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

Part I is here.  In a hurry? Italics in the post represent key dos and don’ts for founders.

How VC firms work

  • One management company (franchise) – this is the name of the VC firm you hear.
  • Under them are several “general partnerships” (no longer a “general partner” i.e. single person, this is a separate legal entity of its own ). Each “general partnership” has different funds – LPs (limited partnerships) under it.
  • Interest of VC firm != interest of the GP/LP always, particularly when new people join or MDs leave.
  • How VCs raise money
    • LPA – limited partnership agreement
    • Fund amount is not actually with the VCs. A capital call is made each they want to invest in a startup, and the LPs are obligated to respond to the capital call in two weeks.
  • Capital calls can fail or result in lower funding than expected .2008-like situations: LPs include HNIs who may be struggling with illiquidity themselves, banks who, like in 2008, may be dissolving themselves, endowments/pension funds etc who are facing capital crunch due to general market conditions.
  • Average total fee over a 10 year period: 15% of the fund. VCs are expected to make capital gains and recycle those gains to cover up for the fees.
  • Partners see base compensation with every additional fund raised.
  • “It takes 10 years to kill a venture fund.” – additional funds / rounds can be raised while the performance of the first few isn’t clear.
  • Carry: VCs get a 20% of the profit cut, which is known as “carry”. This can be reinvested (and is expected to be reinvested, at least till it covers the management fees).
  • Friction within a VC firm – Firms don’t equal allocation between partners- seniority matters. An individual partner can make X times the amount allotted, but still get no carry because of allocation style and poor performance of the overall firm or fund.
  • GP Commitment: LPs want VCs to invest a cut as well – 99% money comes from LPs, 1% from the VCs. Has gone up to 5%.
  • Clawback: VCs can pocket the carry in the middle of the fund (say 20% of 50 mn in profit) and then the overall fund turns out to not do so well. VCs have taken more than the deserved carry and LPs demanding for this back is ‘clawback’.  Harder to pull off across multiple partners.. (e.g. one partner got divorced, paid half to spouse. All partners paid taxes on the carry).
  • Time impact of fund activity
    • If you are raising with a VC fund that closers to closing, higher pressure for an exit.
  • Wary of ‘zombie’ VC firms (no new funds to raise, carrying on their existing funds). Just ask when their last investment was.
  • Wary of ‘secondary sale’ – VC can sell their entire portfolio to someone in a secondary sale.
  • VCs close to end of the fund can also redistribute the portfolio to LPs – hassle for founder if there are too many LPs.
  • Reserves – VC have a fraction of the fund (30-50%) in ‘reserve’ i.e. for future investments with their portfolio companies. Ask upfront for details on this.
  • Cashflow – how does the VC maintain their cashflow? Are they recycling the carry appropriately to make up for the management fees? ([KR]: How does this affect the founder?)
  • Cross-fund investing – bad idea, since there are multiple sets of LPs and multiple kinds of terms involved.
  • Figure out what happens if and when the partner who invested in you departs – does it trip a ‘key-man clause’? (LP can ask for recall of funds).
  • Understand your VC’s fiduciary duties – they are serving you/your board, the VC firm, their own GP/LP and a bunch of other people. Not all VCs are direct about what they have on their plate, making their behavior confusing.
  • Understand your investors motives and financial incentives. Have an open, if difficult conversation about it now, to avoid surprise and trauma later.

Venture financing

  • Funding Negotiations: Prisoner’s dilemma applies, but only somewhat. (Acquisition discussions are closer to prisoner’s dilemma).
    •  Multiple-instance game.
    • Win-win is possible.
  • Ask VCs upfront before the term sheet arrives what their top three concerns are. Articulate yours if asked.
  • During the back and forth, point out that the VCs top asks are being met. (much easier to call them out once you have the original info).

Negotiating Styles

  1. Bully/Yeller: Ignore – this one never gets anywhere. Sign of immaturity.
  2. Nice-guy / Car Salesman: Will talk a lot, seemingly never get to the point. Be clear and direct about what you want, introduce a little bully if needed.
  3. Technocrat: Gets lost in details. Make sure you focus on the points you care about, and make sure you are looking at the overall picture of give-and-take across all points.
  4. Wimp: Might be easy to get his wallet, but remember you’re stuck with him on your board. You’ll end up having to negotiate for him too – an incompetent partner can be worse than a real adversary.
  • In a multi-round game, be the nicest, transparent version of yourself that you can be. Single-round (like acquisition) – “just win it” attitude works.
  • Know what your limits are – when do you walk away? This comes from the BATNA (best alternative to a negotiated agreement). As you walk-away, be clear what your walk-away reason is. If you are sincere, and the other party really wants a deal, they’ll come back with something you can stomach. Else it wasn’t meant to be.
  • Don’t ever make a threat during a negotiation that you aren’t willing to back up.
  • Get each VC you’re talking to, to deliver a term-sheet within roughly the same timeframe.
  • Do not share names or term-sheet details, unless you actually want the VCs to collaborate (that is usually what happens -they’ll start comparing notes with each other).
  • Anchor on particular terms, to build leverage, and be willing to let go of the rest.
  • Feed the ego of the partner – applies to any negotiation.
  • Don’t go point-by-point – pick an ordering of the terms based on your priorities.
  • Never make the first offer.
  • A bad deal can be fixed
    • Next round of financing – the new VC is motivated to improve your terms.
    • Acquisition – tricky, be careful, here since the acquirer has reasons to wedge you and the investor.

Issues in each round

  • Seed: Empirically, there are more cases where the founders got too a deal, than a bad one. Bad because makes raising the next round painful if you don’t live up to the expectations.
  • Early Stage (Series A/B): Watch out for liq. pref (sets a precedent for all future rounds) and protective provisions (maintain a single class for all investors).
  • Mid/Late Stage: Board and voting control matters.
    Valuation – dont have too good a deal, else VCs will force a hold-out on the exit.
  • Seed preferred/Light preferred: Happens if you have angels who favor you a lot and don’t need the regular preferred shares (board, voting control etc). These are “preferred shares” with fewer rights. IRS 409A prevents you from selling common stock to investors (makes common stock expensive for employee stock options).

Letter of Intent

  • The other term-sheet. Acquisition offer first step.
  • First page of LOI
    • Apparent purchase price – usually not the actual one.
    • Escrow – ‘Holdback’ amount that gets cut if certain expectations/provisions are not met. Amount and terms of escrow and indemnity provisions are important.
    • 10-20% of purchase price, period 12-24 months.
    • Working Capital – (KR Question: Why is the seller expected to have a certain amount of working capital?)
    • Earn-outs: Allows buyer to underpay at closing time, and pay later if some conditions are met.
    • Management retention pool: Can be baked into purchase price or added separately. Allows buyer to shift focus away from the capitalization table (founders and investors) which may or may not be to their liking. Easy way to drive a wedge between founders and investors.
  • Expect escrow period to be between 12-18 months. Stand behind your ‘representations’ and ‘warranties’ until then. Escrow can get unreasonable, beware: uncapped indemnity, personal liability of founders/directors, even the ability to capture back more than the deal offered.
  • Asset deals: e.g. selling patents or selling ‘assets’ like hardware/factory. Buying a company without really buying a company. Messy, suggest avoiding – take years for the firm to close down after an asset deal.
    •  Buyers like asset deal because of shielding from liability.
    •  Stock deal: Actually buying the company.
  • Being bought for stock
    •  Private company buyer: obviously risky. You don’t know their cap table, liq pref. etc, so don’t know what common stock of the buyer really amounts to.
    • Public company buyer
      •  Is the stock freely tradable, registered or subject to lockup agreement?
      • What registration rights will you have?
      • Tax considerations.
  • Detailed LOIs are better than vague ones.
  • Employee Option Plans
    • Immediate vesting on acquisition: Great for employees, buyer has to figure out retention incentive.
    • Sometimes buyer will insist on employee options holders to convert to common stock before the acquisition and deal with them like common shareholders.
    • Catch up stock options: The deal should account for (option value – option basis), not just the face value of the option. e.g. 5 mn of option unvested have a value of 2 mn because 3 mn is the basis price. Who pays for these 3 mn?
  • Reps and Warranties
    • Guarantees about the health of the business that the buyer and seller give each other.
    •  Founder tip: Agree to everything as long as it’s ‘to the extent currently known’.
    • Do not agree to “The company shall make standard representations and warranties and provide standard indemnification to the Acquirers.”
  • Check the conditions to close – too many, too detailed is a sign of a picky buyer. Identify important ones and address upfront.
  • No-shop clause: Don’t agree to more than 60 days. Should terminate automatically if buyer declines deal.
  • Fees: Seller can ask a break-up if buyer is competitive and the LOI seems like a fishing expedition. e.g. T-Mobile
  • Shareholder Representative: Unlucky person to get sandwiched between buyer and seller for no personal gains to himself. As seller, don’t appoint some employee/founder who will be employed by buyer in the future (guy gets sandwiched) or a VC (won’t have enough time to represent). Hiring professional firms is a good option. Authors have set up a firm.

Legal Tips for founders

  • Make sure everyone you hire is an at-will employee (else firing is hard).
  • Prebake severance terms into the offer letter.
  • Know a good employment lawyer.
  • Raise money from accredited investors, non-accredited ones can force you to buyback shares anytime they want? (right of rescission).
  • Must file an 83(b) election
  • IRS 409A – gave business to a new accounting sub-industry, made stock options more expensive for employees. Nothing else changed much.

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