Summary of Venture Deals by Brad Feld and Jason Mendelson

Chapter 13: Negotiation Tactics

What Really Matters?

1. Achieving a good and fair result
2. Not killing your personal relationship getting there
3. Understanding the deal that you are striking.

Financing is only the beginning of the relationship, so if you don’t have a good relationship in the beginning, it’s unlikely to go better at the end.

Preparing for the Negotiation

Get a plan about what you want and what you to ask and understand.

Make sure you know who you are negotiating, the things they want, the things they think.

One of your few advantages against a VC is time. Most of them want to go very quickly. But you don’t need to.

A Brief Introduction to Game Theory

Game theory states that there are rules underlying situations that affect how these situations will be played out.

These rules are independent of the humans involved and will predict and change how humans interact within the constructs of the situation.

Knowing what these invisible rules are is of major importance when entering into any type of negotiation.

Negotiating in the Game of Financings

Ask the VC to state their top three priorities in the term sheet, and do so too. If they insist on negotiating a term that isn’t their priority, call them out.

Overall, VC financing is easy as it is a win-win game with explicit rules negotiated in the open.

Negotiating Other Games

1. Winner-takes-all: being sued, or having the company close to bankruptcy. In this case, results are all that count. Reputation doesn’t.
2. A founder departs: negotiate hard, but fair as your reputation will matter.
3. Acquisition: this is both a winner-takes-all and win-win situation. Reputation matters as you will likely be working for the company that acquired you.

Collaborative Negotiation versus Walk-Away Threats

Know your walk-away point by looking at the best alternative. If you reach this point…actually walk away. Don’t make threats you cannot back up.

Building Leverage and Getting to Yes

The best leverage is other VCs that want to invest. Be transparent about that without saying WHO these VCs are.

Never share the term sheets you received from a VC with anyone.

Don’t change your mind after signing.

Never provide a VC with a term sheet.

Don’t negotiate point per point, but negotiate the whole sheet.

Don’t assume that others are as ethical as you are.

Great Lawyers versus Bad Lawyers versus No Lawyers

Hire a great lawyer who is a reflection of who you are and of your personality as whatever they do will directly be associated with you.

Can You Make a Bad Deal Better?

You can wait for an exit, renegotiate the deal with a new VC later, or renegotiate the deal with the current VC later too.

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Chapter 14: Raising Money the Right Way

1. Don’t Be a Machine: Fundraising is about people. If the VC doesn’t like you personally, they won’t invest in your company.
2. Don’t ask for a nondisclosure agreement
3. Don’t send the same email to 1000 VCs. They don’t like spam and know when they’re getting it.
4. No means no.
5. Don’t ask to be referred to another VC after a no.
6. Don’t be a solo founder.
7. Don’t overemphasize patent
8. Don’t tolerate bad behavior and speak up.

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Chapter 15: Issues at Different Financing Stages

Seed Deals

While seed deals have the lowest legal costs and usually involve the least contentious negotiations, they often allow for the most potential mistakes.

Getting great terms (aka a high valuation) is not always good as if you fail in the business development, then the next raise will be at a lower valuation and hence your first investor won’t be happy – they may even block it.

You raise based on a great team with a great idea (that is, “hope”).

When you receive a term sheet, it means the investor is ready to invest.

Early Stage

The deals you had for the seed will likely be similar here, and for all the subsequent raises.

Beware of the liquidation preference, as it can drastically decrease return for a common investor.

Another term to pay extra attention to at the early stage is the protective provisions. You will want to try to combine the protective provisions so that all preferred stockholders, regardless of series, vote together on them.

If they vote per class, then one class could veto a future round of financing.

Mid and Late Stages

Every time you raise, you have to give up one seat on the board to an investor.

If lots of people make up your board since will be complicated. If not, your investors will dominate it.

If your investors are nice, that won’t be a problem. But you really need to start thinking about this and see how you can avoid losing control of the board (and the company).

One way to avoid that is to cap the number of VCs that get a seat on the board.

Once again, don’t raise too high if you intend to sell at some point. Few will accept selling a company for less than a round valuation.

Some VCs will give you a term sheet without being ready to invest (they need XYZ’s accord). Make sure this doesn’t happen by asking the VC if the investment is final after you sign the term sheet.

You raise based on financial results, not “hope”.

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Chapter 16: Letters of Intent: The Other Term Sheet

A letter of intent (LOI) is a letter from a company that wants to acquire your company.

-> the tone and stress are much tougher than that of a regular deal.

The LOI arrives after some negotiations and dinners have already occurred. It’s the first step (non-biding) towards the acquisition.

Make sure to get a detailed LOI as the absence of some terms will not be a good thing.

Structure of a Deal

There are only two things that matter: price and structure.

Price:

• Depends on lots of variables.
• The acquirer often has an escrow condition where they set some money aside until they make sure every obligation has been fulfilled.
• The working capital is”: current asset minus current liabilities. Startups have usually a negative working capital, and it shouldn’t be above zero in general in the LOI.
• Retention pool: money to make sure current employees don’t leave.

Asset Deal versus Stock Deal

An asset deal is when the company only buys certain activities from the company (but not everything). A stock deal is when it buys the whole company.

In general, buyers want an asset deal, and sellers, a stock deal.

A stock deal can be settled with cash and an asset deal, with stocks.

In the end, an asset or stock deal depends on the state of the company, what the acquirer wants, the structure, and the taxes.

Be careful when you are selling your company “for stocks” of a company that isn’t publicly traded. It may be worth much less than you think – or impossible to convert to cash.

Assumption of Stock Options

In the past, the acquirer assumed the stock option plan for employees and nothing changed (assumption).

In some cases though, the acquirer did not follow the plan so all employees received right away their options (substitution).

Some companies finally, do neither, and the employees lose their options.

Representations, Warranties, and Indemnification

The reps and warranties are the facts and assurances about the business that one party gives the other.

The reps that the seller makes are more important. First thing to decide is who is making them? The company only, or the company + the shareholders?

The indemnification is what the company will have to pay in case it fails to give proper reps.

Always specify what the indemnification will be like.

If you sell your company for stocks, make the reps and warranties reciprocal.

Back the reps and warranties with “to the extent currently known” and don’t argue with them too much as it is a big red flag.

Escrow

The escrow (also known as a holdback) is money that the buyer is going to hang on to for some period of time to satisfy any issue that comes up post-acquisition that is not disclosed in the purchase agreement.

The carve-outs (or fundamental reps) to the escrow caps typically include fraud, capitalization, and taxes. Often, especially due to the risk of attack by patent trolls, a buyer will press for intellectual property ownership to be carved out

In all cases, the maximum of the carve-out should be the aggregate deal value, as the seller shouldn’t have to come up with more than it was paid in the deal to satisfy an escrow claim.

The seller should never come up with extra money to satisfy the claim.

Confidentiality/Nondisclosure Agreement

Always mandatory in the case of an acquisition because if the deal falls through, each company has now much info about the other.

The NDA should always be reciprocal and strong.

Employee Matters

Defer the details of individual compensation after the LOI is signed. Indeed, negotiating these and doing due diligence is long and annoying, and it causes unnecessary stress.

Conditions to Close

Buyers normally include certain conditions to closing in the LOI. These can be generic phrases such as “Subject to Board approval by Acquirer”. The more conditions, the more it tells about the buyer.

If there are a lot, push back against them.

The No-Shop Clause

Signing a letter of intent starts a serious and expensive process for both the buyer and the seller. As a result, you should expect that a buyer will insist on a no-shop provision similar to the one that we discussed around term sheets (a no-shop clause prevents you from talking to other buyers).

Ask for a deadline of 45-60 days until the acquisition, and don’t accept more than 60 days.

If the no-shop period ends and the company is still not acquired, the buyer will want to extend the no-shop.

As with no-shops with VCs, no-shops with potential buyers should also have an automatic out if the buyer terminates the process.

Fees and More Fees

The LOI will usually be explicit about who pays for which costs and what limits exist for the seller to run up transaction costs in the acquisition. Transaction costs associated with an agent or a banker, the legal bill, and any other seller-side costs are typically included in the transaction fee section.

Buyers always focus on making the seller pay those fees.

Buyers sometimes want to add a breakup fee (fee for them in case the deal falls through). Resist those as much as you can. Technically, you as the seller, should get one. Only ask one if you’re skeptical about the buyer’s intentions.

Registration Rights

If you receive stocks as compensation, make sure it is registered on the stock market. Unregistered stocks can only be sold after a year, but within a year, lots of things could go wrong (the price can dip).

Shareholder Representatives

The shareholder representative represents all the former shareholders of the seller to deal with post-deal issues (managing the escrow, dealing with earn-outs, working capital adjustments, and even litigation concerning reps and warranties).

It’s an abominable job and you should avoid doing it.

If you are though, negotiate for funds you can use in case you need to hire a lawyer.

Don’t ask someone that works for the buyer to be a shareholder rep, and don’t ask a VC either.

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Chapter 17: How to Engage an Investment Banker

Don’t use them for early or mid-stage (raising) but definitely do in case of an acquisition.

Why Hire an Investment Banker?

If you receive a perfect offer from a perfect buyer, or if your company is being sold for a very low price, then no need to have an investment banker.

But if you want to contact as many buyers as possible and sell for as high as possible, then you should hire an investment banker.

How to Choose an M&A Adviser

Use the following criteria.

1. Referral and references: ask around (from investors, board members, etc).
2. Specific industry and expertise: hire someone that knows about your sector.
3. Connection to buyers: the banker should already know companies interested to buy you.
4. Deal experience
5. Personal commitment
6. Cultural fit

Negotiating the Engagement Letter

The term of engagement is the “contract” between the banker and the company.

Here are the terms you should know:

• Scope of work: make sure to define what the banker will be doing exactly.
• Success fee: 1% – 10% (depending on the size of the deal). What the banker receives after a successful deal, calculated on a percentage of the sum going to shareholders. Be careful with incentive fees.
• Retainer and expense reimbursement: the retainer is a non-refundable monthly fee of 5k-15k, but can be deducted from the success fee provided you make it clear in the engagement letter. Reimbursement often concerns travel. Make sure to explicitly say what you will refund (a coach ticket) and what you will not (a first-class ticket).
• Term, termination, and tails: one-year terms are typical (it sounds long, but it’s not). Negotiate terms of termination for clear reasons too so you don’t remain stuck paying the banker if the deal falls through.
• Indemnification and dispute resolution: Since your banker is working for you during the deal, they will ask for specific risk coverage, called indemnification, in the event that they are sued during or after the engagement for actions taken on your behalf. Make sure to exclude those in case of incompetence or reckless behavior. Also, state how you will deal with disagreement with your banker.
• Key person(s) provision: A key person provision allows you to terminate the engagement and ideally the tail agreement in the event that your banker leaves the bank – and then continues with the same banker in his new bank.
• Fairness opinion: A fairness opinion is a formal letter from the banker to the board that confirms the fairness of the transaction being considered. It protects against any shareholder etc suing.

Helping Your Banker Maximize the Outcome

• Make sure everyone from the board agrees to the acquisition.
• Make sure everyone on the management team agrees too.
• Make sure to have a definite schedule with deadlines.

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Chapter 18: Why Do Term Sheets Even Exist?

You need terms sheets because VCs have people to answer to.

Constraining Behavior and the Alignment of Incentives

Terms sheets also prepare what happens in case there is a disagreement between the investor and the startup.

Transaction Costs

Term sheets minimize costs.

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Chapter 19: Legal Things Every Entrepreneur Should Know

Intellectual Property

Even if you pay for code written by someone else, you don’t own the code unless you get whoever wrote the code to sign a document saying that the code was “work for hire.” The exact words are critical.

VCs won’t invest in companies where there are IP issues.

Be careful who you are talking to, and be careful who you work with.

Patents

A patent provides a company with a 20- year monopoly over making, using, or selling an invention.

It’s also costly and long to make, and requires you from disclosing everything you have discovered.

Trademarks

A trademark gives a company a legal mechanism to protect a distinctive name, symbol, or tagline that identifies a company as the owner of a product or service.

Employment Issues

The most common lawsuits come from employment issues.

Here’s how to avoid them.

1. Make sure that everyone you hire is an at-will employee.
2. Decide on the severance terms. Eg: if you fire someone, you may give them more equity as compensation.
3. Get a good lawyer.

Founders’ Stock

There is no such thing as a founder’s stock. Common stock is issued to founders and preferred stock, to investors.

Founders stock = common stock issued at a very low price to a founder.

Make sure the stock is vested so that if one founder leaves the company, they don’t take it all with them.

Compensating Service Providers

You can give them stock, but make sure for it to be vested so that the company is incentivized to keep on working with you.

You can otherwise, also give these companies options on your stocks.

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