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Book Summary 41 — Venture Deals

You can find all my book summaries — here.

This book is a brilliant summary of things to know when raising capital as a founder. It provides a really valuable perspective of how VCs work and provides insights from angles of VCs as well as entrepreneurs.

I definitely recommend it for anyone interested in the details of venture capital funding, term sheets, legal knowledge and acquisitions.

Chapter 1 — The Players

- Entrepreneurs

- Venture Capitalists — research the VC structure, who has the decision power, talk to Managing/General Partners

- Angel investor — accredited high-net-worth individual, if lots of individuals set up Special Purpose Limited Partnership to only chase down 1 signature instead of 75

- Syndicate — collection of investors, lead by 1 investor, can be co-lead, Do still communicate with all investors!, make sure lead investor speaks for all and has decision power

- Lawyer — get a good one, someone who knows what they are doing

- Mentor — really important, later often board members

- Adviser — unusual in early stage, the operate for a fee

Chapter 2 — How to Raise Money

- Goal is to get several term sheets (BATNA, negotiation power)

- Don’t TRY to raise money, Be committed

- Determine how much you’re raising (not a range, but specific amount), focus on length you need to fund to get to next milestone — financial models are always wrong

- Don’t be too specific about milestones

Fund raising material

- Elevator pitch

Short description you can email.
1–3 paragraphs product, business & team

- Executive Summary

  • 1–3 page summary of idea, product, team and business
  • short, concise, well-written -> it’s the first impression
  • what problem are you solving
  • why product awesome
  • why better than current
  • why team is right
  • high level financial data for aggressive but sensible expectations

- Presentation

  • 10–20 slides — substantive overview of business
  • Visualise the Exec Summary
    The deck you send can be different to the one you present
  • Make it visually appealing — even hire designer to make it look good!

- Business Plan

  • 30 page document, with all the ins and outs

- Detailed Financial Model

  • They are always wrong
  • Revenue side definitely wrong, but assumptions are interesting
  • Expense side interesting to see how you think about the growth, you should be able to manage to plan
  • Burn rate is also of interest

- Prototype/Demo

  • great if you have one, doesn’t need to be perfect and can be thrown away afterwards

- Due Diligence

  • More documents will be required
  • Cap table, contracts, material agreements, employment agreements, board meeting minutes
  • Ideally start collecting them before you even go out fundraising to speed up process later on
  • Always Be Transparent and disclose everything

- Find the right VC

Ask friends, get referrals
Research online
Engage with them online and on a personal level

“If you want Money, ask for Advice”

- Finding a Lead VC

Don’t spend too much time on VCs who say No
Keep “Maybe’s” informed and in the loop

- How VC’s decide to invest

Depends on way you get connected, some VC just serial entrepreneurs, get introduced through the right channel
Then understand who is the decision maker, get to them asap, even if through an associate
Always ask for feedback and learn from it

- Closing the Deal

1) Sign of Term Sheet

2) Signing documents & getting cash

Usually this happens once there is a Term Sheet, unless something was hidden from VC

Chapter 3 — Term Sheet

Is the blueprint of the agreement — most important

2 most important things — economics (how much money) & control (who makes decisions)

Founders receive common stock
Investors receive preferred stock

Chapter 4 — Economic terms of Term Sheet

- Price

Price per Share is the ultimate measure -> determines valuation
premoney — before the investor gives the money
postmoney — after the investor gives the money

Make sure you know what the VC values your company as — pre or post — money

Fully diluted — means that there needs to be an employee options pool to motivate workforce

Large option pool lowers valuation

VC might make a valuation, then tell you to increase the option pool, resulting lower valuation for remaining shares and then want a buy-in with lower valuation

You can:

  • Increase valuation
  • Not increase option pool by that much
  • Increase option pool after financing round

Have an option budget ready — who are you going to hire and give options to + a bit extra

Warrants — allow VCs to buy options at later stage within X years

Unnecessary complexity and accounting headache

If asked for Warrants because of price, lower valuation (apart from bridge loan — that happens)

This happens as a Convertible Debt — converts into Equity at upcoming financing

Old investors will want high valuation — to limit dilution

New investors low valuation — to get more shares cheaper

- Liquidation Preference

Determines how proceeds are shared in a liquidity event — sale of company

Especially important if company sold for less than the amount of capital invested — who will get their money back

1) Preference

Certain multiple (usually 1x) is returned to investor, before money goes to common stock

2) Participation

Full — after receiving liquidation preference, preferred shares participate in profit as-if they are common shares

Capped — same as Full, but only until a certain multiple (3x — so another 2x of return) of investment is reached

No — they can choose either get investment back or as-if converted to common shares

Participation has Big impact on low outcomes, Small impact on high outcomes

Liquidation preferences can either be Stacked (latest round of funding comes first) or Equivalent (pari passu, blended preferences)

Early Stage — Best to have Liquidation with No Participation

- Pay-to-Play

Relevant in a down round financing, can be useful to raise money when struggling

Investors must participate pro-ratably in future financings in order to not have their preferred stock convert into common stock

Good for both — agree that they need to support company through lifecycle

This can be waived in financing round if large investor wants to led whole round

Don’t allows for the right to force recapitalisation of the company if not playing

- Vesting

25% vests after first year, 75% monthly over the next three years

Unvested options go back into pool, unvested founder shares just vanish

Single trigger acceleration — stock vests automatically on merger

Double trigger acceleration — stock vests when merger and fired (much more common than single)

- Employee Pool

Before increasing employee option pool, you can also provide full anti-dilution protection for investors in case you need to increase it

- Anti-dilution

If company offers shares at a lower price than in previous funding rounds then

Full ratchet — earlier round price is effectively reduced to the price of new issuance

Weighted average — takes into account magnitude of the issuance not just the valuation, repricing of previous round

Company is not issuing more shares, just repricing the ones they have — conversion price adjustment

Broad-based — encompasses both, common stock outstanding + common stock which can be obtained by converting all other options

Narrow-based — only common stock outstanding

Carve-outs can easily be negotiated of what shall not be diluted

Series A will probably ask for those rights, because they would lose out if Series B gets them

Try not to eliminate anti-dilution provisions, but focus on minimising impact and build value

Chapter 5 — Control Terms of the Term Sheet

Board of Directors

— very important to pick right people
— voting on per person or on common-as-converted proportional basis
— VCs often want observer (good — usually analyst to be included)
— observers can have power too, as the discussion is important

Typical Board: Founder, CEO, VC, 2.VC, Outside board member
7–9 board members max — majority of additions are outside board members
(CEO requisite sometimes — the then-serving CEO — can be tricky)

- Reimbursed for out of pocket expenses

- Outside board members compensated with stock + invited to invest

Protective Provisions

- Veto rights that investors have

- Hotly negotiated but have become standardised:

  • Change of stock terms
  • Creation of more stock
  • Buy back of common shares
  • Sell of company
  • Change incorporation or bylaws
  • Size of board
  • Pay or declare dividend
  • Borrow money (best to put a threshold here)

Put in restriction of minimum threshold of preferred shares outstanding

- New financing round — same protective provisions?

o Own provisions or vote alongside previous Series

o Best to have one voting — keeps alignment, less bureaucracy

o Beware of inappropriate Veto rights for small investors

Sometimes think they don’t need protective provisions as they are on the board
BUT as board member they HAVE TO act in the company’s best interest, but the veto rights allow them to act as shareholder — it separates the duties which can be good

Drag-along Agreement

- Ability to force all investors and founders to a sale of the company

- Sell of company usually needs majority of shares as-converted basis

- Negotiate to have to get agreement of majority of common stock not preferred

Conversion

- Is a non-negotiable term

- At any time preferred stock can be converted to common stock at 1:1

- Once converted CAN NOT be converted back

- Automatic conversion at IPS

- Important to never allow investors to negotiate different automatic conversion terms for different series of preferred stock

Chapter 6 — Other Terms of the Term Sheet

Dividends

  • Accumulated until IPO, but don’t have impact until then
  • Standard 5–15% annually
  • Don’t make the dividend automatic in stock, can be used as antidilution
  • They matter for the VC if it’s a low exit
  • Cumulative dividends can be an accounting nightmare
  • Dividends are rarely declared

MOST IMPORTANT: dividends need to be approved by majority or even supermajority

Redemption Rights

  • Provide downside protection
  • On 5th year of closing 3 annual instalments to get money + dividends back
  • Matters if company becomes successful enough to become ongoing business, but not successful enough to go public or acquired
  • Provides a guaranteed exit path
  • NEVER agree to Adverse Change Redemption, if something changes materially they can get money back (what is material? Not defined)
  • Make sure you have a maximum protection around your board and all classes of preferred vote in aggregate

Conditions Precedent to Financing

Watch out for:

  • Approval by investors’ partnership — has not been approved yet
  • Rights offering to be completed by company — need to offer all parties shares, not bad but adds time and expenses
  • Employment agreements signed by founders as acceptable by investors — make sure you understand key terms such as compensation and what happens if you get fired, also spell out no-shop clause

Information Rights

  • Defines type of info the VC is entitled to and timeframe you need to provide it
  • Only variation is the number of shares you need to hold to enjoy those rights
  • You can insist of strict confidentiality clause

Registration Rights

  • Rights investors have to register shares in IPO scenario also obligation of company to VC when file additional registration statements after IPO
  • Almost always has to be offered
  • Once you get to IPO the investment bankers are going to be in charge anyway

Right of First Refusal or Pro rata right

  • Right the investor has to buy shares in future financing
  • Almost always in term sheet
  • 2 important things:

o Share threshold which defines major investor can be defined, but you want small investors to also invest so not that important

o Check if there is a multiple of the purchase (super pro rata right) — EXCESSIVE ask

o AT A MINIMUM only get this right if they play in subsequent rights

Voting Rights

  • Not important as important things covered in Protective Provisions section

Restriction on Sales or First Refusal on Sales of Common Stock (ROFR)

  • Better to include this in the bylaws so its less likely to be overlooked
  • Gives the company the ability to know what’s going on and who is selling common stock

Proprietary Information and Inventions Agreement

  • Company owns its IP, employees might sign that knowledge belongs to company
  • Should build this agreement into hiring process
  • Carve-outs for WIP on unrelated work can be granted

Co-sale agreement

  • If founder sells shares the investors can sell proportional amount as well
  • Once the company goes public this does not apply
  • You can ask for a floor for this to sell a small amount of shares

Founder’s activities

  • Has to devote 100% to the company
  • Be upfront, but you will have to sign

IPO Shares Purchase

  • Allows VCs to purchase shares at IPO
  • Usually at IPO they don’t even want to and refuse the right as they want returns

No-Shop Agreement

  • More of emotional than legal agreement
  • Bind this to a time period 45–60 days (even 30 days possible)
  • Basically be open and transparent — it works on good faith
  • Should expire immediately after VC terminates process
  • Ask for a carve-out for acquisitions

Indemnification

  • Company needs carry liability and exposure to damages for board and investors
  • Get directors’ and officers’ liability insurance! & top it up when it needs to

Assignment

  • VC can transfer funds to one of its subsidiaries
  • DON’T let the loophole “assignment without transfer of the obligation under the agreements” occur, everyone needs to obide by same rules

Chapter 7 — Capitalisation Table

You as entrepreneur need to be across your Cap Table and make sure it’s correct!

Convertible Debt

- Debt which will convert to stock at next fundraising at a discount

- No Valuation has to be set

- Less paperwork (fees probably similar)

- No Rights of Preferred Stock

- Often cap on the price to avoid the round being too expensive

- This can lead to problems with new round as investors might not like to pay that much more

- Consider putting in:

o Time horizon on equity financing and forced conversion if horizon not met

o Valuation floor not just ceiling

Discount on Convertible Debt

1) Discounted price to next round (Between 10–30%, Discount can increase overtime — try to keep it simple)

2) Warrants

Valuation Caps

- Puts ceiling on conversion price of debt

- Try to not disclose valuation cap until price has been agreed

Interest Rate

- Should be as low as possible

- Check lowest allowable interest rate and bump up a little bit

- Discount and Interest often related

- Interest Rate between 6–12%

Conversion Mechanics

- Holding debt can be bad as debt holder has strong negotiation position

- Term: time period, what is long enough?, 1 year usually max

- Amount: need to raise $X of new money

- If not converted, they can opt to convert — pay attention to vote and get a majority vote instead of supermajority

- Acquisition:

o Lender gets money back + interest

o Lender gets money back + interest + 2–3x multiple

Warrants

- More complex than discounted pricing, usually only in later series, either:

o $x worth of last round of preferred stock

o $x worth of next round of preferred stock (if no prior preferred)

o $x worth of common stock of last ascribed value (acquisition)

- Term length: how long you have time to exercise them

- Merge consideration: All warrants should expire at merger, acquirers hate buying companies with warrants

- Original issue discount (OID): Accounting issue, best to pay something for the warrants at the start

- NO VALUATION which is a benefit, but more complexity

- DO NOT allow double dipping with warrants and discount

Other Terms

- Pro Rata Right — in future financings, can ask for super pro rata right (will limit long term financing)

- Liquidation preference — not standard

- Bridge loan when company struggles

By definition if you raise a Convertible Debt / Loan your company is insolvent — ability to plaintiff against company is longer when something goes wrong

Chapter 9 — How Venture Capital Funds Work

3 entities in VC:

1) Management company (owned by senior partners, employs everyone, pays for day-to-day

2) Limited Partnership (LP) — contains investors in the fund

3) General Partnership (GP) — legal entity which serves as the actual GP, often managing director of LP

Key Point: separation of VC and funds it raises (LP), can have divergent motivations and interests, especially as managing partners join or leave

How firms raise money

Long contract called Limited Partnership Agreement (LPA)

Cash only comes when VC makes a Capital Call — usually about 2 weeks

Fund partners are legally obliged to send money

How VCs make money

Management Fee — 1.5–2.5% of money committed to fund ($100m fund — 2% fee — $2m annually)

Fee decreases after commitment period (when the fund can’t make more investments, first 5 years)

Usually that means 15% of the fund ends up as management fee

Management fees are received disregarding VC success
“It takes a decade to kill a VC”

Carried Interest

- 20–30% of profits as carry

- Management fees / Profits can be reinvested, assumes returns early enough in life of fund and good cashflow management

- Senior partners have more carry than juniors, can be friction point if seniors not performing

LPs want GPS to co-invest about 1%

Risk: Clawback

- Carry can be taken from early returns, but when the fund after 10 years underperforms that profit needs to be given back to the LPs (= clawback)

- Creates lots of issues around tax and partners who left

Expenses

- Receive expenses back from startups for board meetings

Time

- Commitment period — usually 5 years, can’t invest afterwards, but can invest additional money in existing portfolio companies (beware of zombie VCs with no money)

- Investment term — length of time the fund remains active, follow on investments can be made during investment term, usually 2 1-year options to extend past 10 years (occasionally up to 17 years), after 12 years, GPs have to vote to extend it every year

- Secondary sale — might have to sell their stock if fund stops

Reserves

- At time of investment, VC reserves money for future rounds

- VC won’t tell you how much, but it’s usually well defined

Cross-fund Investing

- Cashflow is fund specific

- Can create problems as some LPs will lose out

Departing Partners

- Key man clause sometimes — defines what happens to LP if certain partners leave

- Sometimes there’s not much incentive for new partners to take over old funds

Fiduciary Duties

- Can be conflicting between LPs

Chapter 10 — Negotiation Tactics

- Most Important: achieve good and fair result, not kill relationships and understanding deal

Prepare!

Know what you want in advance!

Research people!

Use knowledge of people to your advantage!

Make other side feel good

Always be transparent!

You can always walk away

Never tell a VC who else you’re dealing with, unless for a syndicate

Never submit term sheet first

Listen — you can’t lose a point by listening

Probe why market conditions apply to you if they use that argument

Don’t expect everyone to have the same ethical code as you

Chapter 11 — Raising money the right way

Don’t ask for NDA

Don’t Email carpet bomb VCs

No often means No

Don’t ask for referral if you get a No

Don’t be a Solo founder

Don’t overemphasise patents

Chapter 12 — Issues at Different Financing Stages

Seed Deals

- Precedent very important for later

- Valuation, you want a higher one in the next round

Early Stage

- Liquidation preferences can haunt you forever

- Protective provisions — make it one vote

Mid and Late Stage

- Keeping control of board

- Determine early on how many % of board can be VCs

Chapter 13 — Letters of Intent — The Other Term Sheet

- Non-binding (apart from no-shop agreement)

- Aka Indication of Interest (IOI) or Memorandum of Understanding (MOU)

2 most important things: pricing & structure

- Easy to read number on Page 1 is the Best Case Scenario

Escrow/Holdback: money the buyer is holding on to for a while in case any issues come up postfinancing

$ in escrow & indemnity provisions — very important and never standard

reasonable to have it for 12–18 months

Typically 12–24 months of 10–20% of purchase price

Management retention pool — paid out to the management team if they stay onboard, drives an early negotiating wedge between management & investors

Structure: Asset Deal vs Stock Deal

Sellers want to do stock deals (for cash)

- They are buying the whole company

Buyers want to do asset deals (for stock) — buying a company is not really buying a company

- They just buy some aspects of the company

Offer: stock in a public company

- Stock is freely tradable? (insider restrictions?, registration rights?)

- Registered?

- Lockup agreement?

Representations & Warranties

- Facts and assurances about the business that one party gives another, consumes a lot of legal time

- Most important: who is making the reps? Specify

- Company instead of individual shareholders should make the reps

- Sketch out what the indemnification will look like!

Confidentiality / NDA

- Mandatory

Conditions to Close

- Push back on the most restrictive

- Ideally early on in the process

No Shop Clause

- Ideally for 45–60 days

Fees

- Usually carried by seller (transaction fees too)

- Breakup fee usually not, tell them they can rely on No Shop Clause

Registration Rights

- If unregistered shares offered, buyer can’t make guarantee to register them as it depends on SEC (crucial to know current status with SEC filings, any outstanding registration statements and any other promises made to other companies

- Unregistered stock becomes tradable after 12 months

Shareholder Representative

- Managing escrow, dealing with earn-outs, working capital adjustment, litigation concerning reps and warranties

- Appointed Shareholder Rep by shareholders

- Usually not paid, time consuming and often costly job — deals with any issues

- Try to negotiate a pool of money into the merger that he can dip in to hire professional support -> separate escrow

- Don’t let buyer be Shareholder Rep, ideally neither VC due to time sensitivity

- www.shareholderrep.com

Chapter 14 — Legal Things every Entrepreneur should know

Intellectual Property (IP)

- IP issues can be the worst and many VCs won’t touch a company with IP legal cases

- Try to document origination and development of ideas with legal counsel

Employment Issues

- Hire everyone as at-will employee

- Spell out severance packages in contract

State of Incorporation

- Delaware

- Most business beneficial laws

Accredited Investors

- Only Accredited Investors are allowed to invest (wealthy individuals who match the SEC’s definition)

- Otherwise they can force you to buy their shares back

Filing 83(b) Election

- Within 30 days of receiving your stock in the company

- You pay for shares upfront instead of later, which has a better tax structure

Section 409A Valuations

- Stock options need to be fair market value

- 5–15k a year for a professional valuation

You can find all my book summaries — here.

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