venture deals, by brad feld and jason mendelson

Venture Deals often comes recommended as one of the most practical reads for newly minted VCs, and for Founders looking to raise money. It covers all the key terms that come into play during the fundraising process. Here are some of my quick takeaways:

For Founders
The first thing to do when entering the market is to figure out why you want to raise capital, and if your business is venture-backable. If you do decide to raise VC funding, it’s important to figure out how much you want to raise and how this gets you to your next milestone. Feld and Mendelson recommend having a specific number, instead of a range.

If a VC passes on your business, always try and get feedback. If you are lucky enough to receive a term sheet, make sure you do references on the VC. Many people liken the Founder / VC relationship to a marriage. However, with marriages, divorce is always an option, even if it’s an ugly one. The Founder / VC relationship is more like having a child. Once you take money from a VC, it’s very hard to get rid of them. You’ll be in the trenches working on your company for the next 5+ years, regardless of how much you like the VC. The best references will come from their portfolio companies that have been through tough times. 

In terms of the term sheet, the two primary things to focus on are economics and control. Let’s dive into both. 

Economics of the Term Sheet

• Price: The post-money valuation of a business is equal to the pre-money valuation plus the invested amount. Most startups will also have an option pool representing 10% to 20% of the company’s fully diluted shares
• Liquidation Preference: VCs typically invest using preferred shares. The liquidation preference determines who gets paid first and how much they receive. The are 3 types of participation: participating, capped participation, and non-participating (most common). With multiple financing rounds, preferences can either be stacked or they can be equal (i.e., pari passu)
• Pay to Play: This is when investors must participate in future financings to prevent their preference shares from converting to common stock
• Vesting: Founder vesting may vary slightly from employee vesting. The standard term is 4-year vesting, with a 1-year cliff
• Antidilution: In full ratchet antidilution, a company issuing shares at a lower price than the previous round will result in the earlier round effectively being reduced to the price of the new issuance. The weighted average method is more popular since it takes into account the number of shares being issued

Control Terms of the Term Sheet

• Board of Directors: An early-stage Board is typically comprised of the Founders, the CEO, 1 or 2 VCs, and an outside member
• Protective Provisions: This refers to the veto controls that a VC may have
• Drag Along Agreement: This gives a subset of investors the ability to force, or drag along all of the other investors and founders to do a sale of the company, regardless of how they feel about it
• Conversion: Preference shareholders have the right to convert to common stock at any time. However, auto conversion typically occurs at IPO. You want to make sure all investors have the same conversion terms to prevent issues upon exit

Other Terms of the Term Sheet

• Dividends: These are very uncommon to see in venture deals
• Conditions Precedent to Financing: The term sheet is just one step to getting an actual deal done. Be wary of what investors put in this section
• Information Rights: This defines the type of info the VC legally has access to, and when the company must deliver it to the VC
• Registration Rights: These spell out the rights of investors when registering shares in an IPO
• Right of First Refusal: This defines the rights an investor has to buy shares in a future financing
• Voting Rights: Defines how preference and common shares relate in the context of a share vote
• Restrictions on Sales: This lays out the parameters associated with selling shares (whilst the company is still private)
• Proprietary Information and Inventions Agreement: Defines the ownership of IP
• Go-Sale Agreement: If a founder sells shares, investors will have an opportunity to sell a proportional amount of their stock as well
• No Shop Agreement: For Founders, ask that the clause expires if the VC terminates their process. Also, consider having a carve-out for acquisitions
• Indemnification: The company must indemnify directors. You will likely need to purchase D&O insurance
• Assignment: This allows the VC to transfer their shares

​Other Things to Keep in Mind

• Convertible Debt: Sometimes VCs will invest using convertible debt, which is a loan that converts to equity (usually preference stock) at a time when the next round is raised. The conversion will typically be priced with a discount and/or a valuation cap. The discount is typically 10 to 30%. Try to keep the interest rate on the debt low. Conversion mechanics will specify the term length and the amount to be raised in a future financing. In a sale of the company, the lender may either get their money back with interest, or they may get their money back with interest and a multiple of the original principal amount, or some sort of conversion may occur
• Negotiations: Always go into negotiations prepared. Do all the possible homework you can, which includes knowing what is important to you and what isn’t. Study the other party you’re negotiating against. If you are in a position where you are considering walking away from a deal, also consider your BATNA (best alternative to negotiated agreement). If you’re working with multiple VCs in a competitive process, be wary before revealing their names or deal terms to each other
• Acquisitions: The equivalent version of a term sheet in an acquisition is an LOI. Acquisitions can be asset deals or stock deals. In an asset deal, only certain parts of the company are bought (typically the crown jewels), but the remainder of the company will still exist. In a stock deal, the entire company is bought. Consideration is how you get paid, and can be cash, stock, or both