Kickouts: no participation of hit certain return
      - Pay to play
        
        Usually relevant in down round, if don’t put up more money, preferred converts to common
        
        Only for next round of financing if other investors agree as well to pay to play
        
        Good for investors and company: forces investors to stand behind company in troubling times, otherwise lose benefits of preferred and reduces liquidation preference
        
        Avoid where VC can force recapitalization (at pre-money), recap hurts you too, you have to re-vest
      - Vesting: usually 4 years, 1 year cliff (get 25% after year 1), other 3 years get 1/36^th per month
        
        Sometimes founders given 1 year head start (some VCs are very particular
        
        If founder/employee leaves before fully vested = reverse dilution
        
        If a founder: each remaining shareholder’s stake increases
        
        If an employee: it just goes back to the employee pool
        
        Might allow person to pay for unvested shares at same price of round of financing
        
        Protect person from termination without cause
        
        Allow self long term capital gains tax rate (claw back)
        
        Merger
        
        Single trigger: upon merger gain remaining unvested equity
        
        Double trigger: merger and firing: much more common and allow more motivation for employee to stay on and do well for company (otherwise put in place another employee retention incentive)
        
        Employee Pool
        
        Amount company reserves for future issuance to employees
        
        Have larger pool come post money, otherwise give new VC more than he pays for
        
        Anti-dilution
        
        Protects investors if company issues equity at lower valuation than in previous rounds
        
        Ratchet based: as soon as one share is issued at lower price, all older share prices that investors get are at this price
        
        Weighted Average: lowered old prices by weighted average of change of new prices
        
        Usually create a conversion price adjustment when convert/sell (not creating more shares)
        
        Broad based: all shares plus stock plus warrants, etc.
        
        Narrow based: just preferred converted and common
        
        Carve outs: issuing lower than previously priced shared
        
        Not applicable to certain shares
        
        Option pool, equipment loan, merger, majority shareholder rights
        
        Usually granted at a lower price
        
        Hurts series A investors but motivates them to get higher valuation, but that is short term, might not be good long term
        
        Can have anti-dilution provision where company has to hit certain target, otherwise dilute stock (bad approach)
      - Control Terms
        
        VCs: usually have less than 50% equity, but a variety of terms that give them control of decisions
        
        Some are awful board members, even if they are good investors/nice people
        
        Board: 2 picked by investors, 2 by founders/common stockholders, 1 mutually consented
        
        Decide how issues are voted upon: is board 1 person 1 vote, or based on proportional share ownership on a common-as-converted basis
        
        Observers: no vote, but they sway the discussion and minds of board, so be wary
        
        Rarely board get cash compensated, outside board members may get stock options and invited to vest
        
        Protective provisions: effectively veto rights on certain actions
        
        Change terms of stock owned
        
        Authorize creation of more stock
        
        Issue stock senior to or equal to VC
        
        Buyback any common stock (good for VCs)
        
        Sell the company (critical piece): if series A holds enough to be relevant
        
        Change size of board (critical): same as above
        
        Change certificate of incorporation/by laws
        
        Pay or declare dividend
        
        Borrow money (try for a higher limit or exclusion for equipment)
        
        Some ask for “material” clause: materially change certain things
        
        Doesn’t recommend because then debate is on what’s material and usually VCs will go along with it
        
        Series B: many want different rights as A, but keep them similar to avoid conflicting interest and complexity
        
        Be wary of too high thresholds to allow small stakeholders to veto (such as a 90% approval rating)
        
        As long as capitalization table is rational, fight to keep 1 class of stock
        
        This contract is not about “trust” but eliminating ambiguity and making guidelines for the company
        
        Not about 1 VC but for all investors now and future
        
        Protective provisions may help because when negotiating for a buyout, founders know VC won’t accept low terms
        
        Drag-along rights: force all to agree to sale of company (prevents those who are “out of the money to block it”)
        
        Majority of each class (in CA)
        
        Majority of shares on as-converted basis (Delaware)
        
        Most still want 85-90% to agree on sale
        
        Compromise: only majority of common stock, not preferred
        
        Matters most if things are falling apart
        
        Conversion: convert to common stock at a liquidation preference or to control a vote
        
        Because they would get more as common stock participating
        
        Most time VCs/Lawyers say things are “non-negotiable” when really they are, this is negotiable
        
        When VCs say that or based on “how we do things” it is a sign that they don’t really know/are inexperienced
        
        Automatic conversion: on IPO, create thresholds but not differing thresholds, but most I banks won’t back it if there are preferred shares, except Google, and now it’s more common
    - Capitalization table
      - Work backwards to figure out: founders, employee pool, venture investors
        
        Shares, preferred price, valuation, and percentage
      - Known shares of founders, post money valuation, employee option pool percentage and percentage of co-investors, get founders at post-money valuation
      - Calculate: percent founders shares represent, total shares for the round, shares for employee pool, et
      - Have shares go out to 2 digits and recalculate to make sure all adds up
- How VCs work
  - Management company owned by senior partners
    - While funds end, management company stays
  - LP: where money is
  - GP: partners or entity per fund that MPs have share in
    - Usually a 99-1 or 95-5 of money invested split to have investors own skin in the game
  - VCs raise money from institutions so they understand the pains of raising money
    - Have their own LPAs: Limited Partnership agreements
  - When say raise $100M, doesn’t mean they have it in the bank, but capital call
    - Legally binding agreement to get money to VC within 2 weeks
      - When fails because investors scared, failing business, or cash flow issues
      - Can sell their stake in secondary market
    - VCs make money
      - Management fee: 1-2.5% AUM to pay all expenses and salaries
        
        15% over life of fund (10 years)
      - Commitment period: first 5 years of fund to invest in new companies
        
        Can put in more money in existing investments later
        
        Higher fee during this time
      - More funds means greater salary for senior managers
      - Carried interest: gets 20% of sale after returning the original investment
        
        Want fund to “recycle” their management fee to put all investments to work, but this creates a potential cash flow issue
      - If they take a cut halfway through and then lose money, they have to payback that money
      - Reimbursed for reasonable expenses to go to board meetings
    - After commitment period: raise new funds for new fund to generate more cash
      - Those who don’t are “zombie funds”: act like they will invest but won’t invest because they can’t
      - Keep in mind pay to play, if VC is locked up with no cash, they will fight to prevent new financing to protect their investment
    - Over reserving is okay compared to under-reserving, but both the cash is not used effectively
    - Cash Flow issue: cross investing: other fund invests to keep interest in company
      - Creates misalignment of returns if down or flat round
    - Departing partners: “key man” means can stop new investments or shut down the fund
      - So understand the dynamics of the firm
    - Fiduciary duty: even if VC is your buddy, he still has to do what is in the best interest of investors
    - Talk to VCs if you are uncomfortable about something, it will save hassle down the road
    - No one anticipated funds to go on as long as they currently go (12-17 years), so all under reserved and putting money back from successful acquisitions back into the fund (can have investors vote to extend the duration)—other option is getting a bunch of random shares in private companies that can’t be sold
- Negotiation tactics
  - 3 key things
    - Achieve a good and fair result
    - Not ruin the relationship
    - Understanding the deal you are making
  - Not a single instance game: need to play nice
    - A lot of terms don’t matter until the exit
    - Financing is just begging of the relationship
    - Both sides should feel lucky and that it was fair
  - Pick a few items that care about and those don’t really care and can concede on
  - PLAN ahead
  - Prepare: what you want, what willing to give, when to walk away
  - Research: the VC, what he likes, kiss up and schmooze
  - Your advantage: time—you have 1 deal to focus on, VCs have many and kids
    - Time it where VC has to leave or ask to explain parts, etc. to draw out the process
    - Biggest advantage is to have a plan B: BATNA
  - Ask VC upfront what their most important terms are
    - Always have them give first offer
- Styles of people
  - Bully: not smart so yells
    - Either out bully or be very mellow
  - Nice Guy: like a used car salesman
    - Emotional and try to be your friend
    - Always says “let me consider that” never an answer
    - Be direct with him and might try to be a bully with him
  - Technocrat: billion problems and can’t focus on one
    - Just bear it, cover aspects as a whole, not 1 by 1
  - Wimp: negotiate both sides: might not be best investor for you if just going to stand there and let you determine it all
  - Curmudgeon: everything sucks, can’t please no matter what try
    - Be patient, upbeat, and tolerant
  - Always be honest and transparent because it is a multi-round game
  - Can change the game plan to keep people on their toes
  - Don’t make a threat you aren’t willing to backup
  - Have competing offers, time it right, don’t tell who other VC is, but be honest that have other VCs interested
  - Don’t present own term sheet to VC, have them present theirs
  - Don’t go point by point if novice, if have to say something, say “will consider it” and get back to it”
  - Never assume they have the same ethical code you do
  - “That’s the way we always do it” means person is a weak negotiator
    - Make prove why “standard” applies to you
- Raising money the right way
  - Don’t ask them to sign an NDA–is you idea really that fragile and unprotected? Many lawyers will argue against not asking them to sign…most likely they just won’t
    - Prevents them from talking to other VCs
    - VCs won’t steal idea because of time, reputation, etc
  - Don’t spam VCs with template emails: they know
  - No often means no: doesn’t mean it’s a stupid idea, just means no
    - If get no, don’t ask for referral (puts them in a conflict), except if have relationship with VC and not right company size (not issue of idea)
  - Solo founder: red flagàcan’t do it all by yourself, can’t sell others to join you, no “team” to invest in
    - Exception: repeat entrepreneur and will get a team post-funding
  - Don’t overemphasize patents in software because easy to go around them

Share with your tribe: