Notes from Venture Deals (Brad Feld, Jason Mendelson) – Part I

In a hurry? Just skim over the italics in this post – they represent key dos and don’ts for founders. Part II of the post is here.

Resources

Term Sheet

  • Typically 8-ish pages (~2012).
  • Two key aspects, everything else is secondary, don’t waste too much time on other terms:
    • Economics terms
    • Control terms.
  • Signs of the VC not being entrepreneur friendly appear during the term-sheet negotiations.

VC History

  • Early VC example: AR&D:  70k for 78% of the company. Post-money valuation becomes 90k.
  • Individual VCs today own less than 50%, no effective voting control. They negotiate provisions that give them control over the major decisions made by the company.
  • VCs investing at different stages in the company => different ownership percentages, varying rights, diverging motivations.
  • Founders should direct and control the process of financing – leave as little as possible outsourced for the lawyer.
  • Capitalization-table (Cap Table): spreadsheet that defines the economics of the deal.

VC hierarchy

  1. MD/GP: Managing Director or General Partner. They make the final decisions and sit on the boards of the companies they invest in. Prefixes “executive” or “founding” may be applied to indicate seniority.
  2. Principal/Directors: Have deal responsibility, need a MD involved to take the final decision. These are junior partners making their way up to MD.
  3. Associates: Not deal partners, they work for the partners. They do: scout new deals, due diligence on existing deals, write internal memos about prospective investments. Associates likely spend the most time with the cap table.
    – Many VC firms have a 2 year associate program – after that, the associate leaves to go to B-school, work for a portfolio company or start up her own company. Star associates may go on to become principals.
  4. Analysts: Bottom of the ladder, crunch numbers and write memos.
  5. Other people involved in VC:
    1. Venture partners/Operating Partners: Experienced entrepreneurs who have a part-time relationship with the VC firm. May take an active role in managing the investment as chairman or board member.
    2. EIR (Entrepreneur in residence): Experience entrepreneurs who park themselves at a VC firm while figuring out their next company. Help the VC with intros/networking and due diligence. Last 3-12 months typically. Some VCs pay the EIR , some just offer office space and an implicit agreement to fund the next company.

What information does an entrepreneur need about the VC firm?

  • Who am I talking to?
  • What kind of decision-making power does the person have?
  • What process do we go through to get the investment approved?
  • Best source for this info:
    • Talk to other entrepreneurs who the VC has funded in the past.
    • Piece together what you can from the VC firm’s website.
    • Less likely to get completely accurate information talking to folks down in the hierarchy of the VC firm.
    • Insist on developing a direct relationship with an MD or GP.

Angel Investors:

  • Active in the seed stage.
  • Can be professional investors, successful entrepreneurs, friends or family members.
  • Figure out if the VC is comfortable investing with angels.
  • All VCs don’t share the same view of angels.
  • Not all angels are created equal.
  • Pay-to-play and drag-along rights are designed to help VCs force a certain type of behavior on the angels (and other VC investors) in the difficult financing rounds.
  • Angels are typically HNIs. SEC rules require them to be accredited investors. Founders should make sure this is true – each of the angels should be accredited or have an appropriate exemption.
  • Super angels:
    • “Promiscuous” angels who make a lot of small investments. Typically these are people out of startup exits themselves.
    • When super angels raise funds themselves, they are micro VCs. Have the same fiduciary responsibility as VC

What the founder needs to keep in mind with angels

  • Angels shouldn’t be in a position to determine the company’s direction.
  • Set up a special purpose limited-partnership controlled by one among the group of family and friends. This will be a vehicle for them to invest. This avoids you having to chase many signatures in the next financing round or while selling.
  • Don’t make social meetings with family and friends an investor-relations meeting. They should treat their seed contribution as a lottery ticket.

Syndicate

  • Collection of investors. Includes anyone that ends up purchasing equity in the financing.
  • Has a lead investor. Typically it is one of the VCs. There may be two or three co-leads.
  • Lead in the syndicate negotiates terms for the entire syndicate with the founder.
  • Its the founder’s responsibility to communicate with each and every investor during the process – don’t assume the lead will do so.

What the founder should do dealing with a syndicate

  • Make investors agree that the lead speaks for the whole.
  • Don’t negotiate the same deal multiple times (by-product of the above line).

Lawyers

  • A lawyer experience with VC financings is invaluable. Founder should have one to arm against the imbalance (VCs do financing all the times, even the most experienced founders have seen very few financings).
  • Avoids the founder getting hung up on subtleties that a VC has thought through many times.
  • Good lawyer avoids the founder from being distracted over insignificant negotiation terms.
  • Bad/Inexperienced lawyers will focus on the wrong issues – running up the bill on both sides.
  • The lawyer affects the founder’s reputation.
  • Lawyer fees (as of 2012): Fees can be capped ahead of the bill, though they bill by the hour. Early (seed?) stage for 5-15k. Typical financing: 25-40k. Costs increase if you have items to clean up from the past.
  • Standardization in documents has ensured that lawyer fees stay the same as a decade ago despite doubling of hourly fees (lawyers are spending less time on the deal).
  • A good entrepreneur can ensure that the lawyer be paid out of the proceeds of the deal.

Mentors

  • Every entrepreneur should have a group of these. Helps if they know the VC.
  • Stay away from “advisors” who offer to help raise money and then take a cut of the deal as compensation.
  • Most great mentors do it because they enjoy it. Having fees isn’t required, though a share in equity could help cut off the obligation on the founder’s part. Use options, as long as you have control over the vesting of the options based on the mentor’s performance as an advisor. ([KR]: Advice about equity for mentors reinforced by several folks like DP).

What the founder should do while fund-raising

  • Pre-assume success. Don’t meet an investor saying “trying to raise money”, “testing the waters” or “exploring different options”.
  • Determine how much you are raising. Focus on a length of time you want to fund the company to get to the next meaningful milestone.
    •  Don’t exceed what you need. Bad situation to have: you want X, VC is interested in you, but only wants to invest X/4. They won’t because they don’t know yet where the remaining comes from.
    • Instead, try to create a situation like: I need X, I have 3X/4 and I have room for one or two more investors.
  • Give a specific number. Don’t give ranges like 5-7 million – makes you immature in front of the VC. Determine what you need and give that specific number, you can always end up raising more.
  • Fund-raising materials:
    • Elevator pitch – a few paragraphs you can email, not to be confused with executive summary.
    • Executive Summary – 1-3 page of idea, team, product and business.
    • Powerpoint presentation (legacy thing).
    • Business plan or Private Placement Memorandum (PPM): More common in late stage investments.
    • Demos/Prototypes – good VCs always like and prefer these. Especially needed for early-stage companies.

Tips:

  • Quality of presentation matters, but don’t overdesign.
  • Work hard on the executive summary – its the first impression, it is what gets passed around in the VC office and it will be used to judge how deeply/critically you’ve thought of your business and how good your communication skills are.
  • Executive Summary content:
    • What problem are you solving, why is it important?
    • Why is your product awesome, and better than what’s on the market?
    • Why is your team the right one to pursue it?
    • High-level financial data. Have sensible expectations.
    • Exec summary is what you should follow up with if you meet a VC for coffee or at a conference.

Presentation

  • Recognize your audience (single partner, full VC firm, or 500 investors at a demo day event?) and tune your presentation accordingly.
  • Well-designed and well-organized slides are more important for a consumer facing product.
  • Invest in a good designer for this.
  • Most good presentations are done in 10 slides or fewer.

PPM

  • B-plan wrapped in legalese.
  • Waste of time and money for early stage.
  • Only use if investment bankers are involved.

Financial Model

  • Mostly useless.
  • VCs might ask it for one purpose- they are in the business of pattern recognition, they will apply their experience to understand how much you grasp the financial dynamics of your business.

Demos

  • Should tell a story about your product/business.
  • Watch the VCs very carefully while they play around with these.

Due Diligence

  • Asked for, mostly after term sheet : Cap table, board meeting minutes, contracts and material agreements, board meeting minutes.
  • Formal due diligence process starts after signing term sheet.
  • # of docs depends on how long you’ve been in business.
    • Deal with messy stuff upfront.
    • Full disclosure early on – a good VC will help you work through any issues that you may have.

If you are a hot company

  • You’ll have your pick of investors.
  • Do your homework and judge based on
    • who will be most helpful to your success
    • who has a temperament and style compatible with yours.

Grouping VCs

  • Leaders, followers and everyone else.
  • Leader: leads the round, most active new investor.
  • Four kinds
    1. Most interested, wants to lead.
    2. Not interested, wants to pass
    3. “Maybe” – keep this person warm by continually meeting and updating.
      They won’t catalyze your investment, but you can bring them into the mix.
    4.  “Slow nos” – always in react mode, will sporadically respond. Ditch them and move on.

Are you swimming upstream? (while dealing with the VC)

  • Are you in the demographic they like? e.g. first time entrepreneur v/s experienced one.
  • Is your point of contact a weighty name at the firm? You need a GP/MD interacting with you.
  • You’ll learn a lot about the attitude and culture of the VC firm by the way they conduct their due diligence.
  • Before you jump through hoops in the due diligence, make sure you are dealing with a partner. Don’t be an associate’s fishing expedition.
  • Due diligence works both ways – ask other entrepreneurs what they think of the VC.
  • Best VCs will give you a list of ALL the people they’ve worked with in the past. Will ask you to pick a few for reference checks. Pick ones where you can understand how the VC deals with messy situations – founder swapped out, company went through hard times etc.
  • Be wary of the VC who goes from hot->warm->cold, but never says no. They might just be keeping their options open.

Closing the deal

  1. Signing the term sheet
  2. Definitive documents, and getting the cash.
    (1) almost always leads to (2). Messy internals of a company and poor lawyer handling can derail (2). Keep a tab on what both sides of lawyers are up to.

Term Sheet

  • Determines the final deal structure
  • Blueprint of your future relationship with your investor.
  • Economics – what the VC gets in a liquidity event
  • Control – how does the VC exercise control over the business or veto certain decisions the company can make.
  • Anyone who doesn’t focus on one of these two (eco and control) isn’t going to be good deal with as owner, board member or compensation committee member.
  • Founders: common stock.  VCs: preferred stock.

Economics

  • Not just valuation
  • Components:
    1. Price
    2. Liquidation preference
    3. Pay-to-play
    4. Vesting
    5. Employee Pool
    6. AntiDilution
  • Pre-money: Valuation before investment. Post-money: Pre-money + total investment amount
    Basic Trap: “Invest X at Y valuation”. Y is usually meant post-money. Clarify this.
  • Option Pool/Fully diluted
    • The option pool that the VC expects is usually covered in the pre-money valuation, lowering the pre-money valuation (usually).
    • Option pool is a key pricing point of the negotiation – the VC will insist on expanding option pool before funding, and its in the 10-20% range.
    • Either ask for smaller option pool or increase pre-money valuation to accommodate a larger pool.
    • Make an option budget. This is a list of hires you expect to make between this funding round and the next, and the approximate options you will need to land each.
    • Be prepared if the investor wants an option pool higher than your budget, but not by too much.
  • Warrant
    • Another way to sneak in lower financing.
    • Warrant: Similar to a stock option. It is a right for an investor to purchase a certain number of shares at a predefined price for a certain number of years.
    • Example: 10 year warrant to buy 100k Series A stock at $1 per share. (what happens when these 100k shares are worth very little because of dilution?)
    • Warrants create accounting headaches. Negotiate for lower pre-money in exchange for no warrants.
    • Warrants artificially inflate valuation – they affect how liquidity proceeds will be handled, but they are not calculated as part of the valuation.
    • Warrants are justified in “bridge loan” rounds.
  • Bridge Loan
    • Existing investor wants to fund, but is waiting for additional investors.
    • Will issue funding as convertible debt, which will convert into equity at the next financing.
    • He either gets a discount (upto 20%) or warrants that effectively offer the same discount. These are justified.
  • Liquidation Preference
    • Important in the case where company is sold for less than the amount invested.
    • Generally at 1x. Used to be at heights of 10x in the dot-com bubble days.
    • What it means: in a liquidation event, investors will get X times the amount invested back, before common stock holders. e.g. Investor bought preferred stock at $20 – they get $20 per share back in a liquidity event before common stock owners are compensated.
  • Participation
    • Full Participation: Liquidation preference + whatever you deserve after conversion to common stock.
    • Capped Participation: First get the liquidation preference, and then get proceeds from the conversion to common stock, up to a limit. e.g 1x liquidation preference + additional upto 2x return from conversion to common stock.
    • No Participation: Either/Or: Either you get the liquidation preference, or you convert to common stock and investors get the proceeds on an as-converted basis.
  • Participation feature has lot of impact at relatively outcomes and lesser impact at higher outcomes. This makes sense – at higher outcomes, the conversion to common directly gives you the best outcome 🙂
  • Participation feature matters more as more money is raised that has this feature (Series B, C).
  • Liquidation preferences: easy to understand with only series A.
  • Multiple Rounds:
    • Stacked preferences: Series B gets preference first, then Series A.
    • Blended preferences: Series A and B share proratably until the preferences are returned.
    • Example loss case with 2 rounds: 
      • Series A: 5 million at 10 pre (liq pref: 1x)  Series B: 10 million at 20 pre (liq pref::1x)
      • Total investment: 25 mn. Company sold at 15 mn.
      • In case of stacked preference – the B investor gets all the 15. In case of blended preference – the A investor gets 3 and B gets 12 (20% and 80% – the ratio of the capital put in by them).
      • In both cases, the entrepreneur or employees get nothing, irrespective of participating or nonparticipating.  Why? They raised 25mn at a preference, and company is being sold for less.
  • Keep it simple and lightweight in early rounds
    •  If the seed investor has liq. pref + participation in the seed round and doesn’t participate in future rounds, he stands to suffer, since future rounds will have at least the terms of the previous rounds.
    • Greater the liquidation preference, lower the value of management or employee equity.
  • Kick-outs: Used to be there in the 1990s, where participation goes away as long as you can provide a 2x-3x return to the VC. This should be reinstated!
  • Pay-to-play: Became widespread after 2001.
    • Relevant in down-round
    • Useful when the company is struggling and needs another financing.
    • “Pay” (participate pro-ratably in future financings) in order to “play” (not have your preferred stock converted to common stock).
    • Pay-to-play is good: Only continuing (read: committed) investors continue to have preferred stock, and the rights that come with preferred stock.
    • Conversion to common stock on not paying is OK.
    • What to avoid: A pay-to-play scenario where the VC has a right to force recapitalization of the company if fellow investors don’t play into a new round. ([KR]Would love to have an example of this).
  • Vesting: Industry standard: 1 year cliff (25%) and monthly vesting (remaining 75%) thereafter for next 3 years. Applies to founders too.
    • Founders can sometime get one year of vesting credit right at the closing of the financing (you can vest back to the inception of the company – getting credit for your work earlier on).
  • Unvested stock:
    • Founder stock: Disappears into the ether, everybody else’s shares increase in pro-rata fashion.
    • Employee stock: Goes back into the employee option pool, for future employees.
  • Founder buy-back: Own their stock outright through a purchase right when the company is established. Different from vesting. ([KR] Would appreciate examples on this).
  • Founder tips:
    • How your stock vests is important
    • Consider allowing yourself to purchase unvested stock at the same price as the financing if you leave the company, protects your position for a termination “without cause” ([KR] Needs examples).
    • Treat your vesting as a “clawback” with an IRC Section 83(b) election so you can lock in long-term capital gains tax rates early on. ([KR]: Needs explanation + examples).

What happens to vesting schedules upon a merger or an acquisition?

  • What is accelerated vesting?
    • Single-trigger: Merger itself leads to accelerated vesting.
    • Double-trigger (more common): Merger + employee in question should be fired by the acquiring company.
  • Acquisition case: Acquirer has two choices:
    • Offer unvested equity: motivation to stay around for X time after acquisition.
    • Offer a “management retention piece” as part of the deal – VCs obviously don’t like this because this will be included in the deal value and effectively reduces the value of equity, and hence the proceeds that the VCs or any founders no longer with the company will get.
    • [KR]: How do vesting provisions guarantee that a founder who walks away or is fired, gets to hold some of his equity, while giving the founders who are staying back a differential ownership?
  • Time to exit has huge impact on relevancy of vesting. e.g. in late 90s companies would exit in <2 years, today with companies taking 5-7 years, by the time of the exit, everyone is fully vested (4 years). 

Anti-Dilution

  • Antidilution clause: Protects investors in case of a future down-round.
  • Two varieties: weight average and ratchet-based.
    • Full-ratchet: Reduce the earlier round price to the new issuance price, if the new round is a down-round. (KR: would be good to work with a simplified example here). Partial ratchets are less harshly, but are rarely seen (1/2 or 2/3rds ratchets).
    • Weighted-average anti-dilution: number of shares issued at the reduced price is considered in the repricing of the previous round.
    • Conversion Price Adjustment.
      • Broad-based v/s Narrow-based adjustment: do you count all common outstanding stock (after conversion of preferred, other options, rights etc) or just currently outstanding stock for the “conversion price adjustment”?
  • Anti-dilution “carve-outs”: Classes of stock where the anti-dilution clause doesn’t apply. For the company/entrepreneur – more exceptions are better, and good investors will accept them.
  • An important carve-out is one which allows majority shareholders to waive anti-dilution rights. This is helpful when minority investors sit on the sidelines, don’t participate in the future rounds, and rely on anti-dilution to get a larger stake. 🙂
  • Case in point: Series A at $1 a share, Series B at $5 a share, C at $3 a share. A didn’t ask for anti-dilution. B did. Claim is that B benefitted at the expense of A. ([KR]: Needs more details).
  • Founder tips:
    • Don’t get hung up in trying to eliminate the anti-dilution provisions.
    • Focus on minimizing their impact (how does one calculate this) and build value into the company so that they don’t ever come into play.
  • Recent trend: Tie anti-dilution calculations to milestones that the investors have set for the company. Anti-dilution occurs automatically if the company doesn’t meet its goals, unless investors waive it after the fact (KR notes: sounds like a bad idea!)

Control Terms

  • VCs care about control terms not only to keep an eye on the investment, but also because of the kind of investors who invest in VCs (LPs?), federal tax statutes apply where control terms matter.
  • VCs mostly own less than 50% of the company, but they have a variety of control terms helping them.
  • Key control terms:
    • Board of directors
    • Protective provisions
    • Drag-along rights
    • Conversion.
  • Process of electing board of directors.
    • Think about proper balance between the investor, company, founder and the outside representation on the board.
    • Board = inner sanctum, strategic planning department, judge, jury and executioner, all at once. VCs who are good people and good investors can make terrible board members.
    • Many VCs will include a board observer as part of the agreement.
    • Be wary of board observer – they don’t vote but they can sway the discussion. You don’t want to be a pre-revenue company and have a 15 people board.
    • Many VCs ask for CEO to be a board member.
    • Sample early-stage company board: Founder, CEO, VC1, VC2, and outside board member. (equal representation for founders (if CEO is a co-founder) and VCs, and the outside guy resolves the disputes).
    • Mature boards: 7-9 members, mostly the additions are outside guys, experience executives in the domain.
    • Private board members don’t get cash compensation. Outside board members are compensated with stock options, just like key employees, and are invited to invest money in the company alongside the VCs.
  • Protective Provisions
    • Veto rights for investors to prevent the company from doing something
    • Strive hard to put all your investors in the same protective provisions category, else you are dealing with multiple stakeholders with varying interests and multiple kinds of veto rights.
    • Some of these protective provisions only make sense if your Series A investors hold enough of your cap table to be relevant (e.g. change size of board of directors, sell the company).
    • Avoid the term “material” or “materially” qualifier in your protective provisions – figuring out what “material” means is a legal rabbit-hole.
    • Be wary of inappropriate veto rights for small investors (e.g. someone who holds 10% shouldn’t be able to veto key decisions).
    • Can’t argue that the VCs board seat will imply their representation and therefore veto/protective provisions should be removed – the guy representing the VC on the board needs to act in the interests of the company while the VC firms’ interest as shareholder might be different.
    • DO NOT NEGOTIATE protective provisions thinking only about your current relationship with your current VC. You are negotiating the deal on behalf of the company (no matter who runs it in the future) and with the investors (whoever they are).
  • Drag-along rights
    • A subset of investors have right to ‘drag along’ other investors and founders to sell the company.
    • Required in case of downturns – when company is sold for less than liquidation preference.
    • Your ownership situation decides whether drag-along is worthy of worrying for you or not.
    • Acquisitions don’t need unanimous consent, buyer will want 85-90+ percent consent though.
    • State laws: California: Majority shareholders of each class agrees. Delaware: Majority shareholders on an as-converted basis agrees. ([KR] How is this “majority on as-converted” basis computed?)
  • Conversion: Only term that is actually non-negotiable in a financing deal
    • Preferred to common stock.
    • Events where this happens –
      • Conversion to common is more beneficial to investor than liq pref + participation.
      • Convert to common to increase stake and influence a decision like a sale.
      • IPOs – most investment bankers will insist on conversion to common for everyone before IPO.
    • [KR] Is conversion always 1:1? When is it X:1? What are the industry norms today?
    • Automation Conversion on IPO: Key terms : it will occur for no less than X times the purchase price of the preferred, and if the offering is at least Y million.
    • Your investors from different Series should always have same automatic conversion threshold else it is a headache for you. Rely on the board to convince a VC to waive automatic conversion stance, if required. (e.g. you want to IPO at 100 mn, Series A has threshold at 80, Series B has threshold at 120). 
    • Apart from conversion, using “this is non-negotiable”, “this is how we always do deal”, “this is the market way” is lame on part of the VC. Run from this. 

Other terms (Non-economics, non-control)

  1. Dividend: More common in PE, VCs dont care.
    • Where it matters: Large investment amount, and lower the expected exit multiple.
      e.g. 40 mn investment at 100 mn post-money valuation, 80 mn sale at end of year 5. Dividend was 10% (annual, assume not compounded) On the sale investor gets 40 for 1x liq pref, and 20 (4 mn year x 5) for dividend. Bad!
    • Ensure that dividends have to be approved by a majority of the board of directors.
    • Be wary of dividend paid in stock – it becomes another form of anti-dilution protection.
  2. Redemption rights: Company pays back the investor their original purchase price (redeeming the preferred stock) after X years.. This is a liability on the company’s balance sheet – whether it can pay or not is a different story.
  3. NEVER AGREE TO: “Material adverse change redemption clause” – basically says whenever things go bad (subjective) investor can redeem his preferred stock + unpaid dividend. This is loan shark behavior, not VC.
  4. Condition precedent to financing
    • Watch out for ways out of a deal. This section shows investor mindset.
    • Term-sheet is non-binding, these conditions matter.
    • Do not agree to pay VC’s legal fees unless the deal is completed.
    • More relevant if you are signing a term-sheet with no-shop clause.
    • Key employment terms for founders not being spelt out is a red flag.
    • “Approval by investors’ partnerships” is a red flag – shows the VC firm isn’t unanimous on the deal yet. Uncommon today.
  5. Information Rights
    • What info VC has legal access to and what timeframe it should be provided in.
    • Don’t bother about these at all – run a transparent ship. Get a strict confidentiality clause to go along with the information rights.
  6. Registration Rights
    • Long and tedious, defines investors’ right to register shares in an IPO event
    • Totally ignore in early stage.
  7. Right of first refusal
    • Investor gets right to purchase X times # of shares they bought in current round, before anyone else, in the next round. X =1 (pro-rata) is fair, X>1 is (super pro-rate) is not.
    • Give this only to major investors.
  8.  Voting rights clause: This is just an FYI section.
  9. Restriction of Sales
    •  Defines sales of common shares while company is a private company.
    • This clause goes in the company bylaws
    • [KR] How is second-market trading enabled with this clause?
  10. Co-sale agreement
    •  Important for founders. It says if a founder sells stock, investors should get the chance to sell a proportional amount of stock as well.
    • Structure this such that you get some leeway to sell stock for a house if you need. Fair deal – let the investor have the right of first refusal on purchasing stock from the founder, which the purchase price set to a fair-valued outside offer. 
    • Obviously don’t agree to excluding everyone else from buying. ([KR]: Travis Kalanick’s FailCon 2011 intro covers this story).
  11. Founders activities
    • Only experienced founders with lots of credibility can wriggle out of it.
    • Puts down in legalese that 100% of your time goes to this company.
  12.  IPO Purchase
    • Forget this one. Used to exist traditionally “investor gets right to buy atleast 5% in event of an IPO”. No longer relevant – if investor has to buy during IPO, this signals a crisis. If company is going to IPO – investor is making enough money anyway, so they are happy even without this.
  13.  No-shop clause.
    • Obvious. “Stop looking for an investor and close the deal” applies at some point in the process.
    • Best case: 30 days. Usual case: 45-60 days. longer is unreasonable.
    • Author’s/VC’s tip: Quality and character of the people involved matters way more here, than the legal no-shop clause itself. Substantiated with examples from their experience.
    • Ask for a no-shop clause that expires if the VC terminates the financing offer (protection against evil VCs). Also, ask for a carve-out for acquisitions (though good VCs will almost always let you pursue the acquisition). 
  14.  Indemnification
    • Most VCs will ask for this.
    • Get D&O (Directors and Officers) liability insurance for founders + VCs/board members.
  15. Assignment
    • Allows VCs to transfer stock, to partnerships or funds managed by itself.
    • Assignment should be allowed as long as the transferee abides by the same terms of the deal as the original. 

Capitalization Table

  • Term sheet contains a summary cap table.
  • What is known – total pre or post valuation, VC stake in %, employee pool %.
  • You solve for – founder stake post investment, price per share, # of shares for VC and employees.

Convertible Debt

  • Used at seed. Many angels opt for only this.
  • Loan that converts to equity when the next round is raised. Includes discount on the next round price.
  • Relevant terms
    • Discount
    • Valuation cap
    • Interest rate
    • Conversion mechanics
    • Conversion in a sale event
    • Warrants – Convertible debt for late stage
    • When is debt dangerous to use?
  • Valuation Cap: “I’ll take a 20% discount on the next round, if the valuation is <= $X. If its > $X, then my valuation is $X.”
    • Series A investors can refuse to fund until the seed investors remove or change the cap. (KR Questions: Has this been seen in practice?)
    • Consider a convertible debt deal with (a) bound timeframe for Series A / or any equity financing (b) if that time bound isn’t met, forced conversion with a floor, not a cap/ceiling on the valuation at that price. ([KR]: Is this easy to achieve?)
  • Discount: Range 10-30%. 20 is most common. You can have it time-varying (10% for next 90 days, 20% after) but better to keep it simple.
  • Usually there’s a minimum amount of equity raising to happen before notes can be converted.
  • Interest: The discount makes up for the seed guy’s risk, so there’s a no reason to go high on interest. Look up the AFR (applicable federal rate) and propose something slightly above it.
  • Conversion Mechanics
    • Debt holders have great leverage in a negotiation ([KR]: Why cases like SurveyMonkey – heavily debt-financed then?)
  • Two parameters to convertible debt terms:
    • Term/Length: Founder wants longest possible, max VCs will agree to is 1 year (can’t issue debt for longer than that).
    • Amount: Min. equity raise needed for debt to convert. Founder gets to decide this.
      i.e raise $1mn in equity within 180 days for automatic conversion to occur.
    • If the milestones are not achieved, the debt stays outstanding unless the debt holders agree to convert their holdings.
  • Conversion in case of a sale
    • Company is sold before conversion to equity happens
    • Lender gets back either of (a) money + interest (b) money + interest +some multiple (2-3x) of the original principal amount. (c) some kind of conversion of debt to equity.
    • Founder Tip: Acquisition while there is debt outstanding is a tricky case. Address how conversion will occur (do you convert debt to equity at last preferred price? how do you convert debt to acquirer stock?)
  • Warrants
    • Not advisable during seed. Perhaps use during later stage convertible debt.
    • Warrants and discounts on the next round are either/or. Never agree to both. e.g .100k convertible debt. Investor gets 20% in warrants i.e. Instead of 20% in discount on the next round, you have 20k worth in options to purchase a certain number of shares at a pre-determined price. Which shares? Either the last round at the last round’s price or the next round at the next round’s price.
    • Key terms of a warrant:
      • Length: exercisable for 5-10 years. Longer the better for investor. Shorter the better for company.
      • What happens in an acquisition: This is a key factor. Acquirors dont want to deal with the mess of pending warrants.
    • Warrants must expire on acquisition.
    • Accounting caveat: IRS needs something to be paid for, for the warrant.
    • Warrants add complexity (legal and financial), they are used, among other reasons, because they are not factored into the valuation, discounts are.
  • Other terms in convertible debt:
    • Super pro-rata rights for next round: be careful with these. (e.g. 200k in debt, pro-rata rights won’t help if you do the next round at 50mn valuation).
    • Liquidation preference: same as how preferred stock works.
  • Keep in mind while considering convertible debt:
    • In case of raising equity, the company is solvent (i.e. not under debt). The fiduciary duty of founders and board is to increase shareholder value.
    • In case of raising debt (convertible note), the company is insolvent. The fiduciary duty is higher towards lenders for the founders and boards and this increases personal liability on them.
    • It becomes tougher to justify that they were acting in the best interests of the lenders.
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3 thoughts on “Notes from Venture Deals (Brad Feld, Jason Mendelson) – Part I

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