Chapter 6: Control Terms of the Term Sheet
These terms define the control a VC firm will have over the company it invests in.
Board of Directors
The board of directors is the most powerful element of a company’s management structure and almost always has the power to fire the CEO.
The board approves many important decisions the CEO makes, such as:
- Budget
- Option plan
- Merger
- IPO
- Hiring executives
Be careful who comes to your board, there shouldn’t be too many people, and whoever comes should be helpful.
After the first round, a board will usually consist of:
- Founder/CEO
- VC
- External board member
Protective Provisions
Veto rights investors have on certain actions the company takes, such as:
- Change the terms of stock owned by the VC
- Authorize the creation of more stock
- Issue stock senior or equal to the VC’s
- Buy back any common stock
- Sell the company
- Change the certificate of incorporation or bylaws
- Change the size of the board of directors.
- Pay or declare a dividend; Borrow money
- Declare bankruptcy without the VC’s approval
- License away the intellectual property of the company, effectively selling the company without the VC’s consent
- Consumate an initial coin offering or similar financings;
- Create a token-based interest in the company.
Make sure that your investors vote as a single class, and make sure that small investors can’t veto big decisions.
Drag-Along Agreement
This agreement enables the company to compel a shareholder to change (or not) his stocks with everyone from his series, or with everyone else in general.
This would help VCs avoid having smaller investors veto decisions they wanted to make.
Today this type of agreement concerns founders. When they leave, their stocks get “dragged along” by other classes of stocks, so they don’t “block things”.
Conversion
It is the right to convert from preferred stocks to common stocks, and this right is non-negotiable to VCs.
Chapter 7: Other Terms of the Term Sheet
Dividends
VCs don’t really care about dividends because compared to the growth of the share, it doesn’t make much money. When there are some though, they will range from 5% to 15%.
Redemption Rights
Redemption rights exist to allow the investor to exit no matter what.
Eg: the company becomes successful enough to survive, but not enough to IPO or be acquired.
Do not ever agree to an adverse change redemption.
Conditions Precedent to Financing
These are the conditions that must be met for the deal to be signed.
Try to avoid these.
There are three conditions to watch out for:
- Approval by investors’ partnerships: this means the deal the VC presented you with was not yet approved…by the VC itself. Understand: it’s not because you signed the term sheet that you have a deal.
- Rights offering to be completed by the company: the VC wants to offer the previous investors in the startup to also participate in the financing.
- Employment agreements signed by founders as acceptable to investors: know what those agreements are (eg: what happens if you get fired).
Information Rights
What information the VC has access to and the time the company has to give it to them if they ask for it.
Registration Rights
Registration rights define the rights that investors have for registering their shares in an IPO scenario as well as the obligation of the company to the VCs whenever they file additional registration statements after the IPO.
Right of First Refusal
The right of first refusal defines the rights that an investor has to buy shares in future financing.
Only give this to a major investor.
Voting Rights
Voting rights define how the people that own preferred stock and people who own common stock relate to each other in the context of a share vote.
Restriction on Sales
It defines the parameters associated with selling shares of stock when the company is a private company.
Proprietary Information and Inventions Agreement
This is the VC making sure that whatever the company makes belongs to the company. It forces the company to make their employees sign a paper related to inventions and information property.
Co-Sale Agreement
If the founder sells shares, then the VC should be also allowed to sell some too.
Founders’ Activities
This is to force founders to focus on the company 100% and prevent them from doing “side hustles”.
If you don’t agree with this, don’t try to raise money.
Initial Public Offering Shares Purchase
In case there is an IPO, this will give the VC the right to buy shares at the initial price.
No-Shop Agreement
Prevents you from negotiating with other VCs as you are about to close the deal.
Indemnification
This is a clause forcing the company to indemnify its board members.
Assignment
This gives them the right from VC to transfer their shares to other people/company they own/know.
Make sure that whoever the VC transfers shares to agrees to the same conditions.
Chapter 8: Convertible Debt
Nowadays, most financing happens with convertible debt.
Convertible debt is a loan, so there’s no discussion about valuation. When the company raises money in the future, then the debt converts to equity (often at a discount).
Eg: raising 100k at a 10% discount. If your company is worth 1 million, then the 100k will transform to 100k/0.9 = 111 111.
Here’s what you should know about convertible debt.
- It’s easier because since it’s debt, there is no need to fix a valuation. In early-stage financing, VCs and founders often fight over valuation. Some investors ask for a valuation cap. If the valuation of the company is more than X when they raise, then the investor will ask Y% of discount. This is good for the investor but not for the company as other investors may not want to invest at a higher valuation than the cap.
- It may inflate the price of the financing later on. And if the price is too high, your lender will end up with a little share despite being your “first fan”.
- The cap may influences the overall valuation of the company.
To do it properly, raise debt but wait long enough before raising a round so the cap does not negatively influence the valuation. Offer as well forced conversion to your lender if you end up not raising any round.
The Discount
The discount is there to reward the investor for taking the risk at an early stage in the venture. Indeed, the interest on the debt is too little to be financially significant.
The discount can work in two ways:
- The price is discounted in the next round: that’s what we explained above. Discounts go from 10% to 30%.
- Warrant: discussed below.
Valuation Cap
The valuation cap puts a ceiling on the valuation of the company.
Eg: if you receive 100k of debt, the investor will get much more money if you raise at $1 million than at $10 million.
So the cap ensures that the lender can get a good deal. In this case, if the cap is set at $5 million and the company raises at a $10 million valuation, then the lender will see his shares converted as if the company raised at $5 million.
Interest Rate
Since it’s debt, it has an interest rate. These should be as low as possible since the debt will convert at some point.
Conversion Mechanics
Debt holders have more power than equity holders, so you do have an interest in the debt converting to equity.
For the debt to convert automatically, all conditions must be met. These are the terms you should know.
- Term: the amount of time after which the company must sell equity for the debt to convert. Make it as long as possible.
- Amount: minimum sum the company must raise.
If the company fails to reach these milestones, then the debt will remain debt unless the holders agree to convert it.
Warrant
A warrant is another way to convert the debt.
A warrant is an option to purchase X stocks at a predetermined price.
Eg: $100k debt with a 20% warrant coverage. In this case, that’s $20k of stocks.
Now, how do you figure you the price?
It can be:
- 20k of stocks at the last value.
- 20k of stocks at the round’s price
- 20k of stocks for the next round
Other terms you should know:
- Term length: the period during which the warrant can be exercised.
- Merger considerations: what happens if the company is acquired? The warrant should expire at the merger.
Other Terms
- Pro rata right: allow debt holders to participate proratably in a future financing.
- Liquidation preference: the debt holder gets back his money first in the event of a liquidation.
Early Stage versus Late Stage Dynamics
These debts were issued so that the startup could develop enough and get to a point where it could raise money (that is, mid to late stage).
But since it was cheap to do, it became more and more popular to save on attorney fees.
Can Convertible Debt Be Dangerous?
When you raise debt, your company becomes insolvent (from a financial perspective). If it goes bankrupt, the board may become liable.
An Alternative to Convertible Debt
SAFE: it’s an unpriced warrant instead of being convertible debt.
Chapter 9: The Capitalization Table
The cap table summarizes who owns what part of the company before and after the financing.
Don’t blindly trust lawyers and make sure to check the cap table yourself.
Note: this entire chapter used an example to explain the cap table, which explains why I did not include it here.
Chapter 10: Crowdfunding
There are two types of crowdfunding.
- Product crowdfunding: product crowdfunding is pre-sales, and there is no equity involved.
- Equity crowdfunding: selling shares in your company in crowdfunding.
The advantage of crowdfunding is that you are in a position of strength and set the terms of the deal yourself. The disadvantage is that you must do everything yourself.
Chapter 11: Venture Debt
The Role of Debt versus Equity
Venture debt is a type of loan offered by banks and nonbank lenders that is designed specifically for early stage, high-growth companies with venture capital backing.
Venture debt complements equity. It doesn’t replace it. It is rarely available to seed-stage companies, and comes later.
The Players
Banks and venture debt funds can give you debt.
How Lenders Think about Loan Types
Banks need to ensure that you have two sources of income to repay the loan.
Loan companies don’t, and loan you money based on the cash flow. So if you want to use the loan to grow instead of earning more, then this won’t work.
Most venture debt takes the form of a growth capital term loan that has to be repaid within three to four years. The first six to twelve months are to repay interests only (it’s the I/O period). The company pays accrued interest, but not principal, and begins to pay principal after.
Economic Terms
Economic and control terms should be the primary focus for most entrepreneurs.
- Interest rate: Most VC debt lenders only offer variable rates based on the rate by the central bank.
- Loan fees: 0.25% to 0.75% of the loan amount.
- Final payments: another common pricing mechanism. It is a loan fee paid at the very end of the loan’s life and is typically quoted as a percentage of the commitment amount.
- Prepayments: the longer you take on the loan, the more money the VC makes. So if you repay your loan faster than planned, you’ll have to pay a fee called prepayment.
Warrants as compensation are also common. While a no-warrant loan is preferable to both entrepreneurs and investors because it is nondilutive, in the early-stage market, warrant pricing is considered a critical feature by most lenders.
Amortization Terms
It’s important to ensure you actually can refund the loan.
- The draw period: it’s a period during which you can draw extra cash under the loan and during which the lender does not earn any interest on. The bigger it is, the better it is for you.
- The interest-only (I/O) period: it’s the period during which you repay only the interest of the loan and not the principal. A typical loan structure is 12 months of I/O period followed by 36 months of amortization.
Control Terms
The defining characteristic of growth capital loans to early stage technology companies is the lack of financial covenants.
Financial covenants give the lender the right to cancel its commitment, accelerate the repayment schedule, or seize and liquidate collateral if the borrower’s financial performance fails to stay within established parameters.
Obviously, these are too dangerous for early-stage companies which fail often anyway, so the lenders may ask for warrants instead.
Financial covenants are a subset of a broader category of contractual terms that lenders use to manage repayment risk.
You have two types of covenants:
- Affirmative covenants are actions that the company promises to take during the term of the financing contract. Such as:
- Regulatory compliance
- Government approval
- Reporting
- Taxes
- Insurance
- Accounts
- Negative covenants define behaviors and actions that the company may not engage in as a condition of the loan.
- Dispositions: don’t sell or transfer business assets without the authorization of the lender.
- Change in control/location
- Mergers/acquisitions
- Indebtedness
- Encumbrance: don’t provide lien interest (the right to acquire a part of the business)
- Distribution of dividends
- MAC: Material Adverse Change: this is a big change of circumstances that cannot be occurring before lending. Sometimes it is not written in the sheet. If it is not, ask questions about it.
Negotiation Tactics
The venture capital industry is relationship-driven, which applies equally to debt and equity.
It is important that you have a good reputation. Don’t try to get away with negotiating every term of the sheet if the organization lending you the money brings you benefits (they know lots of people, etc).
You can also leverage the best deal by getting several firms to compete for the loan.
Restructuring the Deal
Once you have a problem and need to renegotiate, do so as soon as possible. Be transparent too.
The first priority will be to see the risk that restructuring the loan will have.
The second priority is to look at how likely the company is to fail. The company may look at raising more equity, focusing on earning more money, or firing people.
Chapter 12: How Venture Capital Funds Work
Overview of a Typical Structure
A VC fund is made up of three entities:
- The management company: owned by senior partners, employs all of the people with whom you interact at the firm. Makes money by creating and retiring funds.
- The Limited Partnership (LP) vehicle: the actual fund that will invest in the company.
- The General Partnership (GP) entity: This is the legal entity for serving as the actual general partner to the fund.
The management company and the fund can ultimately have different purposes, especially if managed by different people.
How Firms Raise Money
VCs raise from:
- Government
- Corporate pension funds
- Large corporations
- Banks
- Professional institutional investors
- Educational endowments
- High-net-worth individuals
- Family offices
- Funds of funds
- Charitable organizations
- Insurance companies
The arrangement between the VCs and their creditors is in a sheet called the limited partnership agreement and it dictates what the VC must do.
The creditors don’t wire the money to the VC right away. They commit to wiring a certain amount, but give in effect every time the VC asks for it as it wants to make an investment. The money itself arrives within two weeks, usually.
So when a fund “raises $10 million”, this means it got “the legal agreement to receive $10 million of funding within a certain period”. Doesn’t mean the cash is actually there.
How Venture Capitalists Make Money
- Management fees: the smaller the fund, the higher the management fee (between 1.5% and 2.5%, paid per year and starts to decrease after the commitment period has passed, usually five years). The more funds they raise, the more money they make.
- Carried interest: the money they earn after returning the capital to LPs (that is, money on profits). Usually 20%, sometimes 30%.
- Reimbursement for Expenses: VCs charge the company when they sit on the board.
How Time Impacts Fund Activity
The commitment period (usually five years) is the time when a VC can invest in new companies. After, it can only invest in the companies it already invested in the past.
The investment term is the total duration of the fund’s duration, usually 10 years. It is therefore better to invest in a young fund that will not feel the pressure to exit the investment, than in an old fund.
Beware of the VC zombies. These are VCs that can no longer invest as a failure of raising a new fund.
Reserves
Reserves are the amount of investment capital that is allocated to each company that a VC invests in.
This is the money the VC thinks you will need but does not yet give you.
Strategic Investors
Companies that aren’t in the business of making venture capital investments, but for a particular reason want to invest in your company.
It can be your manufacturer, for example. Things get annoying when you want to partner with a company rival of the company that invested in you.
