Notes - Venture Deals

October 21, 2024

Chapter 1: The Players

This chapter introduces the various players in a venture capital financing, including entrepreneurs, venture capitalists, angel investors, syndicates, lawyers, and mentors. Entrepreneurs, also known as founders, are the central figures in the entrepreneurial universe. Venture capitalists (VCs) come in various forms with differing experience levels, but they invest in companies and often seek control provisions to oversee their investments and adhere to federal tax statutes. Angel investors are individuals who provide capital to startups, often using their personal wealth. A syndicate is a group of investors collaborating on a financing deal, typically led by a lead investor who negotiates on behalf of the entire group. Lawyers play a crucial role in negotiating and drafting legal documents, with experienced legal counsel being invaluable for both entrepreneurs and VCs. Mentors are experienced individuals who provide guidance and support to entrepreneurs, sometimes for compensation in the form of options or fees.

Chapter 2: How to Raise Money

This chapter outlines the process of raising money from VCs, emphasizing the need for multiple term sheets and highlighting the importance of tailoring fundraising materials to specific VCs. Fund-raising materials include a short description of the business (elevator pitch), an executive summary, a presentation (often a PowerPoint), and occasionally a business plan or private placement memorandum (PPM). The elevator pitch is a concise, one- to three-paragraph description of the product, team, and business, suitable for a brief encounter. The executive summary expands on the elevator pitch, providing a one- to three-page detailed overview of the idea, product, team, and business, serving as a critical first impression for potential investors. The presentation typically uses PowerPoint to visually communicate the information from the executive summary, adapting the style and content based on the audience and the context of the presentation.

Business plans are comprehensive documents detailing all aspects of the business, though their usefulness for fundraising is debated. Some argue that the discipline of writing a business plan is valuable for clarifying ideas and hypotheses, even if it's not presented in a traditional format. Due diligence materials include documents like capitalization tables, contracts, employment agreements, and board meeting minutes, which VCs request for a thorough assessment of the company. Closing the deal involves two main steps: signing the term sheet and finalizing the definitive documents and receiving the investment funds.

Chapter 3: Overview of the Term Sheet

This chapter provides an overview of the term sheet, a document that outlines the key terms of a VC financing deal. Term sheets often contain nonbinding provisions, with VCs typically including various conditions precedent to financing. Economics and control are highlighted as the most critical aspects of the term sheet, representing the financial returns and the decision-making authority of the investors, respectively. The chapter explains that while VCs may negotiate aggressively on every term, entrepreneurs should prioritize understanding the impact of these terms on economics and control, avoiding distractions from less important details. When companies are formed, founders receive common stock, while VCs typically acquire preferred stock, which carries additional rights and preferences.

Chapter 4: Economic Terms of the Term Sheet

This chapter examines the economic terms of the term sheet, including price, liquidation preference, pay-to-play, vesting, employee pool, and antidilution, emphasizing their impact on the financial aspects of the deal. Price is represented as the dollar amount per share and is used to calculate the pre-money and post-money valuations of the company. The pre-money valuation represents the company's worth before the investment, while the post-money valuation reflects the worth after the investment.

Valuation is influenced by several factors, including the stage of the company, competition among investors, the experience of the entrepreneurial team, perceived risk associated with the business, and the size of the investment round. Liquidation preference defines how proceeds are distributed in a liquidity event, such as a merger, acquisition, or sale of the company, with different types of liquidation preferences (participating, capped participation, and non-participating) influencing how proceeds are shared between preferred and common stockholders.

Pay-to-play provisions require investors to participate in future financing rounds to maintain their ownership percentage, protecting the company from investors who choose not to contribute further. Vesting schedules determine the ownership rights of founders and employees over time, typically granting full ownership after a specified period of continued service. Employee pool refers to the shares reserved for granting stock options to employees, impacting the overall ownership structure of the company.

Antidilution provisions protect investors from dilution in the event the company issues shares at a lower price in subsequent rounds, often employing full ratchet or weighted average methods to adjust the conversion price of preferred shares. The chapter distinguishes between broad-based and narrow-based weighted average antidilution, depending on the definition of common stock outstanding, with broad-based including all potential common shares and narrow-based limited to currently outstanding shares. Carve-outs in antidilution provisions exclude specific share issuances from triggering antidilution adjustments, providing flexibility for the company.

Chapter 5: Control Terms of the Term Sheet

This chapter focuses on control terms in the term sheet, outlining provisions that grant investors influence over company decisions. The composition of the board of directors is a key control mechanism, with entrepreneurs needing to carefully consider the balance of representation between investors, company management, founders, and independent directors. Protective provisions grant investors veto power over specific actions by the company, such as amending corporate documents, issuing new shares, incurring debt, or engaging in mergers and acquisitions.

Drag-along rights allow majority shareholders to compel minority shareholders to participate in a sale of the company, streamlining the process and preventing minority investors from blocking a deal. Conversion terms define how preferred stock converts to common stock, typically occurring automatically in certain scenarios like an IPO.

Chapter 6: Other Terms of the Term Sheet

This chapter covers a wide range of additional terms found in a term sheet, highlighting their significance and potential implications. Dividends are payments made to shareholders, with preferred stockholders typically receiving preferential dividends. Redemption rights grant investors the option to sell their shares back to the company under certain circumstances, offering a potential exit strategy for investors.

Conditions precedent to financing outline requirements that must be met before the investment is finalized, providing investors with safeguards and ensuring specific conditions are in place before the deal closes. Information rights detail the access investors have to company information, such as financial statements and budgets. Registration rights define the rights of investors to register their shares for sale in an IPO, protecting their ability to liquidate their investment in a public offering.

Right of first refusal grants existing investors the opportunity to participate in future funding rounds, ensuring they can maintain their ownership position and prevent dilution. Voting rights determine how different classes of shares participate in company decisions, impacting the balance of power between investors and common stockholders. Restriction on sales provisions limit the ability of shareholders to sell their shares, particularly in private companies, protecting the company's ownership structure.

Proprietary information and inventions agreement clauses require employees and consultants to agree to confidentiality and intellectual property ownership provisions, safeguarding the company's sensitive information and inventions. Co-sale agreements allow investors to participate in a sale of shares by founders or key employees, providing investors with an exit opportunity alongside the selling shareholders. Founders' activities clauses restrict the founders' involvement in competing businesses or activities that may conflict with the company's interests.

Initial public offering (IPO) shares purchase terms grant investors the right to purchase additional shares in an IPO, allowing them to increase their ownership in a public offering. No-shop agreements prevent the company from seeking alternative buyers or investors during a specified period, providing exclusivity to the negotiating party. Indemnification clauses protect one party from losses or liabilities incurred due to actions or omissions of another party, often included in financing and merger agreements. Assignment provisions define the ability of parties to transfer their rights and obligations under the agreement, clarifying the conditions for assigning contractual rights to other entities.

Chapter 7: The Capitalization Table

This chapter explains the capitalization table (cap table), a spreadsheet that outlines the ownership structure of the company, detailing the types and amounts of shares held by each shareholder. The cap table includes pre-money and post-money ownership percentages, reflecting ownership before and after the investment, and it's a crucial tool for understanding the distribution of equity in the company. The chapter emphasizes that entrepreneurs should carefully review and understand the cap table, as it significantly impacts the distribution of ownership and control, and they should not solely rely on legal counsel for its accuracy.

Chapter 8: Convertible Debt

This chapter explores convertible debt, a financing method where investors provide loans that convert into equity at a later stage, often used in seed rounds when valuing the company is challenging. The chapter discusses arguments for and against using convertible debt, highlighting its simplicity and speed of execution as advantages, while potential drawbacks include delayed valuation discussions and complexity in later financing rounds.

Key terms in convertible debt deals include:

The chapter concludes by highlighting the potential risks of convertible debt, particularly if the terms are not carefully structured, potentially leading to unfavorable outcomes for founders or early investors.

Chapter 9: How Venture Capital Funds Work

This chapter provides insights into the structure and operations of venture capital funds, emphasizing the motivations and incentives of VCs, which indirectly influence their interactions with entrepreneurs. A typical VC fund structure involves three entities: the management company, the general partnership, and the limited partnership. Management companies employ the fund's staff and handle day-to-day operations. General partners (GPs) are the fund managers, responsible for investment decisions and fund performance. Limited partners (LPs) are the investors who provide the capital for the fund.

VC funds typically operate within a limited partnership structure, with GPs managing the fund and LPs providing capital. VCs raise money from LPs, such as pension funds, endowments, and wealthy individuals, pooling capital to invest in various startup companies. Carry or carried interest represents the share of profits that VCs receive after returning the invested capital to LPs, motivating them to seek high returns on their investments.

Chapter 10: Negotiation Tactics

This chapter offers practical advice on negotiation tactics specific to VC financing deals, providing insights into strategies that can lead to favorable outcomes for both entrepreneurs and VCs. The authors emphasize the importance of thorough preparation, including identifying key goals, understanding acceptable concessions, and establishing a clear walk-away point to avoid emotional decision-making during the negotiation process.

Researching the VC is crucial, as understanding their investment philosophy, track record, and negotiation style can provide valuable insights for tailoring the approach. Managing leverage effectively is essential, with entrepreneurs encouraged to be transparent about competing offers from other investors while avoiding disclosing sensitive details that might weaken their negotiating position.

Strategizing the order in which deal points are addressed is crucial, with experienced negotiators recommending either a sequential approach or prioritizing points for early agreement to build momentum. Controlling the pace of the negotiation is vital, with entrepreneurs advised to avoid conceding points prematurely and to resist the pressure to address deal points sequentially if the VC is driving the discussion. Active listening is highlighted as a critical skill, enabling negotiators to gather information, understand the other party's priorities, and respond strategically.

Chapter 11: Raising Money the Right Way

This chapter outlines common mistakes entrepreneurs should avoid during the fundraising process, offering advice on best practices for engaging with VCs effectively. Asking for a nondisclosure agreement (NDA) is generally discouraged, as it creates a negative impression and is often unnecessary, given that VCs typically respect confidentiality. Engaging in excessive email communication with VCs is viewed as unprofessional, with concise and targeted approaches preferred.

Over-reliance on patents is cautioned against, particularly in the software industry, with the authors arguing that successful software businesses are built on execution and market dominance rather than patent portfolios.

Chapter 12: Issues at Different Financing Stages

This chapter examines key considerations specific to different stages of financing, highlighting the unique challenges and opportunities associated with seed, early, mid, and later-stage deals. Seed deals, while typically involving lower legal costs and less contentious negotiations, present a higher risk of setting unfavorable precedents that can impact future financing rounds.

Early-stage deals require a balance between attracting investors and retaining sufficient equity for founders and future employees, emphasizing the importance of aligning investor expectations with the company's growth trajectory. Mid-stage deals often involve larger sums of capital, more sophisticated investors, and a greater emphasis on financial performance and market traction, requiring entrepreneurs to demonstrate a clear path to profitability and a compelling business model. Late-stage deals often focus on preparing the company for an exit, whether through an IPO or acquisition, demanding a strong management team, proven financial performance, and a well-defined exit strategy.

Chapter 13: Letters of Intent—The Other Term Sheet

This chapter explains letters of intent (LOIs), nonbinding agreements that summarize the key terms of a potential acquisition, serving as a precursor to a definitive merger agreement. LOIs, also known as indications of interest (IOIs) or memorandums of understanding (MOUs), facilitate the negotiation process by outlining the proposed structure, price, and key terms of the deal, allowing both parties to assess the viability of the acquisition before committing to a formal agreement.

Structure considerations include whether the deal involves an asset purchase or a stock purchase, with each structure having different tax and legal implications for both the buyer and the seller. Price discussions typically involve determining a valuation for the target company, often expressed as a multiple of earnings or revenue, and outlining the form of consideration, whether cash, stock, or a combination of both. The chapter cautions against focusing solely on the headline purchase price, emphasizing the importance of understanding the structure and form of consideration, which can significantly impact the actual value received by the seller.

Assumption of stock options outlines how outstanding employee stock options are treated in the acquisition, impacting the equity distribution and the potential dilution for existing shareholders. Representations, warranties, and indemnification provisions outline the assurances made by the seller about the company's financial health, legal compliance, and intellectual property ownership, with indemnification clauses protecting the buyer from losses arising from breaches of these representations. Escrow agreements involve setting aside a portion of the purchase price to cover potential liabilities or breaches of representations discovered after the acquisition closes, impacting the final payout for the seller.

Confidentiality agreements protect sensitive information shared during the due diligence process, ensuring both parties maintain confidentiality and prevent unauthorized disclosure of proprietary data. Employee matters provisions address how employee compensation, benefits, and employment agreements are handled post-acquisition, impacting the retention and integration of the target company's workforce.

Chapter 14: Legal Things Every Entrepreneur Should Know

This chapter highlights several legal issues that commonly arise for startups, offering practical advice to entrepreneurs beyond the specifics of term sheet negotiations. Intellectual property protection is emphasized, encouraging entrepreneurs to be proactive in securing trademarks, patents, and copyrights, while also acknowledging the evolving nature of intellectual property law and the need for strategic counsel.

Employment issues are addressed, stressing the importance of clear employment agreements, proper classification of workers (employees vs. independent contractors), and compliance with wage and hour laws to avoid legal disputes. State of incorporation considerations are discussed, recommending Delaware as the default choice due to its well-established corporate law framework and favorable legal environment for businesses.

The chapter also touches on the concept of accredited investors, reminding entrepreneurs of the legal restrictions on raising capital from non-accredited individuals, emphasizing the need to comply with securities regulations to avoid legal ramifications. Filing an 83(b) election is discussed as a tax strategy for founders and early employees to potentially reduce future tax liabilities on stock options, highlighting the need for professional tax advice to navigate this complex process.

Section 409A compliance is mentioned as a critical aspect of stock option plan design, requiring adherence to specific valuation and documentation requirements to avoid tax penalties and legal challenges.