Be Smarter Than Your Lawyer and Venture Capitalist

Venture Deals: 1 / 100

Posted by @JeffHicken

Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist was the first book in my challenge to read 100 books in 4 years. This book is a must read for any entrepreneur, or aspiring entrepreneur, who plans to someday raise capital for a startup idea.

Feld and Mendelson provide a detailed, yet easily understood by the amateur, explanation of venture capital and how venture capital firms work. In the “Acknowledgments” section they thank Pink Floyd for writing the Dark Side of the Moon album, which I can certainly respect. You know a book will be good when it has been written under the influence of the great Pink Floyd.

The best characteristic of the book is that it is written in a way that gives you only the information that is absolutely necessary as an entrepreneur. My only worry before reading this book was that it would be too complex and contain too much jargon for me to understand and retain useful knowledge about such a diverse topic. Refreshingly, I found throughout the book that I was able to distill the information provided and become familiar with how venture capital works.

The most important piece of the deal to understand is the term sheet. The term sheet is the legal document that lays out all of the “rules” of the deal. In other words, think of the term sheet as a map for the deal and what happens legally at each milestone. The most important thing to understand about the term sheet is that VC’s have two motives, Economics and Control.

The important stuff:

  1. Economics
  2. Control
  3. Raising money the right way

In order to understand venture capital it is important to first know what motives venture capitalists have when structuring a deal. It comes down to essentially two things: Economics and Control.

ECONOMICS

Price

Economics of course refers to the valuation of the deal, or in other words, the price. The price is determined by the total number of shares received multiplied by the price per share. The way I prefer to think about the valuation is by how large the investment is and how much equity the VC receives in return for providing capital and expertise.

Example: VC firm offers startup $5 million at a valuation of $20 million. The equity percentage is calculated like so: $5 million / $20 million + $5 million = .20 = 20%.

Not so scary, but there is one very important caveat to mention here and a question that every entrepreneur should ask after receiving any offer. Is the $20 million valuation a pre-money or post-money valuation? Although this may not seem like an important issue, it is! A pre-money valuation of $20 million would be calculated exactly as we did above.

A post-money valuation would include the $5 million dollar investment in the value of the company. In other words it would be calculated like so: $5 million / $20 million = .25 = 25%. Wait a second? The VC invested the same $5 million but now gets 25% instead of 20%? This is a huge difference in valuation and is why you should always ask, “We appreciate the offer, now, is that a pre-money or post-money valuation?” This simple question could save you from giving away too much of your company. It is interesting to note that the authors have seen entrepreneurs make this mistake on more than one occasion.

Liquidation Preference

The liquidation preference is the second most important economic term after price. This lays out how the proceeds are shared in the case of a liquidity event, which is the sale of the company or the majority of it’s assets. This can be especially important in the case in which a company is sold for less than the capital invested. The important word to look out for here is whether the preference is participating or not. If it is participating it will often times be accompanied by a multiple.

Example: Participation multiple of 3 (3 times the original purchase price), Participation stops once 300% of its original purchase price is returned. Obviously that would be very different than a multiple of 1x or 10x and should be paid attention to.

Pay-to-Play

Another important economic term is the Pay-to-Play and is particularly important in a down round financing (Financing at a lower price than the previous financing). It can be a very important term when the company is struggling or even in dire circumstances. A short paragraph from the book explains it best.

“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”

Vesting

Vesting is a simple but important term. Typically the vesting period of stock is 4 years, meaning that the employee or founder does not receive all of their stock until they have been with the company for 4 years. It is usual to have a one year cliff where the employee receives 25% of their equity and they then receive the rest on a monthly basis over the next 36 months.

Employee Pool

The employee pool (AKA Option Pool) is another important term to pay attention to when reviewing an offer from a VC. The employee pool is a portion of the company’s stock that must be set aside for employees. The pool is typically around 10–20%, although a VC will want it to be on the large side so that they can get a better deal. This is important to watch out for as VC’s will often times sneak this in to improve their economics. We won’t go through an example here but the point is, watch out for the size the VC is demanding for the employee pool.

Antidilution

This term is a bit more complicated and can be very wordy. For the purposes of this post we will just stick to knowing to pay attention to antidilution and research it or talk about it with your lawyer.

CONTROL

Control is the second motive of the VC to be aware of when reviewing the term sheet. It is for this reason that many entrepreneurs avoid VC financing as long as they can, because they know that the VC will want control over some things.

Board of Directors

The board of directors is very important to a startup and any company for that matter. As said by an entrepreneur in the book, “Your board is your inner sanctum, your strategic planning department, and your judge, jury, and executioner all at once.” Often times the VC firm will want to have an observer from their firm on the board, which can be a problem for the company since they take up a seat and sometimes don’t add any value.

It is typical for an early stage company to have a board of 5:

  1. Founder
  2. CEO
  3. VC
  4. A second VC
  5. An outside board member

Protective Provisions

Protective provisions are essentially veto opportunities for investors on certain actions by the company. This is an attempt to protect themselves but can also be bad for everyone involved in certain circumstances. Here is what the VC is trying to protect against:

  1. Change the terms of stock owned by the VC
  2. Authorize the creation of more stock
  3. Issue stock senior or equal to the VC’s
  4. Buy back any common stock
  5. Sell the company
  6. Change the certificate of incorporation or bylaws
  7. Change the size of board of directors
  8. Pay or declare a dividend
  9. Borrow money

Drag-Along Agreement

This term is fairly simple. A subset of the investors can drag along the rest of the investors and the founders to do a sale regardless of how the people being dragged feel about it.

Conversion

Conversion is a term that is essentially nonnegotiable. This states that preferred shareholders have the right to convert their stock into common stock at any point in time. They will typically convert their stock during a liquidation where they will be better off getting paid on a as-converted common basis rather than the participating preferred stock.

Raising Money the Right Way

In order to keep this post somewhat short and maintain readability we will simply list the important items to remember when raising money.

  1. Don’t ask for an Nondisclosure Agreement
  2. Don’t email carpet bomb VCs
  3. No often means no
  4. Don’t ask for a referral if you get a no
  5. Don’t be a solo founder
  6. Don’t overemphasize patents

If you research any of the previous topics you will most certainly find countless opinions and articles on each. My recommendation would be to pick up a copy of the book and keep it as a reference or talk to someone you know that is a VC or entrepreneur and has actual experience with VC deals.

I highly recommend this book to anyone that will raise money for an idea at some point in their life and especially anyone that will be raising venture capital. You will undoubtably learn something important and probably save yourself from making a big mistake or two.

Do yourself a favor and buy this book here. You deserve it.

What do you think about venture capital? What has your experience been raising money as an entrepreneur? Feel free to comment below or leave feedback.