Venture Deals

1. Venture capital deals revolve around economics and control

In general, there are only two things that VCs really care about when making investments: economics and control.

Economics refers to the financial terms that determine the potential return on investment, including valuation, liquidation preferences, and anti-dilution provisions. Control encompasses the mechanisms that allow investors to influence company decisions, such as board seats and protective provisions.

Key economic terms:

• Valuation - determines ownership percentage
• Liquidation preference - priority in exit proceeds
• Anti-dilution - protects against future down rounds

Key control terms:

• Board seats - representation on board of directors
• Protective provisions - veto rights on major decisions
• Voting rights - ability to vote on key matters

While term sheets often contain many provisions, entrepreneurs should focus their negotiation efforts on these core economic and control terms that will have the most significant impact on the deal.

2. Term sheets outline key deal terms and set expectations

The term sheet is critical. What's in it usually determines the final deal structure. Don't think of it as a letter of intent. Think of it as a blueprint for your future relationship with your investor.

Key components of a typical venture capital term sheet include:

• Amount raised and valuation
• Type of security (e.g. preferred stock)
• Board composition
• Liquidation preference
• Anti-dilution protection
• Voting rights
• Protective provisions

The term sheet serves as a roadmap for the more detailed legal documents that will follow. While most terms are non-binding, they set important expectations. Entrepreneurs should carefully review and negotiate key provisions, as it becomes difficult to change terms once agreed upon in the term sheet.

Red flags to watch for include unusual terms, excessive investor-friendly provisions, or vague language around important issues. Having an experienced lawyer review the term sheet is highly recommended.

3. Valuation and equity dilution are critical negotiation points

The pre-money valuation is what the investor is valuing the company at today, prior to the investment. The post-money valuation is simply the pre-money valuation plus the contemplated aggregate investment amount.

Valuation determines the percentage of the company the investors will own in exchange for their capital. A higher valuation means less dilution for existing shareholders. Key concepts:

• Pre-money valuation: Company value before investment
• Post-money valuation: Pre-money + investment amount
• Price per share: Post-money valuation / total shares

The option pool is another important factor affecting dilution. Investors typically require an unallocated option pool (e.g. 10-20% of shares) be created before they invest, which comes out of the pre-money valuation and dilutes existing shareholders.

Entrepreneurs should push for a higher valuation and smaller option pool to minimize dilution. However, an unrealistically high valuation can lead to issues in future rounds. The goal is to reach a valuation that is fair and allows sufficient runway to hit key milestones before the next round.

4. Liquidation preferences impact investor returns in various scenarios

The liquidation preference is especially important in cases in which a company is sold for less than the amount of capital invested.

A liquidation preference gives investors the right to receive a specified amount of proceeds before common shareholders in a liquidity event. Key types:

• Non-participating: Investor chooses higher of preference or % ownership
• Full participating: Investor gets preference plus % of remaining proceeds
• Capped participating: Investor participation capped at a multiple (e.g. 3x)

The preference multiple (e.g. 1x, 2x, 3x invested capital) also significantly impacts returns. A 1x non-participating preference is most common for early-stage deals.

Modeling exit scenarios is crucial to understand the implications:

• Small exit: Preference ensures investor return of capital
• Medium exit: Can create misalignment between investors and founders
• Large exit: Less impactful as all shareholders do well

Founders should push for a 1x non-participating preference when possible to ensure alignment of incentives across a range of outcomes.

5. Board composition and voting rights determine company control

Entrepreneurs should think carefully about the proper balance among investor, company, founder, and outside representation on the board.

The board of directors has significant power, including the ability to hire/fire the CEO and approve major corporate actions. A typical early-stage board composition:

• 1-2 Founder/Management seats
• 1-2 Investor seats
• 1 Independent director

As companies raise more rounds, boards often expand to 5-7 directors. Founders should be wary of losing control of the board too early.

Voting rights determine how different share classes can influence key decisions. Preferred shares typically get voting rights equivalent to the number of common shares they could convert into. Some decisions require a separate vote of the preferred shareholders as a class.

Founders should negotiate for:

• Maintain board control through early rounds if possible
• Ensure aligned, productive board members
• Avoid separate class votes that give small investors veto power

6. Protective provisions give investors veto power over major decisions

Protective provisions are effectively veto rights that investors have on certain actions by the company.

Common protective provisions give investors veto rights over:

• Changes to charter/bylaws
• New share issuances
• Increase/decrease in board size
• Sale of the company
• Incurring significant debt
• Changing the business model

While some level of investor protection is reasonable, overly broad provisions can hamstring the company's ability to operate. Founders should push to:

• Limit scope to truly major decisions
• Require majority or supermajority of preferred rather than any single investor
• Include carve-outs for anticipated future actions (e.g. specific debt amounts)

Protective provisions are one of the key mechanisms by which minority investors can exert control over company decisions. Negotiating reasonable provisions upfront is crucial to maintaining founder autonomy in running the business.

7. Understanding VC fund structures and incentives is crucial

VCs' motivations and financial incentives will show up in many ways that may affect their judgment or impact them emotionally, especially in times of difficult or pivotal decisions for a company.

VC fund basics:

• 10-year lifespan with 5-year investment period
• 2% annual management fee
• 20% carried interest on profits above returned capital
• Pressure to deploy capital in early years
• Focus on exits in later years as fund nears end of life

This structure creates incentives that don't always align with founders:

• Push for larger rounds to deploy more capital
• Resist smaller exits that don't "return the fund"
• Pressure for exits as fund nears end of life

Entrepreneurs should understand:

• Where the VC's current fund is in its lifecycle
• The fund's target return profile
• Decision-making process for follow-on investments

This context helps predict VC behavior and negotiate better terms. For example, a VC with dry powder in an older fund may be more founder-friendly to win a deal.

8. Negotiation tactics can make or break a deal

The best Plan A has a great Plan B standing behind it. The more potential investors you have interested in investing in your company, the better your negotiating position is.

Key negotiation principles:

• Create competition among multiple interested investors
• Understand your leverage and the VC's motivations
• Focus on what really matters (economics and control)
• Be willing to walk away if terms are unfavorable

Specific tactics:

• Push for a higher valuation with data on comparables
• Trade less important terms for what you really want
• Use time pressure to your advantage
• Leverage relationships and social proof

Avoid common mistakes:

• Negotiating without alternatives (no BATNA)
• Fixating on valuation at the expense of other terms
• Burning bridges - VCs talk and reputations matter

Remember that signing the term sheet is just the beginning of your relationship with the investor. Negotiate hard but fairly to lay the groundwork for a productive long-term partnership.

9. Letters of intent kick off the M&A process

While it might seem like there are only two players in the financing dance—the entrepreneur and the venture capitalist—there are often others, including angel investors, lawyers, accountants, and mentors.

A letter of intent (LOI) outlines the key terms of a potential acquisition, including:

• Purchase price and structure (cash, stock, earnout)
• Key employee agreements
• Conditions to close
• Exclusivity period
• Treatment of stock options

LOIs are typically non-binding except for certain provisions like exclusivity. Key considerations:

• Push for a higher headline price, but pay attention to structure
• Limit the exclusivity period (e.g. 30-60 days)
• Negotiate key employee agreements upfront
• Watch for unusual conditions or broad outs for the buyer
• Consider engaging an investment banker for larger deals

The LOI sets the framework for the more detailed negotiations to follow. Getting alignment on key terms upfront can help streamline the process and avoid deal-breaking issues later.

10. Legal and accounting issues require careful consideration

There are a few legal issues that we've seen consistently become hurdles for entrepreneurs and their lawyers. While in some cases they will simply be a hassle to clean up in a financing or an exit, they often have meaningful financial implications for the company, and in the worst case, can seriously damage the value of your business.

Key areas to address:

Intellectual property:

• Ensure all IP is properly assigned to the company
• Have employees/contractors sign IP assignment agreements
• Consider filing provisional patents for key innovations

Corporate structure:

• C-corporation is standard for VC-backed companies
• Delaware incorporation is preferred by most investors

Capitalization:

• Accurately track all stock/option issuances
• Comply with 409A valuations for option pricing
• File 83(b) elections for early exercise of options

Employment:

• Use at-will employment agreements
• Be careful with promises of equity compensation
• Comply with applicable labor laws

Accounting:

• Maintain clean financial records from the start
• Consider an audit if raising a large round

Proactively addressing these issues early can save significant time and expense down the road. Engage experienced startup counsel to ensure you're following best practices from day one.

Last updated: July 31, 2024