Q: What costs are considered reimbursable to the founder of a start-up company? More specifically, if the founder has been boot-strapping his company since inception, and he agrees to a series a term sheet with a VC firm, are the operational costs incurred by the founder between this time and the closing of the round reimbursable to the founder? For example: The founder of a consumer product company and a VC firm agree to a term sheet in July. The round doesn’t close until October or November due to raising additional capital for the round, attorney delays, etc. In the interim, the founder continues to self-fund the day-to-day operations of the business – packaging design, inventory, PR firm, etc. What expenses can the founder expect – if any – to get paid back out of the series a funding?
This varies widely and is fundamentally a negotiation between the new investors and the founders who have incurred the expenses. The four variables are:
- Amount of expenses
- Amount of funding being raised
- How the expenses have been accounted for
- Attitude / style of the investor
As the amount of expenses increases, the willingness of the investor to reimburse for any of them decreases. This is directly linked to the amount of funding being raised. For example, if $1m is being raised and the expenses are $50k, an investor will likely be ok with 5% of the funding getting paid back to reimburse the founders. However, if $1m is being raised and the expenses are $500k, it’s unlikely that an investor will be ok with 50% of the proceeds going to paying founders back for expenses that have already been incurred.
How the expenses have been accounted for also matters a little, if only for optics. If it has been treated as debt advanced to the company by the founders and is documented in an arms length transaction, it sometimes has more impact on the investors. The issues of amounts far outweighs the structural issues, but the structural issues sometimes signal that there was an intent to see the money get paid back at the close of the financing.
Finally, the attitude and style of the investor matters the most. Some investors are adamantly opposed to the idea of paying the founders back any expenses and view this simply as contributed capital to the business. Other investors will view this as part of the investment required by the founders to justify the pre-money valuation. Other investors will simply not want any of their new investment to pay for past expenses. In contrast, you’ll run across other investors who are more flexible, or who are happy to get a little more money into the company at what they believe is a relatively low valuation.
Ultimately, there is no rule – it’s just part of the negotiation.
Well – I fell off that particular horse. That would be the “I’ll blog daily about the best VC blog post of the past 24 hours.” I could make some snarky comment about how there weren’t any for the last few weeks, but that wouldn’t be true. I just fell of the horse. But yesterday, when I was at an SVB event talking to a bunch of SVB people, a long time friend said “thanks so much for writing the VC Post of the Day – it saves me a ton of time looking through all the VC blog posts.” So I got back on the horse.
Today’s post of the day is from Nic Brisbourne (DFJ Esprit) and it titled What is anti-dilution/downround protection? Nic covers narrow-based, broad-based, and full ratchet anti-dilution with real examples using real math.
Note to self: that was easy – five minutes, done.
Question: Does one need to switch an LLC to a corporation to raise VC funding? Would you recommend starting out as a corporation pre-money or as an LLC?
The short answer is yes, you have to be a corporation to raise VC funding
VCs will want you to be a C-Corp for a few specific reasons. The main advantage of an LLC over a C-Corp is that the taxes are not flow through. In other words, your company’s tax situation will not hit the bottom line of the VC. As VCs are generally structured to be flow through tax entities, if your company was a LLC, your tax situation would flow through the VC and directly to their investors. This is not a good place to be and VC investors demand that we only invest in C-corps to stop this problem.
And you should be happy, because if this wasn’t the case you’d get nagging phone calls every year from every investor in a VC fund looking for that tax documents. 🙂
The second issue is issuing stock to employees. Since stock options are the chief motivator of employees at a startup, you need have a stock option plan. In a LLC, there is no concept of stock ownership. It’s about “unit” ownership and it’s nearly impossible to mimic a standard stock option plan in the world of “units.”
Before raising money, you should feel free to start off as a LLC. In the “old days” (ten years ago, it was time consuming and costly to convert from a LLC to a C-corp, but these days it’s much much easier.
Dan Shapiro has an excellent post up titled What to do when an investor asks you for your business plan. In it he addresses something we missed in Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist.
In the section where we discuss business plans, we say:
“We haven’t read a business plan in over 20 years. Sure, we still get plenty of them, but it is not something we care about as we invest in areas we know well, and as a result we much prefer demos and live interactions…. However, realize that some VCs care a lot about seeing a business plan, regardless of the current view by many people that a business plan is an obsolete document.”
We go on to say:
“Regardless, you will occasionally be asked for a business plan. Be prepared for this and know how you plan to respond, along with what you will provide, if and when this comes up.”
As Dan rightly points out, we don’t tell you what to do. He does:
“Whenever an investor asks you for your business plan, send them the same damn packet you send to everyone else. In our case, that was a 3-page “executive summary” and a dozen slides giving an overview of the business with some screenshots of the product (it was mobile, and 2006, so there wasn’t any easy way to send them a demo). Don’t apologize and don’t mention the business plan.”
Dan – we completely agree. Well said – thanks for adding the paragraph we clearly left out.
Question: What is your take on entrepreneurs who have young children or otherwise active family lives? Is this a factor in funding decisions? I try to live with a family-first mentality but find it hard to compete with young unattached entrepreneurs who can put startup-first.
My answer is simple – this shouldn’t be a factor in funding decisions.
Unfortunately, I know plenty of investors who have lots of inappropriate (at least in my book) biases. This is one of them. There are also plenty of gender, race, and age biases out there. There are endless discussions in the blogosphere about this so I won’t add to the discussion other than to express my opinion, which is that these biases suck.
I’ve worked with many entrepreneurs covering a huge age range, gender dynamic, ethnic mix, and family size. Success comes in many forms, with many styles, and many different dynamics. While each person is constrained by having multiple priorities, balancing conflicting priorities is an essential skill of any entrepreneur. Being able to shift between commitments is vital over the course of an entrepreneurial life span.
As an entrepreneur, you’ll just have to work through it. And search for investors who don’t have these biases – fortunately they exist!
Bryce Roberts (OATV) totally nails it in his post titled You Can Never Size a Market in Excel. The punch line is:
“In every single case that I’ve seen this question (“how big can it get”) persist over more than 2 meetings, it has NEVER been resolved. NEVER.”
There’s plenty of great stuff in the post – go read it.
Remember – Ask the VC reads all of the VC bloggers for you so you only have to read the best posts!
It’s Monday and that means – yup – that Fred Wilson (USV) once again claims the VC Post of the Day due to his excellent MBA Mondays series titled Pricing A Follow-On Venture Investment. In it, Fred walks through an example, with real numbers, of how USV thinks about valuing an inside-led round for a company that is doing well.
Historically, many VC firms wouldn’t lead internal rounds at increased valuations except in extraordinary cases. When we started Foundry Group in 2007, we decided that was nonsense. It never made any sense to us why a firm wouldn’t pay a higher price than the last round for a company that it was already an investor in, especially if the companies in the portfolio were relatively capital efficient.
In our case, as in Fred’s, we try to offer a fair price, but expect to get some level of discount since we enable the company to bypass the fundraising process which is often incredibly distracting, time consuming, and often not much fun. Fred does a really nice job of explaining – both qualitatively and quantitatively, how he thinks about this. While our math is somewhat different, it’s super useful to get inside the head of an actual VC as he thinks this through.
Rand Fishkin, the CEO & co-founder of SEOmoz, has an long, thorough, and incredibly detailed blog post up about The $24 Million Moz Almost Raised. Rand does an awesome job of providing extensive details while maintaining confidentiality of the participants.
The story covers the full lifecycle of the VC fundraising process, beginning with Rand and his teams’ discussion about whether or not to raise money. He documents the fundraising dance, including providing lots of juicy email correspondence to underscore his points. He lays out the numbers for his company, the terms for the deal, and his view of when he was negotiating effectively vs. stumbling around.
Ultimately he gets to a signed LOI and that’s where the fun begins (in the section titled “Then Things Got a Little Weird”.) The deal ultimately falls apart and Rand does a nice postmortem where he speculates on what happened. He then wraps it up with how his team responded and what’s next for SEOMoz.
If you are an entrepreneur, go read this post now. It’s probably the best and most detailed description of the VC fundraising process that I’ve read. Well done Rand – on many levels. Even though this particular deal didn’t close, I love your statement at the end:
“What I can say is that this experience makes me and the rest of the Moz team even more inspired and motivated to build an amazing company. We can’t help but feel passion for proving doubters and naysayers wrong. The greatest revenge is to execute like hell, bootstrap all the way, and do what we said we’d do – become Seattle’s next billion-dollar startup, and make the world of marketing a better place.
I know we can do it.”
Entrepreneurs – if there is one post you read today, read this one. And Rand, email me anytime if I can be helpful. Even though you are too late stage for us to invest in, you just earned a bunch of karma points in my book by sharing this experience with all the entrepreneurs in the world.
Today’s VC Post of the Day is from my partner Seth Levine (Foundry Group) and is titled Should the current market environment change your fundraising strategy? I think it’s right on the money and captures / synthesizes much of the valid advice flying around from VCs and pundits about how entrepreneurs should think about fundraising right now. Do yourself a favor – read it slowly and think about it.
The runner up post of the day is from Bryce Roberts (OATV) titled A Year Ago. It’s a heartfelt reflection from Bryce on living in Silicon Valley for a year after uprooting and moving his family from Salt Lake City.
Albert Wegner (Union Square Ventures) has today’s VC Post of the day titled If You Need To Raise Money, Get Your Financing Done ASAP. In it, Albert expresses his belief that given the current macro economic environment, companies should focus on getting their money raised quickly – as in right now. He’s conveying global / macro pessimism that many people are talking about. While there are obvious timing disconnects between the long term value of a startup (often much more than five years), there is often a sentiment shift in the funding environment – all the way through the funding supply chain – when the economy goes south.
While Albert’s advice is great, I actually feel this is advice that all entrepreneurs should heed all the time. Having been involved in plenty of companies that were flush with cash for a while and then woke up one day needing cash but finding the funding markets tight / dry / dismal, I’ve experienced the pain first hand of being an entrepreneur in a difficult funding environment. You can never predict when this is going to happen, so my point of view is raise the money when you can, make sure you know whether your existing investors can (or will be able to) fund you if the market dries up, and don’t optimize your timing in hope of a modestly better valuation.
Remember rule number 1 – never run out of cash.