Notes - Venture Deals

October 21, 2024

Chapter 1: The Players

The "financing dance" involves more than just the entrepreneur and the venture capitalist (VC); it often includes angel investors, lawyers, and mentors. Understanding the experience, motivation, and power of each participant is crucial for comprehending venture capital financings.

The Entrepreneur

The entrepreneur is at the center of the entrepreneurial universe. Founders should actively direct and control the financing process rather than outsourcing it entirely to lawyers, as many negotiation issues can only be resolved by the entrepreneurs themselves. The relationship between co-founders can fray over time due to stress, competence, personality, or changing life priorities, often leading to one or more founders leaving the business. Investors sometimes structure terms like vesting, drag-along rights, and co-sale rights to anticipate and cleanly resolve these situations, protecting founders from each other and minimizing company disruption. The book aims to take a balanced view, discussing both investor and entrepreneur perspectives.

The Venture Capitalist

VCs vary in shape, size, and experience, and their true entrepreneur-friendliness often becomes apparent during term sheet negotiations. Venture capital firms have a hierarchy:

• Managing Directors (MD) or General Partners (GP): These are the most senior individuals, making final investment decisions and sitting on company boards. Some may have additional prefixes like "executive" or "founding" to denote more seniority.
• Principals or Directors: These are junior deal partners working towards becoming MDs. They have some deal responsibility but usually need MD support for approval.
• Associates: Typically not deal partners, they work for deal partners, scouting new deals, helping with due diligence, and preparing internal memos. They often spend significant time with capitalization tables. Many firms have two-year associate programs, after which associates may leave for portfolio companies, business school, or to start their own ventures.
• Analysts: The most junior, usually recent college graduates, who focus on crunching numbers and writing memos. They have limited power and responsibility.
• Venture Partners or Operating Partners: Experienced entrepreneurs with a part-time relationship with the VC firm. They can sponsor deals but often need MD support. Some operating partners actively manage investments as board members or chairmen.
• Entrepreneurs in Residence (EIRs): Experienced entrepreneurs who temporarily reside at a VC firm while developing their next company. They assist the VC with introductions, due diligence, and networking, sometimes receiving pay or free office space with an implicit investment agreement.

In small firms like Foundry Group, founders' firm, all partners may be managing directors with equal authority. In larger firms, entrepreneurs will encounter a wider array of titles. Entrepreneurs should research VC firms to understand their decision-making process and the power of their contacts, ideally by consulting other entrepreneurs who have worked with the firm. According to "The Entrepreneur's Perspective," MDs/GPs hold the real power within VC firms; while respecting other roles, entrepreneurs should strive to build direct relationships with MDs or GPs as others are less likely to stay long-term.

The Angel Investor

Angel investors are individual investors who often provide early-stage, or seed-stage, funding. They can be professional investors, successful entrepreneurs, friends, or family. Many VCs are comfortable investing alongside angels. Angels typically invest in early rounds and may not participate in future rounds, which can become an issue if the company struggles and needs additional financing. Terms like "pay-to-play" and "drag-along rights" are designed to influence angel behavior in difficult financing situations. Angels are usually high-net-worth individuals, and there are specific SEC rules for "accredited investors" that must be followed. "Super angels" are very active, experienced angels, often former entrepreneurs, who invest their own money in startups. When super angels raise capital from others, they become "institutionalized super angels" or "micro VCs," taking on fiduciary responsibilities similar to VCs. Entrepreneurs should remember that angels, like VCs, have diverse incentives, pressures, experiences, and sophistication levels, making it dangerous to lump them together. "The Entrepreneur's Perspective" advises entrepreneurs not to be held hostage by angels and suggests setting up a special-purpose limited partnership for diffuse groups of friends and family to simplify management and avoid chasing numerous signatures for future financings or sales. Friends and family investors should understand their investment is a "lottery ticket" and that holiday gatherings are not investor relations meetings.

The Syndicate

A "syndicate" is a collection of investors, often VCs, who invest together in a financing round. Most syndicates have a "lead investor," usually a VC, who takes the primary role in negotiating terms for the entire group, though sometimes there are co-leads. Despite having a lead investor, entrepreneurs are responsible for communicating with all investors in the syndicate. "The Entrepreneur's Perspective" suggests insisting that investors verbally agree that the lead investor speaks for the syndicate on investment terms, to avoid negotiating the same deal multiple times.

The Lawyer

A great lawyer is invaluable in VC financings, while a bad or inexperienced one can be disastrous. Experienced lawyers can help entrepreneurs focus on what truly matters—economics and control—and avoid getting sidetracked by unimportant terms that VCs might use as negotiating tactics. An inexperienced lawyer may focus on the wrong issues, fight over trivial points, and increase legal bills for both sides. An entrepreneur's lawyer reflects on their reputation within the startup ecosystem, and a bad lawyer can tarnish it or create unnecessary tension with future investors. "The Entrepreneur's Perspective" cautions against VCs talking an entrepreneur out of their chosen lawyer, emphasizing that the lawyer is their lawyer, not the VC's, and that entrepreneurs should ensure their lawyer is reasonable and communicative. Lawyers experienced in VC investments often cap their fees, ranging from $5,000–$15,000 for early-stage and $25,000–$40,000 for typical financings in 2012. Higher fees may indicate unorganized past issues or lawyer inefficiency. If lawyers don't get along, bills can skyrocket unless the entrepreneur stays involved. The standardization of documents means lawyers spend less time per deal now than in the 1990s. "The Entrepreneur's Perspective" advises not to be shy about asking for a lower fee cap or payment only upon deal closing, especially for solid businesses.

The Mentor

Entrepreneurs should have experienced mentors who can be highly useful, especially if they know the VCs involved. The authors prefer the term "mentor" over "adviser" because advisers often imply a fee agreement, which is unusual and discouraged for early-stage companies, as some advisers "prey" on entrepreneurs by asking for a cut of the deal or a retainer. Mentors usually help because they were once helped themselves, sometimes becoming early angel investors or receiving a small equity grant, but rarely asking for upfront compensation. Building long-term relationships with mentors is highly encouraged for their enormous and often surprising benefits. "The Entrepreneur's Perspective" suggests that giving a small success fee for genuine help in raising money (not just random email introductions) is acceptable, and compensating mentors with options controlled by vesting based on performance as an ongoing adviser can also make sense.

Chapter 2: How to Raise Money

The goal of raising a financing round is to get multiple term sheets, and there is no single method to achieve this, as VCs are not a homogeneous group.

Do or Do Not; There Is No Try

Entrepreneurs should adopt a mindset of presumed success when fundraising, avoiding phrases like "trying to raise money" or "testing the waters," as such uncertainty is off-putting to investors. While failure is part of entrepreneurship, attitude significantly impacts outcomes.

Determine How Much You Are Raising

Before fundraising, entrepreneurs must determine the exact amount they aim to raise, as this impacts the choice of potential investors. For example, a $500,000 seed round targets angels, seed-stage VCs, super angels, and micro VCs, while a $10 million round targets larger VC firms that can lead with a $5 million check. Instead of complex financial models, entrepreneurs should focus on funding the company to its next meaningful milestone, such as shipping a first product or reaching a specific user/revenue target. A time cushion, like raising $1 million for a year's burn rate, is advisable, assuming no revenue growth. It's important not to ask for more than needed, as investors prefer an oversubscribed round. Stating a specific number rather than a range is recommended, allowing for an increase later if demand exceeds expectations.

Fund-Raising Materials

Required fundraising materials can vary, but typically include a short business description, an executive summary, and a presentation. Some investors may request a business plan or a private placement memorandum (PPM), more common in later stages. Quality of substance is key, not over-designed visuals. Prototypes or demos are highly desirable for early-stage companies, allowing VCs to interact with the vision.

• Short Description of Your Business: An "elevator pitch" (1-3 paragraphs) sent via email, describing the product, team, and business directly, often as the body of an introductory email.
• Executive Summary: A concise 1-3 page document detailing the idea, product, team, and business, serving as a first substantive impression for prospective investors. It should clearly state the problem, the solution, product superiority, team's suitability, and high-level financial expectations.
• Presentation: A 10-20 page PowerPoint for visual overview, adaptable to the audience (e.g., 3-minute pitch vs. 30-minute partnership meeting). Visual appeal is important, especially for consumer-facing products. "Less is more" for investor presentations, with most good ones being 10 slides or fewer, covering problem, opportunity size, team strength, competition, plan, status, summary financials, use of proceeds, and milestones.
• Business Plan: The authors haven't read one in over 20 years, finding them a "waste of time" for fundraising, preferring demos and live interactions. However, writing one for internal clarity is still useful, even if not a conventional detailed document (e.g., Lean Startup methodology).
• Private Placement Memorandum (PPM): A traditional business plan with extensive legal disclaimers, time-consuming and expensive to prepare. It's usually generated when investment bankers are involved for large institutional investors. The authors view it as a "waste of money and time" for early-stage companies and often ignore it.
• Detailed Financial Model: All financial predictions for startups are 100% wrong, especially for early-stage companies. VCs focus on revenue forecast assumptions and monthly burn rate. While some VCs (often those with associates) analyze every line item, others focus on specific metrics like headcount and user acquisition.
• The Demo: VCs "love demos" and find them more important than business plans or financial models for early-stage companies. Demos showcase vision, building capability, and allow direct interaction and assessment of entrepreneur enthusiasm. Demos are expected to be rough and may change significantly.

Due Diligence Materials

As fundraising progresses, VCs will request additional information. After a term sheet is offered, lawyers will ask for capitalization tables, contracts, employment agreements, and board minutes. Entrepreneurs should organize these materials for quick delivery. Full disclosure of any issues is paramount; hiding anything will damage the relationship later. Good VCs will engage to help resolve disclosed challenges or provide feedback if issues are showstoppers.

Finding the Right VC

The best way to find VCs is through referrals from friends and other entrepreneurs, offering unfiltered insights and more effective introductions than cold emails. VCs today have extensive online presences (websites, blogs, social media) allowing entrepreneurs to research their investment types, stages, past successes, failures, and personnel. Engaging VCs via social media by thoughtfully commenting on their posts can help develop relationships. Research is crucial; sending irrelevant pitches (e.g., medical tech to a software-focused VC, or demanding an NDA) shows a lack of preparation. VCs receive thousands of inquiries annually, so research, referrals, and engagement improve response rates. Entrepreneurs with "super-hot deals" should also do their homework to find compatible VCs who will be the most helpful long-term partners.

Finding a Lead VC

Potential investors can be categorized as leaders, followers, or "everyone else". The goal is to find a "lead VC" who will issue the term sheet and drive the financing. Co-leads are possible, and ideally, multiple VCs compete to lead. VCs will give one of four vibes: clearly interested (engage aggressively), not interested (don't worry), "maybe" (keep warm but don't expect them to catalyze), or "slow no" (treat as a no and stop spending time).

How VCs Decide to Invest

VC investment decision processes vary, often depending on how the entrepreneur connected with them (e.g., prior connection, VC introduction) or the VC's preferred focus (seasoned vs. first-time entrepreneurs). Entrepreneurs should quickly determine if they are engaging through the VC's preferred channel and assess the primary contact's role within the firm; associates rarely have real pull. "Due diligence" begins when a VC shows more than passing interest, signifying a deeper exploration. A VC firm's attitude and culture can be revealed by its diligence process; for example, a VC asking for detailed five-year financial projections from a pre-revenue company may lack early-stage experience. VCs will request presentations, projections, customer pipelines, development plans, competitive analyses, and team bios, which is normal. Entrepreneurs should conduct their own due diligence on VCs by asking for references from backed founders, especially those whose companies struggled or failed, to understand how the VC handles difficult situations. Multiple meetings, emails, phone calls, and potentially partnership presentations will occur. VCs who are interested may slow down communication rather than explicitly saying no to keep options open or avoid shutting the door. "The Entrepreneur's Perspective" advises politely insisting on feedback when a VC passes on a deal, seeing it as a crucial learning opportunity.

Closing the Deal

Closing the deal involves two main activities: signing the term sheet and signing definitive documents to receive cash. Most executed term sheets with reputable VCs lead to a closed financing, provided no "smoking guns" are discovered during due diligence and the entrepreneur avoids mistakes in definitive document drafting. Lawyers primarily handle the drafting of definitive agreements based on the term sheet. In the worst case, a deal can blow up or leave hard feelings. Entrepreneurs must oversee the process, preventing lawyers from behaving poorly and ensuring responsiveness to requests. If legal teams become gridlocked over an issue, entrepreneurs should directly contact the VC to understand the true situation before reacting emotionally.

Chapter 3: Overview of the Term Sheet

The term sheet is a critical document, acting as a blueprint for the future relationship with an investor, rather than just a letter of intent. The book's explanation of term sheet terms was inspired by a challenging financing in late 2005, where participant ignorance of what truly mattered prolonged negotiations. VCs often negotiate hard on every term, sometimes due to inexperience, but often as a negotiation tactic. The specific language referenced in the book is from actual term sheets.

The Key Concepts: Economics and Control

At their core, venture capitalists care about two main things when investing: economics and control.

• Economics refers to the return investors will receive in a liquidity event (like a sale or IPO) and terms directly impacting this return.
• Control refers to the mechanisms that allow investors to either actively control the business or veto major company decisions. If an investor focuses heavily on provisions that don't impact economics or control, they are often "blowing smoke" rather than addressing substantive issues. "The Entrepreneur's Perspective" emphasizes that an inexperienced VC harping on unimportant terms signals what that VC will be like as an owner, board member, and compensation committee member.

Founders typically receive common stock, while VCs purchase preferred stock, which comes with preferential terms. Financings are usually designated by letters (e.g., Series A, Series B), with "Series Seed" being a recent pre-Series A round. The letter increments with subsequent financings (e.g., B after A), and sometimes numbers are added (e.g., Series A-1) to limit how far into the alphabet rounds go. The book will proceed to explore these terms in detail, starting with economic terms.

Chapter 4: Economic Terms of the Term Sheet

When discussing a VC deal's economics, focusing solely on "valuation" is a mistake, as other terms significantly impact the deal's financial outcome. This chapter covers price, liquidation preference, pay-to-play, vesting, the employee pool, and antidilution.

Price

The most entrepreneur-focused economic term is price. Price is typically represented as a "$____ per share (the Original Purchase Price)," linked to a "fully diluted premoney valuation" and "fully diluted postmoney valuation". Alternatively, it can be defined by the "Amount of Financing" and a percentage ownership position on a "fully diluted basis".

• Premoney vs. Postmoney Valuation: "Price" is often referred to as "valuation," which has two types: "premoney" (company's value before investment) and "postmoney" (premoney valuation plus the investment amount). A common trap is ambiguity in verbal discussions; a VC saying "$5 million at a valuation of $20 million" usually means $20 million postmoney (25% ownership for $5M), while an entrepreneur might interpret it as $20 million premoney (20% ownership for $5M in a $25M postmoney company). Entrepreneurs should clarify this upfront, presuming "premoney" to force the VC's clarification.
• Fully Diluted: This phrase means the valuation calculation assumes conversion of all outstanding preferred stock, exercise of all stock options and warrants, and any increase in the "employee pool" (or "option pool").
• Employee Pool (Option Pool): This is equity reserved for future employees. While a larger pool reduces the risk of running out of options, its size is factored into the premoney valuation, effectively lowering it. For example, if a $5M investment is at $20M premoney, but VCs insist on increasing the option pool from 10% to 20%, the extra 10% comes out of the premoney valuation, making the effective premoney valuation $18M. Option pools typically range from 10-20%. Entrepreneurs can negotiate pool size, adjust premoney valuation, or propose the pool increase postmoney. "The Entrepreneur's Perspective" advises coming armed with an "option budget" detailing future hires and their grants to justify a specific pool size.
• Warrants: These are rights for an investor to purchase shares at a predefined price within a certain period, similar to stock options. Warrants associated with financings, especially early-stage, add complexity and can subtly lower the effective valuation. The authors recommend negotiating a lower premoney valuation instead of including warrants, unless it's a bridge loan. In bridge loans (short-term loans pending a larger financing), warrants are common, typically offering a 20% discount on the future equity price, and are generally not worth fighting.
• Negotiating Price: The best way to achieve a higher price is to have multiple VCs interested, demonstrating demand. In early rounds, new investors seek the lowest price that keeps founders/employees motivated. In later rounds, existing investors may push for a higher price to limit their dilution. If no new investors are interested, existing investors may argue for a "flat round" (same price) or "down round" (lower price). "The Entrepreneur's Perspective" stresses having a strong "best alternative to a negotiated agreement (BATNA)".
• VC Valuation Factors: VCs use both quantifiable and qualitative factors:
  • Stage of the company: Early-stage valuations are driven by entrepreneur experience, amount raised, and perceived opportunity; mature companies are valued more by financial performance and imminent exit.
  • Competition with other funding sources: More competition increases price, but overstating competition can damage credibility.
  • Experience of the entrepreneurs and leadership team: More experience means less risk and higher valuation.
  • The VC's natural entry point: Some VCs invest only at low price points (e.g., below $10M postmoney); others focus less on specific price and more on company status.
  • Numbers: Past performance, future predictions, revenue, EBITDA, cash burn, and headcount all factor in, though early-stage financial projections are inherently inaccurate.
  • Current economic climate: Valuations are lower during economic downturns and higher during expansion. The best advice for entrepreneurs to maximize price is to focus on controllable factors and generate competing VC interest. "The Entrepreneur's Perspective" advises not taking valuation personally, as VCs are simply negotiating to their advantage.

Liquidation Preference

The liquidation preference is the second most important economic term after price, determining how proceeds are shared in a "liquidity event" (company sale or IPO). It's especially critical when a company sells for less than the invested capital.

• Components: It consists of the "actual preference" (money returned to preferred shareholders before common) and "participation".
  • Actual Preference: Typically a multiple of the Original Purchase Price plus unpaid dividends. A 1× preference (returning the invested amount) is standard, though it increased to as high as 10× after the 2001 Internet bubble burst.
  • Participation: Determines if preferred stock shares in remaining proceeds after the liquidation preference is paid.
    • Fully Participating: Preferred stock receives its preference and then shares ratably with common stock on an as-converted basis.
    • Capped Participation: Shares participate until a certain multiple return (e.g., 3× the original purchase price) is reached, after which they stop participating. This multiple includes the liquidation preference amount.
    • No Participation: Investor chooses either the liquidation preference or conversion to common stock for an as-converted share of proceeds.
• Liquidation Event Definition: In VC terms, a "liquidation event" includes mergers, acquisitions, or change of control, not just bankruptcy, determining proceeds allocation in both good and bad outcomes. IPOs are not considered liquidation events, as preferred stock usually converts to common upon IPO.
• Examples: Numerical examples illustrate the impact of participation in different acquisition scenarios. Participation significantly impacts outcomes at lower sale prices and less so at higher outcomes.
• Multiple Series of Stock: Understanding liquidation preferences becomes complex with multiple series (e.g., Series A, Series B). Two approaches exist:
  • Stacked Preferences: Follow-on investors' preferences (e.g., Series B) are paid first, then prior series (e.g., Series A). This can mean later investors take all proceeds in low-value sales.
  • Pari Passu (Blended Preferences): All series of preferred stock are equivalent in status and share proceeds pro-rata until their preferences are returned. Which approach is used depends on negotiation power, company financing options, and existing capital structure. Investors always get the greater of their liquidation preference (plus participation, if any) or their as-converted common holding. In early-stage financings, simple liquidation preference with no participation is often in the best interest of both investors and entrepreneurs, as it avoids complex terms that might carry over to future rounds and disproportionately affect founders. Professional investors generally avoid excessive liquidation preferences to maintain management and employee motivation. "The Entrepreneur's Perspective" calls participating preferred deals an "unfortunate standard," advocating for kick-out rights where participation goes away after a certain return, and calling multiple preferences "greedy".

Pay-to-Play

A "pay-to-play" provision is an economic term relevant in "down round" financings (new rounds at lower valuations) and is useful when a company struggles. It typically states that if an investor is offered to participate in a qualified financing (next round) but does not purchase their pro rata share, their preferred stock will convert to common stock. It became ubiquitous after the 2001 Internet bubble burst. The authors believe it's generally good for companies and investors as it incentivizes original investors to continue supporting the company. If an investor doesn't "play," they lose the rights associated with preferred stock. This impacts economics by reducing non-participating investors' liquidation preferences and impacts control by reshuffling the preferred shareholder base. When companies are doing well, pay-to-play provisions are often waived if a new investor wants to take a large part of the round, leading to an "up-round" financing. "The Entrepreneur's Perspective" views conversion to common as appropriate for lack of follow-on investment but warns against provisions that force recapitalization at a $0 premoney valuation, which can be particularly bad for less sophisticated angel investors and the entrepreneurs themselves.

Vesting

Vesting dictates how much of an entrepreneur's or employee's stock or options are owned based on time with the company.

• Standard Terms: Typically, stock and options vest over four years, with a "one-year cliff" (no vesting until after the first year) followed by monthly vesting. So, after 12 months, 25% vests, and then monthly thereafter. Founders may receive different terms, such as credit for one year of vesting at closing, with the remaining balance vesting over 36 months.
• Unvested Stock: Unvested stock typically disappears upon departure, leading to "reverse dilution" (increased ownership for remaining shareholders). For founders' stock, it vanishes; for employee options, it usually returns to the option pool. For founders who purchased stock outright, vesting is functionally a "buy-back right" for the company, important for tax purposes. "The Entrepreneur's Perspective" suggests founders consider alternatives like purchasing unvested stock upon leaving, protection for "without cause" termination, or using an 83(b) election for early capital gains tax rates.
• Acceleration on Merger:
  • Single-trigger acceleration: Automatic accelerated vesting upon a merger.
  • Double-trigger acceleration: Requires both an acquisition and the employee being fired by the acquiring company. Double-trigger is more common in VC-funded deals. Founders often desire full vesting upon transaction ("we earned it!"), while VCs aim to minimize the impact of outstanding equity on the purchase price and prefer unvested equity for post-acquisition incentives. The abolition of pooling of interests accounting treatment in 2000 means changing vesting arrangements during a merger no longer has significant accounting impact, making a double trigger with one-year acceleration a common balanced approach. Some VCs have strong principles against single-trigger acceleration.
• Vesting as an Alignment Tool: Vesting benefits VCs and founders by incentivizing continued work and constructive participation. It prevents a departing founder from walking away with all their stock, ensuring differential ownership for those who remain. In a market where early-stage companies take 5-7 years to exit, vesting provisions matter less for long-term employees who will likely be fully vested by then. "The Entrepreneur's Perspective" supports double-trigger acceleration with boundaries, noting its importance for transition in acquisitions.

Employee Pool

The "employee pool" (or "option pool") is the portion of the company's common stock reserved for future issuance to employees, directors, officers, and consultants. It clarifies the capital structure and typically ranges from 10-20% of fully diluted capital stock post-financing.

• Impact on Valuation: VCs often increase the option pool on a premoney basis, which effectively lowers the actual premoney valuation and is a "sneaky" way for VCs to gain additional economics. For example, if a company has a 10% unallocated pool but investors demand 20% post-financing, the additional 10% comes out of the old shareholders' ownership, not shared with the new investors. This results in a lower price per share for the new investors and a lower effective premoney valuation. Entrepreneurs can counter by arguing they have sufficient options or requesting antidilution protection if the pool needs to expand later.

Antidilution

Antidilution provisions protect investors from dilution if the company issues equity at a lower valuation than previous financing rounds.

• Types:
  • Full Ratchet: If shares are issued at a lower price, the earlier round's price is effectively reduced to the new, lower price. This is severe and less common now, largely used during the 2001-2003 down-round period.
  • Weighted Average: More common, this considers the magnitude of the lower-priced issuance, not just the price. The calculation results in a "conversion price adjustment" for the previous series of stock, allowing it to convert into more common shares.
    • Broad-based weighted average: Denominator includes all common stock outstanding, convertible preferred, and all other options/rights (employee options).
    • Narrow-based weighted average: Excludes other convertible securities, limiting calculation to currently outstanding securities.
• Antidilution Carve-outs: These are standard exceptions for shares granted at lower prices where antidilution does not apply, typically including employee options, shares for mergers, debt financing, and instances where a majority of preferred shareholders waive their rights. The last carve-out encourages minority investors to participate in new rounds to avoid dilution.
• Relevance: Antidilution is usually requested, as later investors will demand it, prompting earlier investors to also request it. It can influence a company to seek higher valuations in new rounds. Occasionally, antidilution calculations are tied to milestones, leading to automatic conversion price adjustments if goals aren't met. This creates a powerful incentive but can misalign management and investor objectives if business evolves. Entrepreneurs should focus on understanding the nuances, minimizing impact, and building company value to prevent these provisions from coming into play.

Chapter 5: Control Terms of the Term Sheet

Control terms define how VCs exert influence and protect their investment, often to comply with federal tax statutes related to their fund investors. Even with less than 50% ownership, VCs typically negotiate terms that give them control over major company activities. This chapter discusses board of directors, protective provisions, drag-along rights, and conversion.

Board of Directors

The process for electing board members is a key control mechanism. Entrepreneurs should carefully consider the balance among investor, company, founder, and outside representation. "The Entrepreneur's Perspective" emphasizes that the board is the "inner sanctum," and bad board members can be detrimental, even if they are good investors or nice people.

• Composition: A typical clause sets the board size and allocates seats to investor representatives (e.g., Acme's designee), common stock holders, and mutually agreed-upon directors. For a balanced early-stage board, five members are common: two founders/CEO, two VCs, and one outside member. A mature board may have 7-9 members with more outside directors, with the CEO and a founder still present along with a few VCs.
• Board Observers: VCs often request board observers (non-voting attendees) in addition to or instead of an official board member. "The Entrepreneur's Perspective" advises caution with observers, as they can sway discussions without voting power and lead to an unwieldy number of people at board meetings for a pre-revenue company.
• CEO Seat: Many investors mandate that the CEO (often a key founder) holds one of the common stockholder board seats.
• Compensation: Board members and observers are typically reimbursed for out-of-pocket expenses for attending meetings. Cash compensation for private company board members is rare; outside board members usually receive stock options.

Protective Provisions

These are "veto rights" that investors have over certain company actions, protecting VCs even from themselves. While often hotly negotiated, they have become largely standardized.

• Typical Veto Rights: Consent of preferred shareholders (usually a majority) is required for actions such as:
  • Altering preferred stock rights or privileges.
  • Increasing/decreasing authorized common or preferred stock.
  • Creating new classes of stock senior or pari passu to preferred.
  • Redeeming/repurchasing common stock (except employee equity incentive agreements).
  • Mergers, corporate reorganizations, sale of control, or sale of substantial assets.
  • Amending company Certificate of Incorporation or Bylaws.
  • Increasing/decreasing board size.
  • Paying or declaring dividends.
  • Issuing debt above a certain threshold (e.g., $100,000).
• Negotiation Points: The debt threshold (ix) is often raised for operating businesses. Adding a minimum threshold of preferred shares for protective provisions to apply is also an accepted change. Company counsel often seek "materiality qualifiers" (e.g., "materially alters"), but the authors "always decline" this, preferring specificity over vague terms that can lead to disputes over interpretation. "The Entrepreneur's Perspective" generally agrees with protective provisions (i, ii, iii, v, vi, vii, viii) as fair, but suggests trying to increase the debt limit in (ix) or exclude equipment financing.
• Voting Among Series: In subsequent financing rounds (e.g., Series B), there's discussion about whether the new class gets its own protective provisions or votes with prior investors as a single class. Entrepreneurs almost always prefer a single vote to avoid multiple veto constituencies. New investors often request a separate vote due to differing interests, but experienced investors may align with entrepreneurs to avoid headaches. "The Entrepreneur's Perspective" insists on a single class vote for all investors, as it keeps them aligned and is critical for sanity.
• Purpose: Protective provisions are not about trust but about clearly defining roles, control, and engagement rules upfront. They can also help entrepreneurs in acquisition scenarios by giving VCs leverage to block sales, potentially driving up the price. These provisions have become largely boilerplate due to judicial decisions. "The Entrepreneur's Perspective" reminds entrepreneurs that they are negotiating for the company's future, not just their current relationship.

Drag-Along Agreement

This control provision allows a subset of investors (e.g., a majority of preferred shareholders) to force all other investors and founders to agree to a company sale. It became prevalent after the Internet bubble burst, when company sales at or below liquidation preferences led founders to resist unless they received some consideration. VCs wanted to compel support for such transactions.

• Relevance to Founders: If founders own a small percentage, a drag-along may not matter much unless many small owners collectively hold a significant stake.
• Compromise: The most common compromise for entrepreneurs is to link drag-along rights to the majority of common stock holders, rather than preferred, meaning common stockholders are only dragged along if the majority of their class consents. Preferred investors could convert to common to achieve this majority, which benefits common stockholders by lowering the overall liquidation preference.
• "The Entrepreneur's Perspective" notes that this term is most relevant when things are falling apart, and it can be beneficial by forcing multiple investors to agree to a deal, saving agitation. It also emphasizes the importance of having enough board members controlled by founders to prevent bad deals.

Conversion

This is one of the few truly "nonnegotiable" terms. "The Entrepreneur's Perspective" humorously notes that "nonnegotiable" is often a phrase used by junior VCs who are inexperienced.

• Right to Convert: Preferred shareholders always have the right to convert their stake into common stock at any time, typically at a 1:1 initial conversion rate (subject to adjustment). This allows them to choose the as-converted common basis if it yields a better payout in a liquidation, or to control a common stock vote. Once converted, there's no reconversion to preferred.
• Automatic Conversion: Preferred stock automatically converts to common stock upon a "Qualified IPO" (firmly underwritten public offering meeting minimum price and total offering thresholds). Investment bankers almost always want all shares converted to common for an IPO.
• Negotiation Points: Entrepreneurs want lower thresholds for automatic conversion to ensure more flexibility, while investors prefer higher thresholds for greater control over IPO timing and terms. It's crucial to equalize automatic conversion thresholds across all series of preferred stock to prevent later-stage investors from holding up an IPO by having a higher threshold. "The Entrepreneur's Perspective" advises understanding IPO norms and that a board decision to pursue an IPO will pressure VCs to waive this provision.

Chapter 6: Other Terms of the Term Sheet

Beyond economics and control, many terms are less impactful, primarily relevant in downside scenarios, or don't matter much at all.

Dividends

Unlike private equity, many VCs (especially early-stage) don't prioritize dividends, viewing them as additional "juice" in a deal rather than a primary return driver.

• Types: Dividends can be "noncumulative" (paid only when declared by the board) or "cumulative" (automatically accrue annually). They typically range from 5-15% of the Original Purchase Price.
• Impact: In a large success scenario (e.g., 50x return), a 10% cumulative annual dividend adds little to the overall return. However, in downside scenarios or with larger investment amounts, dividends can be material, significantly increasing the investor's return. This is why they are more common in private equity/buyout deals with larger investments and lower expected multiples.
• Side Effects: Automatic cumulative dividends can push a company into a "zone of insolvency" and create accounting nightmares. Noncumulative dividends declared by the board are "benign, rarely declared, and an artifact of the past". "The Entrepreneur's Perspective" stresses ensuring dividends require approval by a majority or supermajority of the board.

Redemption Rights

These rights allow investors to force the company to repurchase their shares, usually after a specified period (e.g., five years). While rarely exercised, VCs focus on them for downside protection.

• Rationale: To provide an exit path if a company becomes successful but isn't acquired or goes public. Also, to ensure liquidity for VC funds with a limited life span (e.g., 10 years). However, a company not attractive for IPO/acquisition often lacks the cash to redeem shares.
• Balance Sheet Impact: Companies may argue redemption rights create a liability on the balance sheet, but this is usually not the case unless mandatorily redeemable.
• Adverse Change Redemption: The authors strongly advise against this "overreaching" and "evil" term, which allows VCs to demand immediate redemption if the company experiences a "material adverse change". This vague term grants investors arbitrary control and can be punitive. "The Entrepreneur's Perspective" agrees this clause is "evil" and stresses maximum board protection.

Conditions Precedent to Financing

These clauses outline conditions that must be met before an investor's obligation to finance is binding. While often innocuous, they can offer investors "ways out of a deal".

• Binding vs. Non-Binding: Typically, legal fees, no-shop agreements, and governing law are binding upon signing the term sheet, while the investment itself is conditional.
• Conditions to Watch Out For:
  • Approval by investors' partnerships: Signals the deal isn't fully approved internally by the VC firm.
  • Rights offering to be completed by company: VCs want to allow previous investors to participate, adding time and expense.
  • Employment agreements signed by founders acceptable to investors: Entrepreneurs should try to negotiate key employment terms before signing a term sheet with a no-shop clause. "The Entrepreneur's Perspective" advises avoiding conditions precedent and not paying the VC's legal fees unless the deal closes (with an exception for the entrepreneur canceling).

Information Rights

These define the type and frequency of financial and operational information VCs legally have access to (e.g., annual budgets, audited financial statements). While important to VCs, they "shouldn't matter much to the entrepreneur". The only typical variation is setting a minimum share threshold for investors to retain these rights. "The Entrepreneur's Perspective" views information rights as largely irrelevant, advocating for transparent organizations and noting that if an entrepreneur can't commit to providing financial information, they shouldn't take outside investors. It also suggests insisting on a strict confidentiality clause if paranoid.

Registration Rights

These define investors' rights to register their shares for an IPO and the company's obligations for future registration statements post-IPO. This section is often lengthy and negotiated, but the authors consider it "tedious" and "rarely matters". In an IPO, investment bankers usually dictate the deal structure regardless of prior registration rights. "The Entrepreneur's Perspective" advises not focusing much energy here, as "the world is good if you're going public".

Right of First Refusal (ROFR)

This defines an investor's right to buy shares in a future financing. Also known as a "pro rata right," VCs almost universally insist on it.

• Negotiation Points: The minimum share threshold to qualify as a "Major Investor" (and receive this right) can be negotiated, though it's often not worth fighting given the desire for existing investor participation. More importantly, watch for "super pro rata rights" (e.g., "[X] times their pro rata portion"), which allow investors to purchase more than their pro rata share and are considered an "excessive ask". "The Entrepreneur's Perspective" views ROFR as "not a big deal" and sometimes beneficial, but emphasizes defining "Major Investor" and linking the right to participation in subsequent rounds.

Voting Rights

This clause defines how preferred and common stock vote together or separately. It generally doesn't matter much, as key rights are in protective provisions.

Restriction on Sales

Also known as "right of first refusal on sales of common stock (ROFR on common)," this defines parameters for selling shares in a private company. The company's bylaws typically contain this right, which the company can assign to investors if it doesn't exercise it.

• Purpose: Historically, it controlled the shareholder base, benefiting existing shareholders. With the rise of secondary markets for private stock (e.g., Facebook, Twitter shares), this clause became subject to more scrutiny. The authors strongly believe ROFR on common is good for the company as it helps manage share ownership and comply with SEC private shareholder rules.
• "The Entrepreneur's Perspective" notes that while eliminating this clause is unlikely, entrepreneurs can ask for a floor (e.g., allow small sales for personal needs like buying a house).

Proprietary Information and Inventions Agreement

Every term sheet includes this clause, requiring current and former officers, employees, and consultants to sign an agreement ensuring the company owns its intellectual property (IP). This benefits both the company and investors, serving as a mechanism to legally confirm IP ownership. Pre-Series A companies often have issues with this if prior legal representation was poor, and it's crucial to clean up before financing. Companies should integrate these agreements into their hiring process from the start. "The Entrepreneur's Perspective" agrees it's good for the company and advises having all employees (including founders) sign it, with specific carve-outs for unrelated work if needed.

Co-Sale Agreement

Most investors insist on this, meaning if a founder sells shares, investors have the right to sell a proportional amount of their stock too. The chance of eliminating this provision is "close to zero," and it applies only while the company is private. "The Entrepreneur's Perspective" suggests asking for a "floor" to allow small sales by founders without investor participation.

Founders’ Activities

This clause, often found at the back of the term sheet, typically requires founders to devote 100% of their professional time to the company, with any other professional activities requiring board approval. Its presence might signal investor suspicion or concern about founders' focus.

• Dilemma: It's a "no-win situation" for founders: undisclosed outside work violates the agreement and trust; pushing back on the clause reinforces concerns.
• Authors' Advice: Unless genuinely engaged in other activities, simply agree to it. If other obligations exist, upfront disclosure is appreciated by VCs and allows for resolution. VCs rarely get comfortable with founders working on multiple companies simultaneously, except for very experienced entrepreneurs with whom they have a long-standing relationship. "The Entrepreneur's Perspective" advises against seeking professional VC financing if one cannot agree to this clause, or to negotiate a very specific carve-out with awareness of potential consequences for other terms like vesting or IP rights.

Initial Public Offering Shares Purchase

This term, in the "nice problem to have" category, grants investors the right to purchase a percentage (e.g., 5%) of shares in a "friends and family" or "directed shares" program during a Qualified IPO. It "blossomed in the late 1990s" when IPOs were expected quickly. However, investment bankers usually resist this to direct stock to institutional investors. Ironically, if bankers don't push back (or ask VCs to buy shares), it signals a weak IPO. The authors recommend not worrying about this term or spending legal time on it.

No-Shop Agreement

This clause, nearly always part of the final term sheet, commits the company and founders to exclusively work towards closing the deal with the chosen investor, prohibiting solicitation or negotiation with other parties. It's seen as an emotional commitment, reinforcing a "handshake" to get the deal done.

• Negotiation Points: Entrepreneurs should bound the agreement by a time period (typically 45-60 days) to make the commitment bidirectional. While hard to legally enforce, getting caught "cheating" will likely derail the financing.
• VC Perspective: Reputable VCs avoid issuing term sheets without internal approval, as a reputation for backing out spreads quickly. The authors' experience suggests the no-shop agreement is usually "irrelevant," with the "quality and the character of the people involved" being more important than the legal term.
• "The Entrepreneur's Perspective" advises asking for the no-shop clause to expire immediately if the VC terminates the process and to consider a carve-out for acquisitions, as financings and acquisitions often follow each other.

Indemnification

This clause states that the company will indemnify (protect) investors and board members to the maximum extent permitted by law, covering claims against them arising from the financing. Entrepreneurs "just have to live with" this term.

• Rationale: Given shareholder litigation, companies almost certainly won't get funded without indemnifying directors. The second sentence (often negotiable) indicates a desire for the company to purchase Directors' and Officers' (D&O) liability insurance. D&O insurance is standard practice for follow-on financings to attract outside board members. "The Entrepreneur's Perspective" emphasizes that D&O insurance is good for the entrepreneur too, not just VCs.

Assignment

This clause allows investors to transfer their shares to affiliated partnerships, funds, or their directors/officers/partners, provided the transferee agrees to be bound by the original financing agreements. This gives VC firms operational flexibility. It's not worth negotiating, but entrepreneurs should ensure no "loophole" allows assignment without the transferee being subject to the agreements.

Chapter 7: The Capitalization Table

The capitalization table (cap table) is a spreadsheet summarizing company ownership before and after financing. It's crucial for founders to understand who owns what and the implications of a funding round.

• Composition: Initially, 100% ownership is typically allocated to founders and employees. The cap table helps analyze how a VC investment impacts ownership percentages and price per share.
• Example Walkthrough: The chapter provides an example calculation for a $5M VC investment at a $10M premoney valuation, with a new 20% postmoney employee option pool. It details how to calculate founders' ownership, total shares outstanding, shares in the employee pool, VC preferred shares, and price per share, emphasizing the need for precision beyond simple rounding.
• Importance for Entrepreneurs: Entrepreneurs should not blindly rely on legal counsel to generate cap tables due to potential math errors or lack of understanding from lawyers. It's the entrepreneur's responsibility to understand their cap table, which is especially helpful when discussing expanding the employee option pool with the board. "The Entrepreneur's Perspective" advises founders without strong financial skills to find someone knowledgeable in cap tables and VC financings, not just math.

Chapter 8: Convertible Debt

Convertible debt is a loan that converts into equity (usually preferred stock) upon a later equity round, typically including a discount to the future round's price. For example, a $500,000 convertible note with a 20% discount converts at $0.80/share if the next round is $1.00/share, giving angels more shares than new VCs for the same cash amount.

Arguments For and Against Convertible Debt

• Arguments For (from advocates): It's seen as easier to complete than equity financing as no valuation is set, avoiding that negotiation. Being debt, it has fewer preferred stock rights and less paperwork/legal fees. However, the legal fee argument is less persuasive now due to standardized documents and law firm discounts for future business.
• Arguments Against (from authors):
  • Price: The ultimate price for early convertible debt investors might be higher than an initial equity round.
  • Valuation Caps (Caps): While attempting to fix the above by setting a ceiling on conversion price, VCs may peg their valuation of the next round to this cap, potentially underpricing a larger Series A round for the company overall.
  • Dissonance: VCs specialize in valuing companies; if they can't or won't, it raises questions about their view of the company's value proposition.
• "The Entrepreneur's Perspective" suggests considering convertible debt with a reasonable time horizon for equity financing and a "floor," not a ceiling, on the conversion valuation to attract seed investors.

The Discount

Convertible debt deals almost always include a discount to the next financing round, typically 10-30%, with 20% being most common. This compensates early investors for the risk of investing before a larger financing. The discount means the note converts at a lower price per share than new investors pay in the next round. Occasionally, discounts increase over time (e.g., 10% then 20%), but simplicity is generally recommended for seed rounds. Warrants can also be used as a form of discount but are more complex and typically apply to later-stage deals.

Valuation Caps

The "valuation cap" (or "cap") is an investor-favorable term that sets a ceiling on the conversion price of the debt. It addresses investor concern that the next round's valuation might be too high to appropriately reward their early, risky investment.

• Example: If an investor puts in $100K with a $4M cap and 20% discount, and the next round is at a $20M premoney valuation, the investor's shares convert at an effective $4M valuation (the cap), not the $16M effective valuation from the discount alone.
• Impact on Next Round: Caps can influence the next VC's valuation, sometimes making them view the cap as a price ceiling, potentially underpricing the subsequent larger round. Entrepreneurs prefer no caps, but many seed investors recognize that uncapped notes create risk/return disparities in frothy markets. Thoughtfully negotiated caps can align entrepreneurs and seed investors long-term.

Interest Rate

As a loan, convertible debt almost always includes an interest rate, representing the minimum upside for the investor. The authors believe interest rates should be as low as possible, as the discount is the primary compensation for risk. Interest rates typically range from 6-12% and are often linked to the discount.

Conversion Mechanics

The specifics of how and when convertible debt converts into equity are important. Debt holders traditionally have superior control rights, so outstanding debt can give them leverage in negotiations.

• Automatic Conversion Triggers: Typical language requires specific conditions for automatic conversion, such as selling a certain amount of equity within a set timeframe (e.g., 180 days, $1M new money). If conditions aren't met, the debt remains outstanding unless holders agree to convert.
• Amendment Provision: The "amendment provision" in the notes defines the consent required from debt holders to change terms (e.g., "Majority Holders" consent). Entrepreneurs should ensure this standard doesn't get too high (e.g., requiring a supermajority), as it can create problems with minority holders.

Conversion in a Sale of the Company

If the company is acquired before the convertible debt converts to equity, several scenarios are possible:

• Lender gets principal plus interest: This is the default if no specific language is present, meaning lenders don't participate in acquisition upside. The company may need to find cash to repay the loan in an all-stock deal.
• Lender gets principal plus interest plus a multiple: Documents may dictate a payout of 2-3x (or more in later stages) the original principal amount.
• Conversion to acquiring company stock: In early-stage companies without preferred stock, debt may convert into the acquirer's stock at a valuation subject to a cap. In later-stage companies, investors usually structure notes for maximum flexibility, allowing them to choose between a multiple payout or equity upside based on the previous preferred round. If the acquisition price is low, debt holders can typically opt out of conversion and demand cash payment. It is crucial to address how debt will be handled in an acquisition within the documents.

Warrants

Warrants are another approach to providing a discount on convertible debt, especially in later-stage deals or when investors insist, though less common and more complex for seed rounds.

• Mechanics: An investor might receive warrant coverage (e.g., 20% of the note amount) which allows them to purchase a certain number of shares at a predetermined price. The value of these warrants can be calculated in various ways (e.g., worth of common stock at last value, last preferred stock price, or next preferred stock price). The second method (attached to prior preferred stock round) is most common.
• Extra Terms for Warrants:
  • Term length: Typically 5-10 years, with shorter terms favoring the entrepreneur.
  • Merger considerations: Warrants should ideally expire upon a merger unless exercised beforehand. Acquiring companies dislike warrants that survive a merger and allow purchase of equity in the acquirer, often leading to deal delays or demands for repurchase/editing of warrant terms.
  • Original Issue Discount (OID): If warrants are part of a debt deal, they must be paid for separately (even a small amount, e.g., low thousands of dollars) to avoid OID issues with the IRS, where part of the debt repayment could be treated as interest or accrued income.
• Comparison to Discounts: Warrants add complexity and legal costs compared to simple discounts. Warrants avoid the direct valuation discussion that caps might impose. Investors should not receive both a discount and warrants ("double-dip").

Other Terms

Some other terms from equity financings may appear in convertible debt deals:

• Pro rata rights: Allow debt holders to participate proportionally in future financings.
• Super pro rata rights: Allow investors to purchase a multiple of their pro rata share or a specific percentage of the next financing. These are "excessive" and limit long-term financing options.
• Liquidation preference: Investors get their money back first (or a multiple) before other proceeds are distributed. This is common in "bridge loans" when a company struggles. Usury laws historically prevented such terms, but modern laws often allow debt holders security and preferred stock upside.

Early Stage versus Late Stage Dynamics

Traditionally, convertible debt was used for mid-to-late stage "bridge financings" to reach a larger equity round, often with more complex terms if the company was struggling. For seed-stage companies, convertible debt became popular due to perceived simplicity and lower legal costs compared to preferred stock financings. However, equity rounds have become cheaper, making the legal fees argument less significant. The primary driver for convertible debt in early-stage companies is now the desire to avoid setting a valuation.

Can Convertible Debt Be Dangerous?

• Insolvency Implications: Raising cash via equity results in a positive balance sheet (solvent company), with board/executives owing fiduciary duties to shareholders. However, convertible debt can immediately render a company technically "insolvent" (obligations greater than assets), potentially shifting fiduciary duties to creditors. This increases the liability exposure for officers and directors, as plaintiff lawyers can scrutinize their actions during the "insolvency time" (until debt converts). Some states impose personal liability on directors for actions during insolvency, allowing creditors to sue them personally. While these are "doomsday predictions" and few actual cases exist for early-stage companies, it's a legal nuance often overlooked.

Chapter 9: How Venture Capital Funds Work

Understanding VC motivations and incentives is crucial for entrepreneurs, as these impact business decisions.

Overview of a Typical Structure

A typical VC fund structure involves three entities:

• Management Company: Owned by senior partners, it employs all firm personnel (partners, associates, staff) and covers day-to-day operating expenses (office lease, salaries). It acts as the "franchise" that outlives individual funds.
• Limited Partnership (LP) Vehicle: This is the actual "fund" that holds the money committed by investors (Limited Partners, or LPs).
• General Partnership (GP) Entity: The legal entity acting as the general partner to the fund, often owned by the managing directors on a fund-by-fund basis. The key takeaway is the separation between the management company (franchise) and the funds (LP entities), which can have "divergent interests and motivations," especially if managing directors join or leave the firm.

How Firms Raise Money

VCs raise money from various entities like pension funds, corporations, banks, endowments, and high-net-worth individuals. The terms are governed by a complex "limited partnership agreement (LPA)," which establishes that LPs are the VCs' "bosses".

• Capital Calls: When a VC firm announces a fund, it doesn't have all the cash upfront; it requests money from its LPs through "capital calls" (typically 2-week notice) as needed for investments, expenses, or management fees. LPs are legally obligated to fund these calls.
• Refusal to Fund: While rare, LPs may refuse a capital call if they believe the VC is making bad decisions or if they face their own cash constraints (e.g., during economic crises, as seen in 2008). In such cases, VCs usually find new LPs in the "secondary market" to buy out the old LPs' interests.

How Venture Capitalists Make Money

VC compensation dynamics can influence their behavior during a company's life cycle.

• Management Fees: This is the annual salary source for VCs, typically 1.5-2.5% of the total committed fund amount. For a $100M fund with a 2% fee, this is $2M annually, covering all firm operations (salaries, rent, travel, etc.). The percentage inversely relates to fund size, leveling out around 2%. Fees usually decrease after the 5-year "commitment period". Multiple funds mean stacked fees, increasing senior partners' base compensation. This fee is independent of investment success in the short term, though long-term poor returns hinder future fundraising.
• Carried Interest (Carry): The primary source of VC income in successful funds, dwarfing management fees. It's the profit VCs get after returning the capital committed to their LPs (e.g., 20% of profits after LPs receive their $100M back from a $100M fund). In a 3x successful $100M fund ($300M return), the VCs get $40M carry. VCs can "recycle" management fees, reinvesting early returns to fully deploy the committed capital. Carry allocation among partners isn't always equal and can cause internal friction, especially if a fund underperforms but one or two partners generate positive returns. LPs usually require VCs to invest their own money (GP commitment), historically 1% but sometimes up to 5%.
• Clawback: A provision allowing LPs to reclaim carry if the VC overpaid themselves mid-fund (e.g., took carry on early profits, but later investments tanked the overall fund). This can be complex and contentious, especially with departing partners or personal financial issues.
• Reimbursement for Expenses: VCs charge reasonable board meeting expenses to portfolio companies. Excessive spending should be confronted.

How Time Impacts Fund Activity

VC fund agreements define investment capabilities over time:

• Commitment Period (Investment Period): Usually 5 years, during which the VC can make new investments. After this, no new investments, only follow-on investments in existing portfolio companies. This drives VCs to raise new funds every 3-5 years.
  • "Walking Dead" (Zombie VCs): VCs who are past their commitment period and haven't raised a new fund, but still take meetings to maintain deal flow without being able to invest. They may be spotted by asking about their last new investment (over a year ago) or future fund plans.
• Investment Term: The fund's total active life, typically 10 years with 1-2 year extensions, sometimes longer (up to 17 years). Beyond 12 years, LPs must affirmatively vote annually to extend. For zombie firms, management fees decline, leading partners to leave or push for quick company exits.
• Secondary Sale of Portfolios: Sometimes entire portfolios are sold to new firms, leading to a complete change in board members and investor agendas (often pushing for speedy, even if lower-value, exits).
• "The Entrepreneur's Perspective" emphasizes understanding a prospective investor's fund age, as older funds may exert pressure for liquidity or distribute shares directly to LPs, which can be problematic for the company.

Reserves

"Reserves" are the capital allocated for future follow-on investments in each portfolio company. VCs usually don't disclose this amount, but it's defined internally. Earlier-stage investments typically receive more reserves.

• Impact: If a VC "underreserves" (allocates less than needed), they may be unable to fund all companies, leading to picking favorites, resisting additional financings, limiting dilution, or pushing companies to sell. "Pay-to-play" terms can exacerbate this. "Overreserving" (allocating more than needed) is also an issue, leading to underinvesting the fund, which is economically disadvantageous for LPs and VCs. Most VC funds can raise a new fund once 70% committed and reserved.
• "The Entrepreneur's Perspective" stresses knowing a firm's reserve policy, especially if a company anticipates multiple financing rounds, to ensure the VC has enough "dry powder" to avoid contentious situations later.

Cash Flow

VCs also manage cash flow. Fund capital is used for investments, management fees, and expenses. A $100M fund with typical fees will spend ~$15M on non-investing activities, requiring $15M in returns to recycle cash and fully invest the fund. Unpredictable exits mean funds can run out of cash later in their life, even if they have adequate reserves, leading to inability to support investments and pay employees.

Cross-Fund Investing

This occurs when a VC firm invests in the same company from multiple, sometimes separate, funds (e.g., Fund III and Fund IV). It often happens when the first fund is underreserved.

• Problems: Different LP compositions and return profiles across funds can lead to economic conflicts, particularly in "down rounds" where one fund is disadvantaged. This "fiduciary sandwich" can "melt [the VC's] brain".

Departing Partners

Most VC firms have a "key man clause" in their LPA, which defines what happens if specific partners or a certain number of partners leave. If triggered, LPs may suspend new investments or shut down the fund. Even without triggering the clause, partner departures can cause friction over firm economics, especially if the departing partner holds significant carry or the firm's structure is poor. Entrepreneurs are advised to be sensitive to these dynamics, especially if the departing partner was their board member or sponsor.

Fiduciary Duties

VCs owe concurrent fiduciary duties to their management company, GP, LP, and each board they serve on. While normally fine, these duties can conflict, putting VCs in a "fiduciary sandwich". Some VCs are transparent about conflicts, others act confusingly. If an entrepreneur feels uncomfortable, their legal counsel can help understand the situation.

Implications for the Entrepreneur

Entrepreneurs should be aware of VCs' motivations and incentives, as these affect judgment and emotional responses during critical decisions. Openly discussing these issues with VCs, even if uncomfortable, can prevent future trauma and company-impacting interactions.

Chapter 10: Negotiation Tactics

This chapter focuses on negotiation tactics, asserting that most people, including lawyers, are weak negotiators, and aims to equip entrepreneurs with effective strategies.

What Really Matters?

When negotiating a financing, the three crucial aspects are achieving a good and fair result, maintaining personal relationships, and fully understanding the deal. A financing deal should result in both parties feeling satisfied and fortunate to be working together, as it marks the beginning of a long relationship. If the negotiation is handled poorly, tensions may persist, potentially leading to issues, and a lawyer who behaves badly might lose the VC as a future client. The key deal terms to focus on are economics and control; time spent negotiating beyond these is often wasted, and a VC who fixates on unimportant terms may be revealing their future behavior as a board member or owner.

Preparing for the Negotiation

Lack of preparation is the biggest mistake in negotiation. Entrepreneurs should have a plan, know their desired outcomes, be aware of what they are willing to concede, and recognize their walk-away point before beginning. Researching the other party (e.g., VCs) to understand their strengths, weaknesses, biases, curiosities, and insecurities can provide an advantage. Even seemingly disadvantaged parties have advantages; for instance, a first-time entrepreneur might have more time to dedicate to the negotiation than an experienced VC with many commitments. Personal connections, like shared interests in charities or sports teams, can also be leveraged to build sympathy. The best leverage for an entrepreneur is having multiple interested VCs, creating competition for the deal.

A Brief Introduction to Game Theory

Game theory is a mathematical theory that provides strategies for maximizing gains and minimizing losses within defined constraints. It posits that invisible rules influence how situations play out, independent of the humans involved. The prisoner's dilemma is a classic example illustrating why two rational individuals might not cooperate even when it's in their collective best interest, due to incentives for betrayal in a single-play game. In contrast, multiplay games, where interactions repeat, foster tit-for-tat strategies and can lead to equilibrium, as parties avoid actions that would provoke retaliation. Understanding whether a negotiation is a single-play or multiplay game is crucial.

Negotiating in the Game of Financings

Venture financings are multiplay games, making reputation and the fear of retaliation significant considerations. A win-win outcome is possible, and the ongoing relationship between VC and entrepreneur emphasizes the importance of a productive negotiation. VCs, being involved in many financings, should also be mindful of their reputation in the long run. VCs who treat every negotiation as a single-round, winner-take-all game should be approached cautiously. Entrepreneurs can ask VCs upfront what their three most important terms are and articulate their own, using this to manage the negotiation and call out VCs who focus on peripheral points.

Negotiating Styles and Approaches

Negotiators exhibit different styles:

• The Bully: Yells, threatens, and relies on force; best countered by either out-bullying them (if capable) or remaining calm to sap their energy.
• The Nice Guy: Pleasant but evasive, constantly defers decisions; requires clarity and directness, sometimes even a touch of aggressive behavior to prompt action.
• The Technocrat: Obsessed with details, struggles to prioritize; requires patience and a focus on core issues, covering all points together to avoid piece-by-piece renegotiation.
• The Wimp: Easy to take advantage of, but a "too good" deal can lead to future problems with them as a board member, requiring the other party to negotiate both sides.
• The Curmudgeon: Consistently unhappy and difficult, but won't yell; requires patience, upbeat demeanor, and tolerance.
• Always Be Transparent: In negotiations with reputational and relationship value, transparency and an easygoing approach are recommended to build trust. In single-round games (like some acquisitions), a "just win, baby" mentality might apply, and changing game plans suddenly can keep the other side off balance.

Collaborative Negotiation versus Walk-Away Threats

Knowing one's "walk-away point" before starting a negotiation is essential, making the decision rational rather than emotional. This involves understanding your BATNA (Best Alternative To Negotiated Agreement), which in a financing might be another term sheet or bootstrapping the company. If pushed beyond boundaries, clearly state your walk-away point and be willing to exit; if the other party is truly interested, they will likely reengage with a more acceptable offer. Threats should only be made if one is willing to back them up, as bluffs can permanently damage bargaining position.

Building Leverage and Getting to Yes

The most effective way to gain leverage in a VC financing is to have competing term sheets from different VCs. Managing multiple interested parties requires careful timing to get term sheets delivered in roughly the same timeframe, even if it means "slow rolling" one party. While having a term sheet can motivate others, entrepreneurs should not overshare or be too secretive. It's advisable not to show actual term sheets to other investors or disclose names, as VCs might team up. The goal is to signal legitimate interest from other firms, which often speeds up the process and improves results. Once multiple term sheets are secured, most terms will align, leaving valuation and board control as the primary negotiation points. Anchoring on reasonable, important terms while being flexible on others can be effective. Entrepreneurs should never provide the first term sheet, especially with a price, as it caps potential gains. Controlling the pace after receiving a term sheet is important. Feeding the ego of the negotiating partner and engaging them on points, even minor ones, can foster reciprocity. When leading, addressing points in a strategic order, perhaps starting with easily agreed-upon important points, can build momentum before tackling valuation.

Things Not to Do

Entrepreneurs should avoid presenting the first term sheet to a VC, as it signals inexperience and caps the potential offer. Knowing when to talk and when to listen is critical; "you can't lose a deal point if you don't open your mouth". Do not allow the other party to control the negotiation by addressing points one by one from the legal document, as this can obscure the overall deal and lead to unfavorable cumulative outcomes. Avoid using "it's market" as a sole justification for a negotiation position, and instead, probe for deeper reasons when others use it. Finally, never assume the other side shares the same ethical code, as ethical boundaries can vary, especially in different negotiation contexts. Transparency about key customer information is important with VCs to avoid deal blow-ups or damaged relationships.

Great Lawyers versus Bad Lawyers versus No Lawyers

It is crucial to hire a great lawyer who understands deal mechanics, has a compatible style, and can effectively balance the negotiation with experienced VCs. A lawyer's inexperience or inconsistent behavior can reflect poorly on the entrepreneur. Entrepreneurs should seek references from other entrepreneurs and VCs to find lawyers with good reputations. An expensive lawyer from a nationally known firm isn't always the best choice; smaller firms with lower rates and partner attention can be just as effective if experienced in venture financings.

Can You Make a Bad Deal Better?

Even if a bad deal is struck, there are ways to improve it. Many terms only matter at the point of exit. If raising another round with a new investor, they can serve as an ally to renegotiate unfavorable terms from the previous deal, especially if the company is performing well. Alternatively, if the company is successful, entrepreneurs can directly approach existing VCs for modifications. Finally, at the time of an acquisition, negotiations often include reallocating proceeds to management, where a top-down, fair approach from VCs who want future investment opportunities can be beneficial. Being open and collaborative with VCs during acquisition negotiations, rather than teaming up with the acquirer against them, typically leads to better outcomes for all shareholders.

Chapter 11: Raising Money the Right Way

This chapter outlines common mistakes entrepreneurs should avoid when seeking VC financing.

Don't Ask for a Nondisclosure Agreement

Entrepreneurs should not ask VCs for a Non-Disclosure Agreement (NDA). VCs likely see similar ideas frequently, and signing an NDA could create conflicts if they invest in a competing company or prevent them from discussing the company with potential co-investors. Reputable VCs are generally trustworthy due to reputational constraints and time limitations, so cold pitching without an NDA is usually safe.

Don't Email Carpet Bomb VCs

Sending generic, mass emails to VCs (carpet bombing) makes an entrepreneur appear lazy and is generally ineffective. Personalized and thoughtful communication is preferred.

No Often Means No

When a VC says "no," they usually mean it, whether due to lack of personal interest, misalignment with investment themes, or simply being too busy. A "no" does not imply the idea is bad, just not for that particular VC.

Don't Ask for a Referral If You Get a No

If a VC declines an investment, entrepreneurs should not ask for a referral. This puts the VC in an awkward position of implicitly endorsing a deal they've rejected, which is unlikely to lead to serious consideration from the referred party. An exception exists if the rejection is due to the VC firm's internal factors (e.g., company size, competitive portfolio), in which case a polite request for a referral to a better fit might be acceptable, but still requires respect for the VC's discretion.

Don't Be a Solo Founder

Being a solo founder is often a red flag for VCs. No single person can handle all critical tasks of a startup, and the inability to attract a co-founder suggests a lack of passion or belief in the idea from others. VCs often prioritize a strong team over a great idea, as a grade A team can succeed with a grade B idea, but the reverse is rare. The only exception is often a repeat entrepreneur with a proven track record who can build a team post-funding.

Don't Overemphasize Patents

Entrepreneurs in software businesses should not overly rely on patents for their company's worth. For software, patents are primarily defensive weapons; success comes from great ideas and strong execution, not patents. Overemphasizing patents to VCs, particularly those who are vocal critics of business method and software patents, demonstrates a lack of research and misunderstanding of value drivers.

Chapter 12: Issues at Different Financing Stages

This chapter explores the unique considerations and potential pitfalls at various financing stages for a company.

Seed Deals

Seed deals, despite having the lowest legal costs and less contentious negotiations, present the most potential for mistakes due to the importance of precedent. Agreeing to unfavorable terms early on can haunt the company throughout its life. Paradoxically, entrepreneurs sometimes secure "too good" terms, like an inflated valuation, which can lead to difficulties in future rounds if performance doesn't match expectations, potentially causing original investors to block new financings or feel diluted.

Early Stage

Similar to seed deals, precedent is critical in early stage financings, as terms from the first VC-led round tend to carry over. Liquidation preferences, especially participating preferred features, should be carefully considered, as they can significantly reduce returns for common stockholders in larger, later rounds. Protective provisions also require attention; entrepreneurs should aim for all preferred stockholders to vote as a single class to avoid multiple veto constituents, which can complicate future financings.

Mid and Late Stages

Later stage deals often face challenges with board and voting control. As more lead investors join, each seeking a board seat, the board can become unwieldy (e.g., seven, nine, or more members), or founders may lose board control. While well-behaved investors might mitigate this, increasing board size still creates logistical challenges. Entrepreneurs can try to mitigate this by capping the number of VC directors, offering observer rights to dethroned directors, or establishing an executive committee. Valuation is another key issue; overly high valuations in early rounds can pressure VCs to demand huge exit prices, potentially forcing entrepreneurs to pass on reasonable acquisition offers later.

Other Approaches to Early Stage Deals

Beyond classic preferred stock financings, "seed preferred" or "light preferred" term sheets and convertible debt have become common for seed and early stage deals. Light preferred deals involve a class of preferred stock with fewer protections and rights, often suitable for angel investors who don't require extensive control. They are also useful under IRS tax regulation 409A for setting a higher price for investor stock while maintaining a low common stock price for employee options.

Chapter 13: Letters of Intent—The Other Term Sheet

This chapter discusses the Letter of Intent (LOI) in acquisitions, which serves as a term sheet for a merger, outlining key terms between a buyer and a seller.

Structure of a Deal

The LOI is typically the first formal step in an acquisition and, while usually nonbinding (except for aspects like a no-shop agreement), it sets the tone for negotiations. Unlike VC financings, acquisition price can be complex due to factors like escrow, working capital adjustments, earn-outs, and management retention pools, which can significantly alter the "headline" purchase price. Buyers often carve out a management retention pool, which is part of the purchase price, to incentivize key executives to stay, potentially creating a wedge between management and investors.

Asset Deal versus Stock Deal

Sellers generally prefer stock deals, while buyers prefer asset deals. An asset deal involves buying only specific assets and leaving liabilities with the seller's shell company, which can be problematic for the seller due to winding down the entity, contracts, and potential liabilities. Asset deals were more common in shaky economic times to avoid creditor and successor liability issues, but stock deals are now the vast majority. A stock deal means the entire company is acquired and disappears into the buyer's structure. Buyers often propose asset deals for protection, but similar protection can be achieved in a stock deal with less hassle for the seller. The deal structure is closely linked to tax issues and the form of consideration received. If a company is in poor financial shape, an asset sale might be the only option, requiring the seller to manage the winding down and associated liabilities.

Form of Consideration

The form of consideration (cash vs. stock) is crucial. Cash is straightforward and easily valued. Stock, especially in a private company, requires understanding the existing capital structure and its liquidation preferences. Public company stock involves questions of tradability, registration, lockup agreements, and insider selling restrictions. The "value" of a company in an LOI may not be the "price" received after all these considerations.

Assumption of Stock Options

The treatment of stock options is a major deal point. Buyers may assume the option plan, which might be netted against the purchase price. If not assumed, option plans often have provisions for immediate full vesting upon acquisition. This benefits option holders but allocates a portion of the purchase price to them and requires the buyer to create new incentive packages for employee retention. Lawyers often advise for fully vesting plans to compel buyers to assume options, especially with many option holders. Buyers may also deny assuming options to shift merger consideration from prior shareholders to employees. The "basis of stock options" (strike price) reduces their value; sellers should aim to recapture this in the purchase price, ensuring the full gross value is considered. Ultimately, employees should not be short-changed in an exit, as it impacts the entrepreneur's reputation.

Representations, Warranties, and Indemnification

"Reps and warranties" are assurances about the business. It's crucial to clarify in the LOI who is making these representations (the selling company or its shareholders), as many shareholders are unwilling to personally warrant the company's situation. Most LOIs will include a clause for indemnification if a rep or warranty is breached, which buyers may phrase vaguely (e.g., "standard indemnification") to gain negotiating leverage later. Buyers typically make lightweight reps unless they are paying in private company stock, in which case reps and warranties should be reciprocal. Reps and warranties should be qualified by "to the extent currently known" and arguing against them is a red flag.

Escrow

The "escrow" (or "holdback") is money held by the buyer for a period to cover post-acquisition issues not disclosed in the purchase agreement. The LOI should specify the percentage, duration, and carve-outs for the escrow. Typically, 10-20% of the purchase price is held for 12-24 months as the sole remedy for breaches of reps and warranties, with carve-outs for fraud, capitalization, and taxes. Buyers often try to overreach on escrow terms (e.g., uncapped indemnity, personal liability), especially if not defined in the LOI. The maximum of any carve-out should not exceed the aggregate deal value. The form of consideration for the escrow (cash vs. stock) is important, especially with volatile stock.

Confidentiality/Nondisclosure Agreement

NDAs are almost always mandatory in acquisitions, unlike VC investments. They protect both parties' sensitive information if the deal fails and are usually legally binding provisions in an LOI, along with jurisdiction and breakup fees. A one-sided or weak NDA can signal a buyer's intention to conduct a "fishing expedition" rather than a good-faith acquisition. A bidirectional confidentiality agreement is preferred.

Employee Matters

While boards have fiduciary duties to all employees and shareholders, management and boards don't always look out for everyone in an acquisition, especially in private company deals where senior management might receive extra incentives. Conversely, investors might prioritize their returns, leaving management with little. It's advisable to defer detailed discussions about individual compensation until after the LOI is signed to avoid early deal fatigue, buyer discomfort, and internal wedges. However, leaving employment agreements to the very end can also create unnecessary tension. A balanced approach to negotiation is crucial.

Conditions to Close

Buyers include conditions to closing in the LOI, which can be generic (e.g., board approval, no material adverse change) or specific to the seller. These conditions are easy "deal outs" for the buyer. The length and complexity of these conditions reveal the buyer's attitude and can be a point for early pushback by the seller. Sellers should understand these conditions early in due diligence to avoid unexpected hurdles. Once buyers are deep in legal and due diligence processes, they are often as emotionally and financially committed as the seller.

The No-Shop Clause

Buyers almost always insist on a no-shop provision in an LOI, similar to those in term sheets. In acquisitions, these are almost always unilateral. Sellers should negotiate the no-shop period to a reasonable length (45-60 days), as extended lockups are not in their interest. The no-shop should automatically expire if the buyer terminates the process. Carving out specific events like financings from existing syndicates can maintain some pressure on the buyer.

Fees, Fees, and More Fees

The LOI typically specifies who pays for transaction costs (agent, legal, other seller-side costs), with savvy buyers usually ensuring the seller covers these. Breakup fees are rare in private VC-backed deals, usually resisted by sellers unless the buyer is competitive or the deal poses significant customer/employee risk, or is potentially a "fishing expedition".

Registration Rights

When a public company acquires a private company for stock, understanding the registration characteristics and rights of the stock received is crucial. Unregistered stock with a promise to register shares is common, but sellers should be wary as the buyer cannot guarantee SEC timelines. Unregistered stock becomes tradable after a 12-month waiting period.

Shareholder Representatives

Acquisitions don't end at closing; a "shareholder representative" is appointed to manage post-transaction issues like escrow, earn-outs, working capital adjustments, and litigation. This often unpaid role can be a "giant time-wasting nightmare". Neither an executive working for the buyer nor a VC who isn't fully engaged should take this role. If assuming the role, negotiate a separate pool of money to hire professionals. Shareholder Representative Services (SRS) is a company that professionally handles this role for a modest cost.

Chapter 14: Legal Things Every Entrepreneur Should Know

This chapter highlights crucial legal issues that commonly become hurdles for startups, potentially affecting their value and financial outcomes.

Intellectual Property

IP issues can severely damage a startup. Examples include co-founders claiming ownership over ideas discussed informally (e.g., over beers) or contractors asserting IP rights beyond their paid work. VCs will scrutinize IP claims during diligence, and while many can be resolved, being proactive, diligent, and somewhat paranoid upfront is key. While extreme secrecy (e.g., NDAs for every conversation) is generally not recommended, entrepreneurs should be mindful of who they share ideas with and ensure proper legal documentation when starting a business.

Employment Issues

Employment lawsuits are common and unpleasant. Entrepreneurs should ensure all hires are "at-will employees" to simplify termination processes, as state laws vary. Pre-baking severance terms into offer letters can be considered, though it limits flexibility. Every entrepreneur should have access to a good employment lawyer to navigate these complex and unpredictable issues, especially concerning discrimination laws.

State of Incorporation

Most VCs prefer companies to incorporate in Delaware due to its well-defined and business-friendly corporate law. Delaware allows for common practices like faxed signatures and quick changes to corporate documents, and most investment bankers prefer Delaware for IPOs. The main disadvantages are modest extra taxes and potential compliance with two sets of corporate laws (if the company is based elsewhere). Incorporating in the company's or VC's state is generally acceptable, but VCs might resist if unfamiliar with that state's corporate laws due to personal liability concerns as directors. Delaware is encouraged as the default.

Accredited Investors

When selling securities in a private company, entrepreneurs must comply with SEC laws regarding "accredited investors". These laws restrict private stock sales to "rich and sophisticated people". Selling to non-accredited investors creates a lifelong problem, as they can force the company to buy back their shares at any time, known as a "right of rescission," regardless of company performance.

Filing an 83(b) Election

Failing to file an 83(b) election within 30 days of receiving stock can lead to significantly higher taxes (three times the amount) by preventing capital gains treatment upon sale. It's a simple, two-minute form, often provided by lawyers, and crucial for founders.

Section 409A Valuations

Section 409A of the tax code mandates that all stock options granted to employees be at "fair market value". Previously, common stock was often valued at 10% of preferred stock, but 409A changed this, creating penalties for incorrect valuations. The IRS created a "safe harbor" provision, where using a professional valuation firm ensures the valuation is assumed correct unless proven otherwise by the IRS. This has created a new business line for accountants but adds overhead for companies, often valuing common stock at 20-30% of preferred stock, which means employees make less money in a liquidity event due to higher exercise prices.