By Mike Sullivan and Richard D. Harroch
Startups seeking financing often turn to venture capital (VC) firms. These firms can provide capital; strategic assistance; introductions to potential customers, partners, and employees; and much more.
Venture capital financings are not easy to obtain or close. Entrepreneurs will be better prepared to obtain venture capital financing if they understand the process, the anticipated deal terms, and the potential issues that will arise. In this article we provide an overview of venture capital financings.
1. Obtaining Venture Capital Financing
To understand the process of obtaining venture financing, it is important to know that venture capitalists typically focus their investment efforts using one or more of the following criteria:
- Specific industry sectors (software, digital media, semiconductor, mobile, SaaS, biotech, mobile devices, etc.)
- Stage of company (early-stage seed or Series A rounds, or later stage rounds with companies that have achieved meaningful revenues and traction)
- Geography (e.g., San Francisco/Silicon Valley, New York, etc.)
Before approaching a venture capitalist, try to learn whether his or her focus aligns with your company and its stage of development.
The second key point to understand is that VCs get inundated with investment opportunities, many through unsolicited emails. Almost all of those unsolicited emails are ignored. The best way to get the attention of a VC is to have a warm introduction through a trusted colleague, entrepreneur, or lawyer friendly to the VC.
A startup must have a good “elevator pitch” and a strong investor pitch deck to attract the interest of a VC. For more detailed advice on this, with a sample pitch deck, see How to Create a Great Investor Pitch Deck for Startups Seeking Financing.
Startups should also understand that the venture process can be very time consuming—just getting a meeting with a principal of a VC firm can take weeks; followed up with more meetings and conversations; followed by a presentation to all of the partners of the venture capital fund; followed by the issuance and negotiation of a term sheet, with continued due diligence; and finally the drafting and negotiation by lawyers on both sides of numerous legal documents to evidence the investment.
In the rest of this article, we discuss the key issues in negotiating and closing a venture capital round.
2. The Venture Capital Term Sheet
Most venture capital financings are initially documented by a “term sheet” prepared by the VC firm and presented to the entrepreneur. The term sheet is an important document, as it signals that the VC firm is serious about an investment and wants to proceed to finalize due diligence and prepare definitive legal investment documents. Before term sheets are issued, most VC firms will have gotten the approval of their investment committee. Term sheets are not a guarantee that a deal will be consummated, but in our experience a high percentage of term sheets that are finalized and signed result in completed financings.
The term sheet will cover all of the important facets of the financing: economic issues such as the valuation given to the company (the higher the valuation, the less dilution to the entrepreneur); control issues such as the makeup of the Board of Directors and what sorts of approval or “veto” rights the investors will enjoy; and post-closing rights of the investors, such as the right to participate in future financings and rights to get periodic financial information.
The term sheet will typically state that it is non-binding, except for certain provisions, such as confidentiality and no shop/exclusivity. Although it is not binding, the term sheet is by far the most important document to negotiate with investors—almost all of the issues that matter will be covered in the term sheet, leaving smaller issues to be resolved in the financing documents that follow. An entrepreneur should think of the term sheet as the blueprint for the relationship with his or her investor, and be sure to give it plenty of attention.
There are varying philosophies on the use and extent of term sheets. One approach is to have an abbreviated short form term sheet in which only the most important points in the deal are covered. In that way, it is argued, the principals can focus on the major issues and leave side points to the lawyers when they negotiate the definitive financing documents.
Another approach to term sheets is the long form approach, where virtually all issues that need to be negotiated are raised, so that the drafting and negotiating of the definitive documents can be quicker and easier.
The drawback of the short form approach is that it will leave many issues to be resolved at the definitive document stage, and if they are not resolved, the parties will have spent extra time and legal expense that could have been avoided if the long form approach had been taken. The advantage of the short form approach is that it will generally be easier and faster to reach a “handshake” deal (and some VCs prefer a simple short form of term sheet because they think it will be more appealing to entrepreneurs).
In the end, it is usually better for both the investors and the entrepreneur to have a long form comprehensive term sheet, which will mitigate future problems in the definitive document drafting stage.
3. Valuation of the Company
The valuation put on the business is a critical issue for both the entrepreneur and the venture capital investor. The valuation is typically referred to as the “pre-money valuation,” referring to the agreed upon value of the company before the new money/capital is invested. For example, if the investors plan to invest $5 million in a financing where the pre-money valuation is agreed to be $15 million, that means that the “post-money” valuation will be $20 million, and the investors expect to obtain 5/20, or 25%, of the company at the closing of the financing.
Valuation is negotiable and there is not one right formula or methodology to rely upon. The higher the valuation, the less dilution the entrepreneur will encounter. From the VC’s perspective, a lower valuation (resulting in a higher investor stake in the company) means the investment has more upside potential and less risk, creating a higher motivation to assist the company.
The key factors that will go into a determination of valuation include:
- The experience and past success of the founders (so-called “serial” entrepreneurs present less risk, and often command higher valuations)
- The size of the market opportunity
- The proprietary technology already developed by the company
- Any initial traction by the company (revenue, partnerships, satisfied customers, favorable publicity, etc.)
- Progress towards a minimally viable product
- The recurring revenue opportunity of the business model
- The capital efficiency of the business model (i.e., will the company need to burn through significant capital before reaching profitability?)
- Valuations of comparable companies
- Whether the company is “hot” and being pursued by other investors
- The current economic climate (valuations generally climb when the overall economy is strong, and are lower during economic slumps)
While each startup and valuation analysis is unique, the range of valuation for very early-stage rounds (often referred to as “seed” financings) is often between $1 million and $5 million. The valuation range for companies that have gotten some traction and are doing a “Series A” round is typically $5 million to $15 million.
4. Form of the Venture Capital Investment
The founders of a startup typically hold common stock in the company. Angel investors or venture capitalists will usually invest in the company in one of the following forms:
- Through a convertible promissory note. The investor is issued a note by the company, convertible into company stock in its next round of financing. The note will have a maturity date (often 12 months from the date of issuance) and will bear interest (4% to 8% is common). No valuation is set for the company at this time. The investors will usually ask for the right to convert their notes into the stock issued in the next round of financing at a discount to the price paid in the next round valuation (a 20% discount is common), sometimes with a “cap” on the valuation of the company for purposes of the conversion rate (e.g., a $10 million cap). Convertible note financings are much quicker and easier to document than the typical convertible preferred stock alternative discussed below. Convertible notes are often seen in seed rounds.
- Through a SAFE (Simple Agreement for Future Equity), first developed by Y Combinator. SAFEs are intended to be an alternative to convertible notes, but they are not debt instruments—unlike a note, a SAFE has no maturity and does not bear interest. The SAFE investor makes a cash investment in the company that converts into stock of the company in the next round of financing. Just as with notes, SAFEs can convert at discounts and/or at capped valuations. (Read a good primer on SAFEs here.) Institutional investors, such as VCs, are less likely to invest in SAFEs, but they can be useful for companies at a very early stage.
- Through a convertible preferred stock investment, with rights, preferences and privileges set forth in the company’s certificate of incorporation (sometime referred to as the “charter”) and several other financing documents. The preferred stock gives the investors a preference over common shareholders on a sale of the company. Preferred stock also has the upside potential of being able to convert to common stock of the company. Most Series A financing rounds are done as convertible preferred stock. There is a strong benefit to the company in issuing preferred stock to investors—it allows the company to issue stock options (options to buy common stock, which does not enjoy preferred preferences) to prospective employees at a significantly reduced exercise price than that paid by the investors. This can provide a meaningful incentive to attract and retain the management team and employees.
5. Vesting of Founder Stock
Venture investors will want to make sure that the founders have incentives to stay and grow the company. If the founders’ stock is not already subject to a vesting schedule, the venture investors will likely request that the founders’ shares become subject to vesting based on continued employment (and then become “earned”). Standard vesting for employees is monthly vesting over a 48-month period, with the first 12 months of vesting delayed until 12 months of service are completed, but founders can often negotiate better vesting terms.
The key issues that the founders negotiate in this regard are:
- Will the founders get vesting credit for time already served with the company?
- Will vesting be required for shares they acquired for meaningful cash investment?
- Should a vesting schedule of less than 48 months apply?
- Should a vesting schedule apply at all?
- Should vesting accelerate, in whole or in part, on termination of employment without cause, or upon a sale of the company? A form of vesting that is usually acceptable to investors is the so-called “double trigger” acceleration, where vesting accelerates if the company is acquired and if the buyer terminates the founder’s employment without cause after the acquisition.
In our experience, some vesting in early-stage startups is typically required, but the founders will usually get credit for time spent with the company, as long as a meaningful amount of equity is still subject to vesting.
6. Composition of the Board of Directors
The makeup of the Board of Directors of the company is important to venture capital investors as well as to the founders. VCs, especially if they are the “lead” investor in a round of financing, will often want the right to appoint a designated number of directors to be able to monitor their investment and have a meaningful say in the running of the business. From the founders’ perspective, they will want to maintain control of the company for as long as possible. Although circumstances vary, in general Board seat allocation usually follows share ownership, so if the investors have 25% or less of the company’s stock, they will usually accept a minority of the Board seats, and if after multiple rounds the investors own most of the company’s stock, they will often control the Board.
After a Series A financing round, typical Board scenarios might include:
- A three-person Board, with two chosen by the founders, and one chosen by the investors;
- A three-member Board, one chosen by the founders, one chosen by the investors, and one independent director mutually agreed upon; or
- A five-member Board, two chosen by the founders, two chosen by the investors, and one independent director mutually agreed upon.
In lieu of a Board seat, some investors may request Board “observer” rights, granting the investor the right to attend Board meetings in a non-voting capacity with the right to receive financial and other information provided to Board members.
The actual Board composition will be subject to negotiation, factoring in the amount invested, the number of investors, the level of control sought, and the comfort level of the founders.
7. Liquation Preference of the Preferred Stock
A “liquidation preference” refers to the amount of money the preferred investor will be entitled to receive on sale of the company or other liquidation event, before any proceeds are shared with the common stock. VCs insist on a liquidation preference to protect their investment in “downside” scenarios; for happier scenarios in which a company is sold for an amount that would generate big returns for the investors, investors can always convert to common stock.
The liquidation preference is typically expressed as a multiple of the original invested capital, usually at 1x. So in the event of a sale of the company, the investor will be entitled to receive back $1 for every $1 invested, in preference over the holders of common stock.
In situations where the company is particularly risky or the investment climate has turned adverse, investors may insist on a 1.5x, 2x, or 3x liquidation preference (this was more common during the downturns of 2001-2002 and 2008-2009).
8. Participating vs. Non-Participating Preferred
Venture investors will sometimes request that their preferred stock be “participating preferred.” This means that on a sale of the company, the preferred would first receive back its liquidation preference (typically 1x of the original investment), and then the remaining proceeds would be shared by the common and preferred according to their relative percentage share ownership.
For example, if the pre-money valuation of the company is $5 million, and the VCs invest $5 million into the company with a 1x liquidation preference, here is what the founders/common holders would receive on a $50 million sale of the company:
- If the preferred is participating, the first $5 million goes to the preferred holders, and the remaining $45 million is split 50-50 (per the percentage ownership in the company). So the founders/common would receive $22.5 million and the preferred would receive a total of $27.5 million.
- If the preferred in non-participating, the $50 million in proceeds would be split 50-50 and the founders/common would receive $25 million from the sale.
Participating preferred is relatively rare. In addition to claiming it’s “not market,” founders can try to resist participating preferred on the theory that it will hurt the Series A investors down the road if later financings also incorporate that term. If founders are forced to accept participation, they can often negotiate for the participating feature to go away if the VCs have received back some multiple (for example, 3x) of their investment.
9. Protective Provisions/Veto Rights of the Investors
After a financing is completed, venture investors will often hold a minority interest in the company. But they will typically insist on “protective provisions” (veto rights) on certain actions by the company that could adversely affect their investment or their projected return.
The types of actions where a veto right may apply include:
- Amendment of the company’s charter or bylaws to change the rights of the preferred, or to increase or decrease the authorized number of shares of preferred or common stock
- Creation of any new series or class of shares senior to, or on parity with, the preferred
- Redeeming or acquiring any shares of common, except from employees, consultants, or other service providers of the company, on terms approved by the Board
- The sale or liquidation of the company
- Incurring debt over a specified dollar amount
- Payment of dividends
- Increasing the size of the company’s Board of Directors
The most sensitive of these veto rights is the one granting the venture investors a blocking right on a sale of the company. Founders sometimes try to mitigate this veto right by arguing that it should not apply in situations where the VC receives a minimum return on its investment (often 3x-5x).
In most scenarios, the VCs and the company will work out the veto rights issues down the road. For example, if the company needs cash to continue the business, VCs will likely waive their veto rights over future financings. Abuse of veto rights by investors is rare; word spreads quickly in the venture world, and VCs know that if they are arbitrary in blocking sensible deals, it will adversely affect their reputation with future entrepreneurs.
10. Anti-Dilution Protection
It is typical for venture investors to obtain protection (called “anti-dilution” protection) against the company issuing stock at a valuation lower than the valuation represented by their investment. By far the most common is “weighted average” anti-dilution protection, which reduces the conversion price—and so, inversely, increases the conversion rate—of the preferred stock held by earlier investors if lower-priced stock is sold by the company. With weighted average anti-dilution, the more shares that are issued, and the lower the price of the shares, the greater the adjustment to the earlier preferred. Founders will want to avoid the more severe “full ratchet” anti-dilution clause, which reduces the conversion price of the existing preferred to match the price of the new stock (no matter how many shares are issued).
Investors will typically agree to specifically exempt from anti-dilution protection certain types of equity issuances, such as incentive equity for employees and other service providers, equity issued in acquiring other companies, and equity issued in connection with bank financings, real estate and equipment leases, and the like.
11. Right to Participate in Future Financings
Investors will normally receive a right to purchase more stock in connection with future equity issuances, to maintain their percentage interest in the company. These participation rights often go only to so-called “Major Investors” who own a certain amount of stock, and typically terminate on a public offering. As with anti-dilution protection, these rights are typically designed to apply only to bona fide financings, and usually are drafted not to apply to employee equity, equity issued in acquisitions, or “equity kickers” issued to lenders, landlords, or equipment lessors.
12. Stock Option Issues
Venture investors will want to ensure that the company has a stock option pool for future equity grants, typically 10% to 20% of the company’s capitalization, with later-stage companies having smaller pools. The options are used to attract and retain employees, advisors, and Board members.
VCs will almost always insist that this option pool be included as part of the pre-money valuation of the company, and it is standard to do so. However, founders should realize that any increase in the option pool will come at their expense, reducing their percentage ownership of the company. If the size of the pool becomes an issue in the term sheet negotiation, it is a good idea for the founder to produce a grounds-up “budget” for future options, estimating the options that
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