- A term sheet explains the details of an investment deal between a VC and a startup.
- The most important terms to know about are the ones detailing the economics and control of the deal.
- Startups can raise money by selling equity or contracting debt.
- Reputation is of the utmost importance when raising.
- Choosing a good lawyer is of primary importance.
- When it comes to raising, do, or do not. There is no try.
Table of Contents
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What Venture Deals Talks About
Venture Deals is a book written by venture capitalists Brad Feld and Jason Mendelson. It teaches entrepreneurs how to deal with VCs at different stages, how to negotiate a term sheet, what are the most important concepts to know, how to negotiate a buyout, how VCs are structured and work, and much more about startup financing.
This book took me a month to read and summarize. I never thought I’d get to the end. It’s extremely detailed and quite complicated to read for people that never had a law course in their life (like me).
So, should you read this book?
Not sure. If you want to know everything there is to know about a term sheet, yes. But otherwise, I would simply hire a good lawyer and google the terms of the sheet as you read it, like Daniel Dines.
And if you want to know the basics, you can read this article.
Not sure anyone took as much time as I did to write such a summary of such a boring book, so…enjoy it!
Summary of Venture Deals Written by Brad Feld and Jason Mendelson
Introduction: The Art of the Term Sheet
The book will talk about negotiating the term sheet. The term sheet is the sheet with the terms related to an investment in a startup.
Chapter 1: The Players
If you are an entrepreneur, make sure you direct and control the process.
The Venture Capitalist (VC)
The most senior person in the firm is usually called a managing director (MD) or a general partner (GP). VCs have a hierarchy of their own which entrepreneurs need to respect.
Partners are often not partners. They’re just employees.
Under them are principals or directors. They don’t have much decision power.
Then you have associates which are doing the research. And the analysts, who do the work no one wants to do (crunch numbers, write memos).
Some firms have venture/operating partners, which are seasoned entrepreneurs that can scout for deals.
Bottom line: do some research to see who has the power in the firm. It’s most of the time the MD, or GP.
Financing Round Nomenclature
Most VCs define themselves by the round at which they invest (seed, Series A, etc).
These terms often change.
Today, it goes like this: pre-seed, seed, Series A, Series B, etc.
Types of Venture Capital Firms
- Micro VC: usually seasoned angels with their own firm.
- Seed stage funds: up to $150 million. Focus on being the first institutional investor. Often provide a board member.
- Early stage funds: $100-$300 million, seed to Series B.
- Mid-stage funds: $200-$1 billion. Series B and later. Invest for growth.
- Late-stage funds
Focus on the firms that focus on your stage.
The Angel Investor
Individual investors that invest in early rounds only.
Angels aren’t important enough to influence your company.
A syndicate is a collection of investors.
Sometimes, syndicates would each invest tiny amounts of money, which is annoying for the entrepreneur because these VCs don’t have much skin in the game, so they don’t help.
A great lawyer will help you focus on what really matters (economics and control), while a bad lawyer will make everything worse for you. So choose an experienced lawyer.
A lawyer is a reflection of you: a bad lawyer will tarnish your reputation.
Don’t let VCs decide your lawyer.
Make sure the lawyer caps his fees.
Rarely seen at this stage. Work with one used to work with startups.
Rarely there for early stages. Bankers are useful for deals that include a partial recapitalization by a financial sponsor, such as a private-equity firm, or for acquisitions.
Entrepreneurs should have experienced mentors around them that help them with the raise.
These people are usually angel investors.
Chapter 2: Preparing for Fundraising
Choosing the Right Lawyer
You choose a lawyer based on their experience level, cost, and comfort with the communication style. Try to choose someone you like as they will know every detail about your business.
Try to choose one that is well-versed in the startup world, and that also knows accelerators and investors.
Proactive versus Reactive
The best defense is offense. Here’s what you can do now to minimize the hurdles later.
- Get the right type of company: make sure the legal type of company you have enables you to raise easily.
- Establish a data site: use a service that helps investors go through your finances seamlessly. You should also make available on the data site:
- The cap table: spreadsheet with who owns what.
- Financial records, budgets
- Major customer lists
- Employment agreements
Patents, copyrights, trademarks, and trade secrets. These reassure the investors that no one that has worked with the startup in the past is going to copy it.
A founding team should ensure that anyone who has had contact with their company’s intellectual property has signed agreements with confidentiality and IP assignment provisions.
Sometimes, a founder will work on his startup while being employed at a day job. In some cases, the day job owns what the founder makes because he is still employed.
So it is very important that the founder gets a signed agreement from his employer that states clearly that what the founder makes belongs to the founder. If not, the founder should leave his job asap.
Every employee of a startup, including founders and each of the company’s executives, must sign a Proprietary Inventions and Assignment Agreement to protect the startup’s rights to its intellectual property.
This also applies to advisors.
Chapter 3: How to Raise Money
Try to get several term sheets from several VCs to apply pressure and get better deals.
Here’s a set of advice.
Do or Do Not. There Is No Try.
You must raise money with the confidence that you will succeed.
You absolutely cannot be uncertain of yourself. This will turn off investors.
Know How Much You Are Raising
This depends on how long you need to reach the next step in your company. The longer you need + the more resources you need, the more money you will raise.
The amount of money you need to raise will determine which VC you will talk to. Don’t talk to the wrong VCs.
Don’t ask for more than you need, especially if the committed funds are far from the amount you are asking to raise.
Don’t use ranges. Be specific.
- A short description of your business: elevator pitch.
- An executive summary: concise, well-written description of your idea, product, team, and business.
- A slide deck: 10-20 pages. Make sure to adapt it according to your audience. Less is more. Only focus on the problem you are solving, the size of the opportunity, the strength of the team, the level of competition or competitive advantage that you have, your plan of attack, current status, summary financials, use of proceeds, and milestones.
Whatever you send to a VC is both your first and last impression.
If you already have a demo or prototype, send it too. It’s very important and VCs love them.
- Business plan: useless for VC, interesting for the entrepreneur as writing about his idea forces him to think about it.
- Private Placement Memorandum: a traditional business plan wrapped in legal disclaimers. Only made when lawyers and bankers get involved. Often a waste of money and time.
- Detailed Financial Model: 100% of them are wrong.
Never hide anything. Make sure to disclose all issues you have.
Finding the Right VC
Ask your friends or other entrepreneurs for introductions and feedback regarding VCs, or contact them directly on their website.
Never forget the simple idea that if you want money, ask for advice. Try to develop a relationship that evolves over time, instead of viewing fundraising as a single, transactional experience.
Do some research on the VC and make sure their vision and expertise fit with your product.
Finding a Lead VC
There are three types of investors:
- Leaders: They will give you a term sheet, take a leadership role in driving to a financing, and be your most active new investor. You can get several VCs to compete to be your lead VC.
- Everyone else
Your purpose is to find a lead VC.
As you are meeting with VCs, you will get four vibes.
- VC is interested and wants to lead: aggressively engage with them.
- VC isn’t interested and wants to pass.
- Maybe: these VCs hang around, observing what the other VCs do. Keep on meeting with them often.
- Slow no: they never actually say no, but they will not invest. Hard to figure them out from the “maybes”.
How VCs Decide to Invest
The way VCs behave with you depends on how you were introduced to them. Some only invest in companies that someone they trust introduced them to.
So figure out if you were “rightly” introduced, or “wrongly” introduced.
Then know who you are talking to: are these people the ones that make the final decision?
The way the VC will do its due diligence will tell you a lot about its interest. If they’re getting too curious, they’re likely not serious.
Ask for feedback about VCs from entrepreneurs that worked with them.
If VCs want to invest, they will eventually issue a term sheet.
If a VC met with you then decline to invest, ask why.
Using Multiple VCs to Create Competition
This gives you leverage to negotiate. Aim at 3-6 months if you want to make them compete.
Ask how the process goes for each VC after a second meeting.
If they ask you which other VC you’re talking to, don’t tell them.
Closing the Deal
The most important part of the fundraising process is to close the deal, raise the money, and get back to running your business.
This is done in two steps:
- Negotiate and sign the term sheets.
- Sign the final documents and get the cash.
Usually, when the term sheet is signed, you will get the cash.
Chapter 4: Overview of the Term Sheet
The Key Concepts: Economics and Control
VCs care about two things:
- Economics: that’s the return on investment.
- Control: controlling or vetoing business decisions.
When founders receive stocks, it’s called common stock.
When investors buy stocks, it is called preferred stock. Preferred stock can become common stock, but not the other way around.
Chapter 5: Economic Terms of the Term Sheet
The valuation of the company determines how much equity you’re giving away.
It will also determine the price per share.
There are two ways to discuss valuation:
- Pre-money: what the company is worth today.
- Post-money: what the company will be worth after the raise.
Make sure you know which one you are talking about.
Employee Option Pool
The option pool is reserved to give employees stocks to motivate them to work.
The size of the option pool has an impact on the valuation.
Eg: if you have reserved €1 million at a €10 million pre-money valuation (aka 10% for the employee pool), and the VC wants 20% instead, then the pre-money valuation will be €5 million.
Usually, employee option pools are anywhere between 10%-20% in early-stage companies.
The reason why VCs want large option pools is to decrease as much as possible their own dilution.
A warrant is a right for an investor to purchase a certain number of shares at a predefined price for a certain number of years.
Eg: 2-year warrant to buy 10 000 shares at €1 per share (it’s a call option, really).
Avoid warrants, as they complicate the whole thing.
Warrants may happen in bridge loan situations. A bridge loan occurs when an investor is planning to do financing but is waiting for additional investors to participate. Accept warrants only as long as they are structured properly.
When a new investor comes in, he’ll ask for a very low valuation. At the next round, he will ask for a very high valuation (to avoid dilution).
How Valuation Is Determined
VCs use the following variables to determine valuation.
- Stage of the company: in the beginning, the valuation depends on the experience of the entrepreneurs, the money raised, and the opportunity. Later, it depends on cash flow projections.
- Competition with other funding sources: the more VCs want to invest, the higher the valuation goes. Don’t pretend there’s competition if there isn’t. Be honest.
- Size and trendiness of the market
- The VC’s natural entry point
- Cash flow
- Economic context
Don’t take valuation personally.
Liquidation happens when the company is sold, or when a majority of its stake is sold.
The liquidation preference is important when the company is sold for less than what has been invested, but also important when it is sold for more.
The liquidation preference is made out of two terms:
- The actual preference: how much money will be returned when liquidation happens to whom (preferred VS common stock). In case the company is sold for less than the money invested, people may get back X% of what they have invested. Usually, that number is 1x.
- Participation: which shares are participating, and which aren’t?
- No participation: the investor gets his investment and nothing else. Eg: you invest 5 million at a $10 million valuation, the company is sold for 100 million. You get 5 million back.
- Full participation: the investor gets his actual preference + the percentage he owned in the company for the rest of the money.
- Capped participation: the investor gets his investment back + a share of the rest capped at X% of the original price.
Liquidation event: a liquidation event is an event tied to liquidity, when the shareholders receive proceeds for their equity in a company and includes mergers, acquisitions, or a change of control of the company.
In a pay-to-play provision, investors must keep investing pro-ratably in future financings (paying) in order to not have their preferred stock converted to common stock (playing) in the company.
This is good for both the startup and the investor as this ensures skin in the game.
Vesting means that the employee does not receive all of the stocks he is given on the first day of work, but receives it over a certain period (4 years, with a one-year cliff).
Founders often receive one year of their stock right away, then the rest after the next three years.
When someone leaves the company without their stocks, then we have reverse dilution where everyone is getting a bit of those stock.
It’s important to define what happens to the shares in case the company gets acquired before the end of the vesting period (called single-trigger acceleration).
There are two types:
- Weighted average antidilution
- Ratchet-based antidilution: if the new round is done at a lower valuation than the previous round, all stocks in the company go to the new, lower valuation.