Month: July 2011
When discussing the economics of a VC deal, one often hears the question “What is the valuation?” While the valuation of a company, determined by multiplying the number of shares outstanding by the price per share, is one component of the deal, it’s a mistake to focus only on the valuation when considering the economics of a deal.
In this chapter we discuss all of the terms that make up the economics of the deal, including price, liquidation preference, pay-to-play, vesting, the employee pool, and antidilution.
In addition to defining and describing each terms, we give extensive examples in this chapter. Grab a beer – take your time – there’s a lot here. Almost all of the terms also have a special bonus “The Entrepreneurs Perspective” from our good friend Matt Blumberg, the CEO of Return Path.
Firas Raouf from OpenView Partners has today’s VC Post of the day up titled Should You Care About Your VC’s Investors? In it he covers some fundamentals about how VC funds are structured and then lists three things that the nature of the LPs of a VC firm will tell you about that firm.
- VC firm credibility: The quality of a VC can often be judged by the quality of its LPs. High-quality LPs invest in high-quality VCs.
- VC firm stability: Is the LP base stable, or is there significant turnover in LPs from fund to fund? Is there LP concentration, which would increase the risk of turnover? Are the LP funds stable enough to continue funding the VC over time?
- Exit Pressure: Are the LPs pressuring the VC for exits? What is the hold period that LPs are pushing for and how does it vary from the VCs period? How does either period differ from yours?
We cover a lot of this stuff, and more, in Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist in Chapter 8: How Venture Capital Funds Work but are psyched to see other VCs blogging about this in an effort to demystify how VC firms are actually structured, VCs are compensated, and what impacts their motivations at different points in the life of a fund or a firm.
I love a good rant, especially when it’s from one of my partners. Today, Seth Levine has the VC Post of the Day titled Beware of ASSHOLE VCs. He talks in detail about his frustration with an experience he’s just had with a company he invested in unrelated to Foundry Group. He reminds us all to “check out your investors before you go into business with them.”
Chapter 3 of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist is a transitional one that sets up the next few chapters on Term Sheets.
At the end of 2005, we participated in a financing that was much more difficult than it needed to be. All of the participants were to blame, and ignorance of what really mattered in the negotiation kept things going much longer than was necessary. We talked about what to do and, at the risk of giving away super-top-secret VC magic tricks, decided to write a blog series on Brad’s blog (Feld Thoughts) that deconstructed a venture capital term sheet and explained each section.
That blog series was the inspiration for this book. The next few chapters cover the most frequently discussed terms in a VC term sheet. Many VCs love to negotiate hard on every term as though the health of their children depended on them getting the terms just right. Sometimes this is inexperience on the part of the VC; often it’s just a negotiating tactic.
The specific language that we refer to is from actual term sheets. In addition to describing and explaining the specific terms, we give you examples of what to focus on and implications from the perspectives of the company, VCs, and entrepreneurs.
The various terms in a term sheet fall into three categories: (1) economics, (2) control, and (3) everything else. In this chapter we explain what we need by economics and control as we get ready to roll into the meat of the term sheet.
In Chapter 2 of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist, we cover the basics of the VC fundraising drill.
Your goal when you are raising a round of financing should be to get several term sheets. While we have plenty of suggestions, there is no single way to do this, as financings come together in lots of different ways. VCs are not a homogeneous group; what might impress one VC might turn off another. Although we know what works for us and for our firm, each firm is different; so make sure you know who you are dealing with, what their approach is, and what kind of material they need during the fund-raising process. Following are some basic but by no means complete rules of the road, along with some things that you shouldn’t do.
In this chapter, we cover topics like Do or Do Not; There Is No “Try”, Determine How Much You Are Raising, Fund-Raising Materials, Due Diligence Materials, Finding the Right VC, Finding a Lead VC, How VCs Decide to Invest, and Closing the Deal.
Hopefully we are whetting your appetite for the tasty morsels to come.
Rob Go from NextView Ventures has today’s VC Post of the day titled Some Thoughts on Communicating With Your Investors. It contains some great advice for communicating with your seed investors (both VCs and angels), for building both commitment from your early VC seed investors, and creating a cadence that is effective.
Fred Wilson of Union Square Ventures MBA Monday’s post titled Financings Options: Venture Debt is the runner up. Fred continues to knock it out of the park with super useful information in his MBA Monday’s series.
We also owe a special thanks to Mark Suster of GRP Partners for his awesome review of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist which he ran first on TechCrunch and then on his blog titled One Book Every Entrepreneur and VC Should Own. Mark – we humbly thank you for your incredibly kind words.
On day two of our romp through the table of contents of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist, we cover the various players involved.
While it might seem like there are only two players in the financing dance—the entrepreneur and the venture capitalist—there are often others, including angel investors, lawyers, and mentors. Any entrepreneur who has created a company that has gone through multiple financings knows that the number of people involved can quickly spiral out of control, especially if you aren’t sure who actually is making the decisions at each step along the way.
The experience, motivation, and relative power of each participant in a financing can be complex, and the implications are often mysterious. Let’s begin our journey to understanding venture capital financings by making sure we understand each player and the dynamics surrounding the participants.
In Chapter 1, we describe and discuss the entrepreneur, venture capitalist, angel investor, syndicate, lawyer, and mentor. Every book, framework, and deal needs a place to start – knowing the players is the one we thought was best.
Question: In a Series A, the investor is proposing a preferred stock with warrants. The warrants relate to the accomplishment of milestones, are optional, and are priced at 50% above the initial price. Is there an advantage to this versus structuring a two close deal. How do we make the second investment mandatory, more like a call option?
Ahhh. Nothing like a complicated one to kick off the first Ask the VC question in a while. To understand this a little better, let’s break apart the questions from what is being proposed.
It sounds like the proposal is a “Preferred A” with a “warrant” for more “Preferred A” at a price that is 50% more than the initial price. In simpler terms, let’s assume that it’s a Preferred A investment of $1m at $1 / share (or 1m shares of stock). Let’s assume a post-money valuation of $4m. This means that there are 3m shares of common stock since the 1m shares of Preferred buys 25% of the company.
In addition to the 1m shares of Preferred, in this deal the investor would get another 1m shares of Preferred Warrants priced at $1.50 / share. This means that at some point in the future the investor could invest $1.5m for another 1m shares.
Assuming there were no other changes to the capital structure, if the investor exercises the warrant there is a total of $2.5m that goes into the company (the original $1m plus the $1.5m from the warrant). This buys a total of 2m shares. Since there are 3m common shares, this results in the investor owning 40% of the company for $2.5m (2m investor shares / 5m total shares). The post money valuation after the warrant is exercised is $6.25m (2.5m / 0.40).
Got that? Bottom line – the investor is proposing a $3.75m pre-money / $6.25m post-money for a total investment of $2.5m
Now to the questions: First, Is there an advantage to this versus structuring a two close deal? Unless we address the second question, where the investor is compelled to exercise the warrant upon completion of the milestones, this is a bad deal for the entrepreneur. If the warrant conversion is optional on the part of the investor, it’s simply a pricing mechanism for capturing upside if the company is successful. If things aren’t going well, the investor doesn’t need to exercise the warrant. Depending on the actual warrant terms, the investor may have a limited time window to exercise (1 year, 2, years, 5 years) – the longer the time window, the more “optionality” the investor has. Generally, a warrant like this in an early stage investment (e.g. a Series A round) is unusual and either indicates an investor who is unhappy with the pre-money valuation and trying to capture additional economics, or is unsophisticated about typical Series A investments.
The second question is the important one. How do we make the second investment mandatory, more like a call option? The warrant should be tightly tied to milestones that the entrepreneurs believe are achievable. As VCs, we don’t like this approach, but some VCs do as they believe it focuses the entrepreneurs on what the VCs think are the hurdles (or milestones) that define near term success. If the milestones are clearly defined, achievable, and the warrant has to be exercised upon achievement, then this is merely a pricing mechanism and – as the entrepreneur – you need to decide if you are happy selling 40% of your company for $2.5m.
Every day for the next two weeks we’ll give you a small taste of our new book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by giving you the overview of each chapter along with the titles of each subsection. Of course, our goal with this is to be good book salesmen and encourage you to buy the book by teasing a little about the content. So, if you are already a believer, go buy the book now. Otherwise, here’s some background from the Preface on why we wrote the book.
One of the ways to finance a company is to raise venture capital. While only a small percentage of companies raise venture capital, many of the great technology companies that have been created, including Google, Apple, Cisco Systems, Yahoo!, Netscape, Sun Microsystems, Compaq, Digital Equipment Corporation, and America Online (AOL) raised venture capital early in their lives. Some of today’s fastest-growing entrepreneurial companies, such as Facebook, Twitter, LinkedIn, Zynga, and Groupon, were also recipients of venture capital.
Over the past 17 years we’ve been involved in hundreds of venture capital financings. Six years ago, after a particularly challenging financing, we decided to write a series of blog posts that would demystify the venture capital financing process. The result was the Term Sheet Series on Brad’s blog, which was the inspiration for this book.
As each new generation of entrepreneur emerges, there is a renewed interest in how venture capital deals come together. We encounter many of these first-time entrepreneurs through our activities as venture capitalists at our firm Foundry Group, as well as our involvement in TechStars. We are regularly reminded that there is no definitive guide to venture capital deals and as a result set out to create one.
In addition to describing venture capital deals in depth, we’ve tried to create context around the players, the deal dynamics, and how venture capital funds work. We’ve tossed in a section on negotiation, if only to provide another viewpoint into the brains of how a venture capitalist (at least the two of us) might think about negotiation. We also took on explaining the other term sheet that fortunate entrepreneurs will encounter—namely the letter of intent to acquire your company.
We’ve tried to take a balanced view between the entrepreneurs’ perspective and the venture capitalists’ perspective. As early stage investors, we know we are biased toward an early stage perspective, but we try to provide context that will apply to any financing stage. We’ve also tried to make fun of lawyers any chance we get.
We hope you find this book useful in your quest to creating a great company.
Roger Ehrenberg from IA Ventures has today’s VC post of the day titled Financing your start-up. He covers some very relevant ground talking about what he thinks are the key variables an entrepreneur should consider with regard to her financing strategy: (1) Founder objectives and mind-set; (2) Business potential; (3) and Interpersonal dynamics. As with many things in life, Roger states something that we strongly believe: “But at the end of the day, interpersonal dynamics plan a vital role in any financing plan for a business of any size.”