How To Fund-Raised
This blog explains the 20+ best Fundraising Ideas. And also explains how to raise money from the government and corporate pension funds, large corporations, banks, professional institutional investors.
So, while we feel your pain, we also admit that many VCs quickly forget about the whole process and inflict too much pain on the entrepreneurs raising money.
While this knowledge might help a little when you are sitting frustrated in your hotel room after another day of fund-raising, we encourage you to also discover the magic soothing properties of Scotch.
If a VC firm requests money and its investors say no, things get tricky. The VC usually has some very draconian rights in the LPA to enforce its capital call, but we've seen several moments in history when VCs have done a capital call and there has been a smaller amount of money to be had than anticipated.
This is not a good thing if you are the entrepreneur relying on getting a deal done with the VC. Fortunately, this is a rare occurrence.
Why might investors refuse to fund a capital call? For one, LPs may think the VC is making bad decisions and may want to get out of the fund. More likely, something exogenous has happened to the LPs and they are feeling tight on cash and can't, or don't want to, comply with the capital call.
High-net-worth individuals who were feeling lower-net-worth at the time.
Banks that had no cash available.
Endowments, foundations, and charitable organizations that had massive cash flow crises because of their ratio of illiquid investments.
In many cases, the VC will find a new LP to buy the old LP'svinterest. There is an active market known as a secondary market for LPs who want to sell their interest.
Economically, this is almost always more attractive to the LP than not making a capital call, so except in moments of extreme stress, the VC usually ends up with the money to make an investment.
Management Company Structure: General Partnership and Limited Partnership
We realize this is confusing unless you are in law school, in which case you are likely salivating with joy over the legal complexity we are exposing you to. The key point to remember is that there is a separation between the management company and the actual funds that it raises.
These distinct entities will often have divergent interests and motivations, especially as managing directors join or leave the VC firm. One managing director may be your point of contact today, but this person may have different alignments among his multiple organizations that will potentially affect you.
How Venture Capitalists Make Money
Now that we've explained the structure of a typical VC fund, let's explore how VCs get paid. The compensation dynamics of a particular fund often impact the behavior of a VC early in the life of a company, as well as later on when the company is either succeeding or struggling and needs to raise additional capital.
VCs' salaries come from their funds' management fees. The management fee is a percentage (typically between 1.5 percent and 2.5 percent) of the total amount of money committed to a fund. These fees are taken annually (paid out quarterly or semi-annually) and finance the operations of the VC firm, including all of the salaries for the investing partners and their staff.
The percentage is usually inversely related to the size of the fund; the smaller the fund, the larger the percentage—but most funds level out around 2 percent.
There's a slight nuance, which is the fee paid during and after the commitment period, or the period of time when the fund can make new investments—usually the first five years.
But wait, there's more. Most VC firms raise multiple funds. The average firm raises a new fund every three or four years, but some firms raise funds more frequently while others have multiple different fund vehicles such as an early stage fund, a growth stage fund, and a China fund. In these cases, the fees stack up across funds.
If a firm raises a fund every three years, it has a new management fee that adds to its old management fee. The simple way to think of this is that the management fee is roughly 2 percent of total committed capital across all funds.
Although VC firms tend to grow headcount (partners and staff) as they raise new funds, this isn't always the case and the headcount rarely grows in direct proportion to the increased management fees.
As a result, the senior partners of the VC firm (or the ones with a managing director title) see their base compensation rise with each additional fund.
The dynamics vary widely from firm to firm, but you can assume that as the capital under management increases, so do the fees and, as a result, the salaries of some of the managing directors.
The VC firm gets this management fee completely independently of its investing success. Over the long term, the only consequence of investment success on the fee is the ability of the firm to raise additional funds. If the firm does not generate meaningful positive returns, over time it will have difficulty raising additional funds.
However, this isn't an overnight phenomenon, as the fee arrangements for each fund are guaranteed for 10 years. We've been known to say that "it takes a decade to kill a venture capital firm," and the extended fee dynamic is a key part of this.
Reimbursement for Expenses
There is one other small income stream that VCs receive: reimbursements from the companies they invest in for expenses associated with board meetings. VCs will charge all reasonable expenses associated with board meetings to the company they are visiting.
This usually isn't a big deal unless your VC always flies on his private plane and stays at the presidential suite at your local Four Seasons hotel.
In the case where you feel your VC is spending excessively and charging everything back to the company, you should feel comfortable confronting the VC. If you aren't, enlist one of your more frugal board members to help.
How Time Impacts Fund Activity
VC fund agreements have two concepts that govern the ability to invest over time. The first concept is called the commitment period. The commitment period (also called "investment period"), which is usually five years, is the length of time that a VC has for identifying and investing in new companies in the fund.
Once the commitment period is over, the fund can no longer invest in new companies, but it can invest additional money in existing portfolio companies.
This is one of the main reasons that VC firms typically raise a new fund every three to five years—once they've committed to all the companies they are going to invest in from a fund, they need to raise a new fund to stay active as investors in new companies.
It's sad but true that some VCs who are past their commitment period and have not raised a new fund still meet with entrepreneurs trying to raise money.
In these cases, the entrepreneur has no idea that there is no chance the VCs will invest, but the VCs get to pretend they are still actively investing and try to maintain some semblance of deal flow even though they can't invest any longer.
The good zombies are open about their status; the not so good ones keep taking meetings with new companies even though they can't make new investments.
It's usually easy to spot zombie VCs—just ask them when they made their last new investment. If it's more than a year ago, it's likely they are a zombie.
You can also ask simple questions like "How many new investments will you make out of your current fund?" or "When do you expect to be raising a new fund?" If you feel like the VCs are giving you ambiguous answers, they are probably a zombie.
The other concept is called the investment term, or the length of time that the fund can remain active. New investments can be made only during the commitment/investment period, but follow-on investments can be made during the investment term.
A typical VC fund has a 10-year investment term with two one-year options to extend, although some have three one-year extensions or one two-year extension.
Twelve years may sound like plenty of time, but when an early stage fund makes a new seed investment in its fifth year and the time frame for the exit for an average investor can stretch out over a decade, 12 years is often a constraint. As a result, many early-stage funds go on for longer than 12 years—occasionally up to as many as 17 years.
Once you get past 12 years, the LPs have to affirmatively vote every year to have the GP continue to operate the fund. In cases in which a firm has continued to raise additional funds, the LPs are generally supportive of this continued fund extension activity.
There is often a negotiation over the management fee being charged to continue to manage the fund, with it ranging from a lower percentage of remaining invested capital (say, 1 percent) all the way to waiving the fee entirely.
This isn't an issue for a firm that has raised additional funds and has the management fee from those funds to cover its operations, but it is a major issue for zombie firms that find their annual operating fees materially declining.
Time is not the friend of a zombie firm, as partners begin to leave for greener pastures, spend less and less time helping the companies they've invested in, or simply start pushing the companies to sell and generate liquidity.
These secondary buyers often have a very different agenda than the original investor, usually much more focused on driving the company to a speedy exit, even at a lower value than the other LPs.
The Entrepreneur's Perspective
One important thing to understand about your prospective investor's fund is how old the fund is. The closer the fund is to its end of life, the more problematic things can become for you in terms of investor pressure for liquidity (in which your interests and the investors might not be aligned).
An investor requirement to distribute shares in your company to LPs, which could be horrible for you if the firm has a large number of LPs who then become direct shareholders.
Reserves are the amount of investment capital that is allocated to each company that a VC invests in. This is a very important concept that most entrepreneurs don't pay proper attention to.
Imagine that a VC invests $1 million in the first round of your company. At the time of making the investment, the VC will reserve a theoretical future amount of the fund to invest in follow-on rounds. The VC generally won't tell you this amount, but it's usually a well-defined amount within the VC firm.
Typically, but not always, the earlier the stage a company is at, the more reserves the VC will allocate. In the case of a late-stage investment immediately prior to an IPO, a VC might not have any reserves allocated to a company, whereas a first-round investment might have reserves of $10 million or more associated with it.
While most VCs will ask the entrepreneur about future funding needs prior to making an investment, many VCs ignore this number and come up with their own view of the future financing dynamics and the corresponding reserves amount.
In our experience, entrepreneurs are often optimistic about how much capital they need, estimating on the low side. VCs will rely on their own experience when figuring out reserves and will often be conservative and estimate high early in the life of the investment, reducing this number over time as a company ages.
Let's look at how reserve analysis can impact a company. Assume a VC firm has a $100 million fund and invests a total of $50 million into 10 different companies. Assume also that the VC firm has an aggregate of $50 million in reserves divided between the 10 companies.
While it doesn't matter if the firm is accurately reserved on a company by company basis at the beginning, the total amount reserved and how it is deployed over time are critical.
This usually results in VCs picking favorites and not supporting some of the companies. Although this can manifest itself as VCs simply walking away from their investments or being direct that they have no additional money to invest, the behavior by the VC is usually more mysterious.
The less upfront VC will often actively resist additional financings, try to limit the size and subsequently the dilution of these financings, or push you to sell the company.
In cases where a pay-to-playterm is in effect, you'll often see more resistance to additional financings as the VC firm tries to protect its position in the company, even if it's not necessarily the right thing to do for the business.
The LPs want all of the fund capital to be invested because it increases the chance of returning more capital. The VCs also want to get all the money to work, especially when funds become profitable, as the greater the absolute return, the greater the carry.
Most VC fund agreements allow a firm to raise a new fund once they are around 70 percent committed and reserved. While this threshold varies by firms, it is usually reasonably high.
As a result, there is a slight motivation to over reserve to reach this threshold that is countered by the negative economic dynamics of not fully investing the fund. Of course, independent of the threshold, the VC still needs to have good performance and the support of the existing investors to raise a new fund.
The Entrepreneur's Perspective
You should understand how much capital the firm reserves for follow-on investments per company, or in the case of your company in particular.
If you think your company is likely to need multiple rounds of financing, you want to make sure the VC has plenty of "dry powder" in reserve for your company so you don't end up in contentious situations down the road in which your investor has no more money left to invest and is then at odds with you or with future investors.
VCs have to pay as much attention to cash flow as entrepreneurs do, although many don't until they run into trouble.
Remember that the capital raised by a venture firm can be used for investments in companies, management fees, and expenses of the fund, which include paying accountants for an annual audit and tax filings and paying lawyers for any litigation issues.
Also, remember that LPs want their VCs to invest 100 percent of the fund in companies.
More important is that timing matters since the exits that generate this additional cash are unpredictable, and as a fund gets later in its life, it can start to get into a position where it doesn't actually have the cash to recycle.
In the most extreme case, the firm will under reserve and not manage cash flow effectively. As a result, it will find itself crunched at both ends.
It won't have adequate reserves to continue to support its investments and, even if it did, it won't have the cash to pay its employees through management fees. This situation can occur even in firms that have raised follow-on funds, as the cash flow dynamics of recycling are fund specific.
Many VC firms invest out of several linked fund entities (e.g., you may have two funds as investors in your fund—VC Fund III and VC Entrepreneurs Fund III); however, there are also cases where firms will fund out of two completely separate funds, say VC Fund III and VC Fund IV These are called cross-fund investments.
Typically, you'll see this when the first fund (Fund III) is underreserved and the second fund (Fund IV) fills in the gap to help the VC firm as a whole protect its position and provide support for the company.
Cross-fund investing can lead to several problems between the VC firm and its LPs. Cross-fund investing is rarely done from the beginning of an investment, so the later rounds are done at a different price (not always higher) than the earlier rounds.
Since the underlying funds almost always have different LP composition and each fund will end up with a different return profile on the exit, the LPs won't be treated economically equally across the investment.
In the upside case where the valuation is steadily increasing, this won't matter as everyone will be happy with the positive economic outcome. However, in the downside case, or an upside case where the round that the second fund invests in is a down round, this is a no-win situation for the VC.
In this situation, one fund will be disadvantaged over the other and some LPs will end up in a worse situation than they would have been in if the cross-fund investment hadn't happened. And if our friendly VC thinks too hard, the economic conflict will start to melt his brain.
Most VC firms have a key man clause that defines what happens in the case in which a certain number of partners or a specific partner leaves the firm. In some cases, when a firm trips the key man clause, the LPs have the right to suspend the ability of the fund to make new investments or can even shut down the fund.
In cases where a partner leaves the firm but doesn't trip the key man clause, there are often contentious issues over firm economics, especially if the firm has been poorly structured, doesn't have appropriate vesting;
or has a significant amount of economics in the hands of the departing partner, leaving the other partners with insignificant motivation (at least in their minds) for continuing to actively manage the firm.
While the entrepreneur can't impact this, it's important to be sensitive to any potential dynamics in the structure of the firm, especially if the departing partner is the one who sits on your board or has sponsored the investment in your company.
VCs owe fiduciary duties, concurrently and on the same importance level, to their management company, to the GP, to the LP, and to each board that they serve on.
Normally, this all works out fine if one is dealing with a credible and legitimate VC firm, but even in the best of cases, these duties can conflict with one another and VCs can find themselves in a fiduciary sandwich.
For the entrepreneur, it's important to remember that no matter how much you love your VCs, they answer to other people and have a complex set of formal, legal responsibilities.
Some VCs understand this well, are transparent, and have a clearly defined set of internal guidelines when they find themselves in the midst of fiduciary conflicts. Others don't and subsequently act in confusing, complicated, and occasionally difficult ways.
More annoyingly to the VCs who understand this well, some VCs pontificate about their fiduciary duties while not really knowing what to do. If you ever feel uncomfortable with the dynamic, remember that your legal counsel represents your company and can help you cut through the noise to understand what is really going on.
Implications for the Entrepreneur
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. Don't be blind to the issues that affect your investment partners.
More importantly, don't be afraid to discuss these issues with them; an uncomfortable, yet open discussion today could save you the trauma of a surprise and company-impacting interaction later.
Regardless of how much you know about term sheets, you still need to be able to negotiate a good deal. We've found that most people, including many lawyers, are weak negotiators.
Fortunately for our portfolio company executives, they can read about everything we know online and in this blog, so hopefully in addition to being better negotiators, they now know all of our moves and can negotiate more effectively against us.
What Really Matters?
There are only three things that matter when negotiating to finance: achieving a good and fair result, not killing your personal relationship getting there, and understanding the deal that you are striking.
It has been said that a good deal means neither party is happy.
This might be true in litigation or acquisitions, but if neither party is happy following the closing of a venture financing, then you have a real problem.
Remember, the financing is only the beginning of the relationship and a small part at that. Building the company together while having a productive and good relationship is what matters.
A great starting point is for both sides to think they have achieved a fair result and feel lucky to be in business with one another. If you behave poorly during the financing, it's likely that tensions will be strained for some time if the deal actually gets closed.
And, if your lawyer behaved badly during the negotiation, it's likely that lawyer will be looking for a new client after the VC joins the board.
The Entrepreneur's Perspective
Your lawyer shouldn't be a jerk in manner or unreasonable in positions, but this doesn't mean you should advise your lawyer to behave in a milquetoast manner during negotiations, especially if he is well versed in venture financings.
You need to manage this carefully as the entrepreneur, even if your eyes glaze over at legalese. This is your company and your deal, not your lawyer's.
As for which deal terms matter, we've talked previously about economics and control. We'd suggest that any significant time you are spending negotiating beyond these two core concepts is a waste of time. You can learn a lot about the person you are negotiating with by what that individual focuses on.
Pick a few things that really matter—the valuation, stock option pool, liquidation preferences, board, and voting controls—and be done with it.
The cliche "you never make money on terms" is especially true outside of a few key ones that we've dwelled on already. The good karma that will attach to you from the other side (assuming they aren'tjerks) will be well worth it.
Preparing for the Negotiation
The single biggest mistake people make during negotiation is a lack of preparation. It's incredible to us that people will walk blindly into a negotiation when so much is on the line. And this isn't just about venture deals, as we've seen this behavior in all types of negotiations.
Many people don't prepare because they feel they don't know what they should prepare for. We'll give you some ideas, but realize that you probably do know how to negotiate better than you think.
You already negotiate many times a day during your interactions in life, but most people generally just do it and don't think too hard about it. If you have a spouse, child, auto mechanic, domesticated animal, or any friends, chances are that you have dozens of negotiations every day.
When you are going to negotiate your financing (or anything, really), have a plan. Have key things that you want, understand which terms you are willing to concede, and know when you are willing to walk away. If you try to determine this during the negotiation, your emotions are likely to get the best of you and you'll make mistakes.
Always have a plan.
Next, spend some time beforehand getting to know who you are dealing with. Some people (like us) are so easy to find that you can Google us and know just about everything we think.
If we openly state that we think people who negotiate registration rights in term sheets are idiots (which we do), then why on earth would you or your lawyer make a big deal about it?
This being said, more than 50 percent of the term sheet markups we get from lawyers have requested changes to the registration rights section, which makes us instantly look down upon the lawyer and know that the entrepreneur isn't the one running the show.
If you get to know the other side ahead of time, you might also be able to play to their strengths, weaknesses, biases, curiosities, and insecurities. The saying "knowledge is power" applies here.
And remember, just because you can gain the upper hand in using this type of knowledge doesn't mean that you have to, but it will serve as a security blanket and might be necessary if things turn south.
One thing to remember: everyone has an advantage over everyone else in all negotiations. There might be a David to the Goliath, but even David knew a few things that the big man didn't. Life is the same way. Figure out your superpower and your adversary's kryptonite.
If you are a first-time, 20-something entrepreneur negotiating a term sheet against a 40-something, well-weathered, and experienced VC, what possible advantage could you have on the VC?
The VC clearly understands the terms better. The VC also has a ton of market knowledge. And let's assume that this VC is the only credible funding source that you have. Sounds pretty bleak, right?
Well, yes, but don't despair. There is one immediate advantage that you probably have: time. If we generalize, it's easy to come up with a scenario of the VC having a family and lots of portfolio companies and investors to deal with.
You, on the other hand, have one singular focus: your company and this negotiation. You can afford to make the process a longer one than the VC might want.
In fact, most experienced VCs really hate this part of the process and will bend on terms in order to aid efficiency, although some won't and will nitpick every point. Perhaps you'll want to set up your negotiation call at the end of the day, right before the VCs dinner.
Or maybe you'll sweetly ask your VC to explain a host of terms that you "don't understand" and further put burdens on the VCs time. Think this doesn't happen?
After we gave this advice to some of the TechStars teams in 2009, one of the teams waited until two hours before Jason left on vacation to negotiate the term sheet we gave them.
Jason didn't even recognize this as their strategy and figured it was bad luck with timing. As a result, he faced time pressure that was artificially manufactured by a 20-something first-time entrepreneur.
There are advantages all over the place. Is your VC a huge Stan ford fan? Chat him up and find out if he has courtside seats to the game. Is your VC into a charity that you care about? Use this information to connect with your VC so he becomes more sympathetic.
While simple things like this are endless, what matters is that you have a plan, know the other side, and consider what natural advantages you have. In a perfect world, you won't have to use any of these tools, but if you need them and don't bring them to the actual negotiation, it's your loss.
The Entrepreneur's Perspective
Your biggest advantage is to have a solid Plan B—lots of interest and competition for your deal. VCs will fold like a house of cards on all peripheral terms if you have another comparable quality VC waiting in the wings to work with you.
A Brief Introduction to Game Theory
Everyone has a natural negotiating style. These styles have analogs that can work either well or poorly in trying to achieve a negotiated result. It's important to understand how certain styles work well together, how some conflict, and how some have inherent advantages over one another.
Before we delve into that, let's spend a little time on basic game theory. Game theory is a mathematical theory that deals with strategies for maximizing gains and minimizing losses within prescribed constraints, such as the rules of a card game.
Game theory is widely applied in the solution of various decision-making problems, such as those of military strategy and business policy.
Game theory states that there are rules underlying situations that affect how these situations will be played out.
These rules are independent of the humans involved and will predict and change how humans interact within the constructs of the situation. Knowing what these invisible rules are is of major importance when entering into any type of negotiation.
If you both confess I get two convictions, but I'll see to it that you both get early parole. If you both remain silent, I'll have to setde for token sentences on firearms possession charges. If you wish to confess, you must leave a note with the jailer before my return tomorrow morning."
What's fascinating about this is that there is a fundamental rule in this game that demonstrates why two people might not cooperate with one another, even if it is clearly in their best interests to do so.
If the two prisoners cooperate, the outcome is best, in the aggregate, for both of them. They each get eight months of jail time and walk away. But the game forces different behavior.
Regardless of what the co-conspirator chooses (silence versus betrayal), each player always receives a lighter sentence by betraying the other. In other words, no matter what the other guy does, you are always better off by ratting him out.
The other rule to this game is that it is a singk^play game. In other words, the participants play the game once and their fate is cast. Other games are multiplay games. For instance, there is a lot of interesting game theory about battlegrounds.
If you are in one trench fighting and we are in another, game theory would suggest that we would not fight at night, on weekends, on holidays, and during meals. Why not? It would seem logical that if we know you are sleeping, it's the absolute best time to attack.
Well, it's not, unless we can completely take you out with one strike. Otherwise, you'll most likely start attacking us during dinner, on holidays, or while we are watching Mad Men. And then not only are we still fighting but now we've both lost our free time.
This tit-for-tat strategy is what keeps multiplay games at equilibrium. If you don't mess with us during our lunch break, we won't mess with you during yours. And everyone is better off. But if you do mess with us, we'll continue to mess with you until you are nice to us again.
When you are considering which game you are playing, consider not only whether there are forces at work that influence the decisions being made, like the prisoner's dilemma, but also how many times a decision will be made. Is this a one-shot deal, or will this game repeat itself, lending increased importance to precedent and reputation?
Negotiating in the Game of Financings
A venture financing is one of the easiest games there is. First, you really can have a win-win outcome where everyone is better off. Second, you don't negotiate in a vacuum like your hypothetical fellow criminal co-conspirator.
Last, and most important, this is not a single- instance game. Therefore, reputation and the fear of tit-for-tat retaliation are real considerations.
Since the VC and entrepreneur will need to spend a lot of time together post-investment, the continued relationship makes it important to look at the financing as just one negotiation in a very long, multiplay game. Doing anything that would give the other party an incentive to retaliate in the future is not a wise, or rational, move.
Furthermore, for the VC, this financing is but one of many that the VC will hope to complete. Therefore, the VC should be thinking about reputational factors that extend well beyond this particular interaction.
With the maturation of the VC industry, it's easy to get near-perfect information on most VCs. Having a negative reputation can be fatal to a VC in the long run.
Not all VCs recognize that each negotiation isn't a single-round, winner-take-all game. Generally, the more experience VCs have, the better their perspective is, but this lack of a longer-term view is not limited to junior VCs.
While we'll often see this behavior more from the lawyers representing the VCs or the entrepreneurs, we also see it from the business principals. When we run across people like this, at a minimum we lose a lot of respect for them and occasionally decide not to do business with them.
When you encounter VCs who either have a reputation for or are acting as though every negotiation is a single-round, winner-take-all game, you should be very cautious.
Game theory is also useful because of the other types of negotiations you'll have. For instance, if you decide to sell your company, your acquisition discussions can be similar to the prisoner's dilemma presented earlier.
Customer negotiations usually take on the feeling of a single-round game, despite any thoughts to the contrary about partnerships. And litigation almost always takes the form of a single-round game, even when the parties will have ongoing relationships beyond the resolution of the litigation.
The Entrepreneur's Perspective
One successful negotiating tactic is to ask VCs up front, before the term sheet shows up, what the three most important terms are in financing for them. You should know and be prepared to articulate your top three wants as well.
This conversation can set the stage for how you think about negotiating down the road, and it can be helpful to you when you are in the heat of a negotiation.
If the VCs are pounding hard on a point that is not one of their stated top three, it's much easier to call them out on that fact and note that they are getting most or all of their main points.
Remember, you can't change the game you are in, but you can judge people who play poorly within it. And having a game theory lens to view the other side is very useful.
Negotiating Styles and Approaches
Every person has a natural negotiating style that is often the part of your personality that you adopt when you are dealing with conflict. Few people have truly different modes for negotiation, but that doesn't mean you can't practice having a range of different behaviors that depend on the situation you are in.
Most good negotiators know where they are comfortable, but also know how to play upon and against other people's natural styles.
Following are some of the personalities you'll meet and how you might want to best work with them.
The bully negotiates by yelling and screaming, forcing issues, and threatening the other party. Most folks who are bullies aren't that smart and don't really understand the issues; rather, they try to win by force.
There are two ways to deal with bullies: punch them in the nose or mellow out so much that you sap their strength. If you can out-bully the bully, go for it. But if you are wrong, then you've probably ignited a volcano.
Unlike the children's playground, getting hit by a bully during a negotiation generally doesn't hurt; so unless this is your natural negotiating style, our advice is to chill out as your adversary gets hotter.
The Nice Guy
Whenever you interact with this pleasant person, you feel like he's trying to sell you something. Often you aren't sure that you want what he's selling. When you say no, the nice guy will either be openly disappointed or will keep on smiling at you just like the audience at a Tony Robbins event.
While the car salesman always needs to go talk to his manager, the nice-guy negotiator regularly responds with "Let me consider that and get back to you." While the nice guy doesn't yell at you like the bully, it's often frustrating that you can never get a real answer or seemingly make progress.
Our advice is to be clear and direct and doesn't get worn down, as the nice guys will happily talk to you all day. If all else fails, don't be afraid to toss a little bully into the mix on your side to move things forward.
The Entrepreneur's Perspective
You learn a lot about a person in a negotiation. This is one argument for doing as much of the detailed negotiation before signing a term sheet that includes a no-shop clause in it.
If you find that your potential investor is a jerk to you in negotiating your deal, you may want to think twice about this person becoming a board member and member of your inner circle.
Always Be Transparent
What about the normal dude? You know, the transparent, nice, smart, levelheaded person you hope to meet on the other side of the table? Though they exist, everyone has some inherent styles that will find their way into the negotiation, especially if pressed or negotiations aren't going well.
Make sure you know which styles you have so you won't surprise yourself with a sudden outburst. You'll also see a lot of these behaviors come out real-time in board meetings when things aren't going quite as well as hoped.
If you are capable of having multiple negotiating personalities, which should you favor? We'd argue that in a negotiation that has reputational and relationship value, try to be the most transparent and easygoing that you can be, to let the other person inside your thinking and get to know you for who you really are.
If you are playing a single-round game, like an acquisition negotiation with a party you don't ever expect to do business with again, do like Al Davis says: "Just win, baby." As in sports, don't ever forget that a good tactic is to change your game plan suddenly to keep the other side on their toes.
Collaborative Negotiation versus Walk-Away Threats
Of all the questions we get regarding negotiations, the most common is when to walk away from a deal. Most people's blood pressure ticks up a few points with the thought of walking away, especially after you've invested a lot of time and energy (especially emotional energy) in a negotiation.
In considering whether to walk away from a negotiation, preparation is key here—know what your walk-away point is before starting the negotiation so it's a rational and deliberate decision rather than an emotional one made in the heat of the moment.
When determining your walk-away position, consider your best alternative to a negotiated agreement, also known in business school circles as BATNA. Specifically, what is your backup plan if you aren't successful in reaching an agreement?
The answer to this varies wildly depending on the circumstances. In financing, if you are lucky, your backup plan may be accepting your second-favorite term sheet from another VC.
It could mean bootstrapping your company and forgoing financing. Understanding BATNA is important in any negotiation, such as an acquisition (walk away as a stand-alone company), litigation (settle versus go to court), and customer contract (walk away rather than get stuck in a bad deal).
Before you begin any negotiation, make sure you know where your overall limits are, as well as your limits on each key point. If you've thought this through in advance, you'll know when someone is trying to move you past one of these boundaries.
It's also usually obvious when someone tries to pretend they are at a boundary when they really aren't. Few people are able to feign true conviction.
At some point in some negotiation, you'll find yourself up against the wall or being pushed into a zone that is beyond where you are willing to go. In this situation, tell the other party there is no deal, and walk away. As you walk away, be very clear with what your walk-away point is so the other party will be able to reconsider their position.
If you are sincere in walking away and the other party is interested enough in a deal, they'll likely be back at the table at some point and will offer you something that you can stomach. If they don't reengage, the deal wasn't meant to be.
Depending on the type of person you are negotiating with, the VC either will be sensitive to your boundaries or will force you outside these boundaries where BATNA will come into effect.
If this is happening regularly during your financing negotiation, think hard about whether this is a VC that you want to be working with, as this VC is likely playing a single-round game in a relationship that will have many rounds and lots of ups and downs along the way.
Finally, don't ever make a threat during a negotiation that you aren't willing to back up. If you bluff and aren't willing to back up your position, your bargaining position is forever lost in this negotiation. The 17th time we hear "and that's our final offer," we know that there's another, better offer coming if we just hold out for number 18.
Building Leverage and Getting to Yes
Besides understanding the issues and knowing how to deal with the other party, there are certain things that you can do to increase your negotiation leverage.
In VC financing, the best way to gain leverage is to have competing term sheets from different VCs. If you happen to be lucky enough to have several interested parties, this will be the single biggest advantage in getting good deal terms.
However, it's a tricky balance dealing with multiple parties at the same time. You have to worry about issues of transparency and timing and, if you play them incorrectly, you might find yourself in a situation where no one wants to work with you.
The Entrepreneur's Perspective
As I mentioned earlier, having a solid Plan B is one of your most effective weapons during the negotiation process. It's helpful to be reasonably transparent about that fact to all prospective investors.
While it's a good practice to withhold some information, such as the names of the other potential investors with whom you're speaking since there is no reason to enable two VCs to talk about your deal behind your back, telling investors that you have legitimate interest from other firms will serve you very well in terms of speeding the process along and improving your end result.
For starters, pay attention to timing. You'll want to try to drive each VC to deliver a term sheet to you in roughly the same time frame. This pacing can be challenging since there will be uncomfortable days when you'll end up slow-rolling one party while you seek to speed up the process of another firm.
This is hard to do, but if you can getVCs to approve financing around the same time, you're in a much stronger position than if you have one term sheet in hand that you are trying to use to generate additional term sheets.
Once you've received a term sheet from a VC, you can use this to motivate action from other VCs, but you have to walk a fine line between oversharing and being too secretive.
We prefer when entrepreneurs are up front, tell us that they have other interests, and let us know where in the process they are. We never ask to see other term sheets, and we'd recommend that you don't ever show your actual term sheets to other investors.
More importantly, you should never disclose whom you are talking to, as one of the first emails most interested VCs will send after hearing about other VCs who are interested in a deal is something like "Hey, I hear you are interested in investing in X—want to share notes?"
As a result, you probably no longer have a competitive situation between the two VCs, as they will now talk about your deal and in many cases talk about teaming up.
The exception, of course, is when you want them to team up and join together in a syndicate. At the end of the day, if you have multiple term sheets, most of the deal terms will collapse into the same range (usually entrepreneur favorable), and the only real thing you'll be negotiating is valuation and board control. You can signal quite effectively what your other options might be.
Whatever you do, don't sign a term sheet and then pull a Brett Favre and change your mind the next day. The start-up ecosystem is small and word travels fast. Reputation is important.
Another strategy that can help you build leverage is to anchor on certain terms. The anchoring means to pick a few points, state clearly what you want, and then stick to your guns.
If you anchor on positions that are reasonable while still having a little flexibility to give in the negotiation, you will likely get close to what you want as long as you are willing to trade away other points that aren't as important to you.
Although you should try to pace the negotiation, you should do this only after the VC has offered up the first term sheet. Never provide a term sheet to a VC, especially with a price attached, since if you do you've just capped what you can expect to get in the deal.
You are always in a stronger position to react to what the VC offers, especially when you have multiple options. However, once you've got a term sheet, you should work hard to control the pace of the ensuing negotiation.
As with any type of negotiation, it helps to feed the ego of your partner. Figure out what the other side wants to hear and try to please them. People tend to reciprocate niceties.
For example, if you are dealing with technocrats, engage them in depth on some of the deal points, even if the points don't matter to you, in order to make them happy and help them feel like you are playing their game.
When you are leading the negotiation, we highly recommend that you have a strategy about the order in which you will address the points. Your options are to address them either in the order that they are laid out in the term sheet or in some other random order of your choosing. In general, once you are a skilled negotiator, going in order is more effective, as you won't reveal which points matter most to you.
Often experienced negotiators will try to get agreement on a point-by-point basis in order to prevent the other party from looking holistically at the process and determining whether a fair deal is being achieved.
This strategy really works only if you have a lot of experience, and it can really backfire on you if the other party is more experienced and takes control of the discussion. Instead of being on the giving end of a divide-and-conquer strategy, you'll be on the receiving end of death by a thousand cuts.
Unless you are a very experienced negotiator, we suggest an order where you start with some important points that you think you can get to yes quickly. This way, both parties will feel good that they are making progress toward a deal. Maybe it's liquidation preferences or the stock option plan allocation. Then dive into the minutiae.
Valuation is probably the last subject to address, as you'll most likely get closure on other terms but have a couple of different rounds of discussion on valuation. It is completely normal for some terms to drag out longer than others.
Things Not to Do
There are a few things that you'll never want to do when negotiating to finance for your company. As we stated earlier, don't present your term sheet to a VC.
In addition to signaling inexperience, you get no benefit by playing your hand first since you have no idea what the VC will offer you. The likely result is either you'll end up starting in a worse place than the VC would have offered or you'll put silly terms out there that will make you look like a rookie.
If your potential funding partner tells you to propose the terms, be wary, as it's an indication that you are talking to either someone who isn't a professional VC or someone who is professionally lazy.
The Entrepreneur's Perspective
You should never make an offer first. There's no reason to unless you have another concrete one on the table. Why run the risk of aiming too low?
Next, make sure you know when to talk and when to listen. If you remember nothing else about this section, remember this: you can't lose a deal point if you don't open your mouth.
Listening gives you further information about the other party including what advantages you have over them (e.g., do they have a little league baseball game to coach in an hour?) and which negotiation styles they are most comfortable with.
As the old cliche goes, there's a reason you have two ears and one mouth.
When you are negotiating, try to listen more than you talk, especially at the beginning of the negotiation.
If the other party is controlling the negotiation, don't address deal points in order of the legal paper. This is true of all negotiations, not just financings. If you allow a person to address each point and try to get to closure before moving on to the next point, you will lose sight of the deal as a whole.
While you might feel like the resolution on each point is reasonable, when you reflect on the entire deal you may be unhappy. If a party forces you into this mode, don't concede points.
Listen and let the other party know that you'll consider their position after you hear all of their comments to the document. Many lawyers are trained to do exactly this—to kill you softly point by point. A lot of people rely on the same arguments over and over again when negotiating. People who negotiate regularly, including many
VCs and lawyers, try to convince the other side to acquiesce by stating,
"That's the way it is because it's market." We love hearing the market argument because then we know that our negotiating partner is a weak negotiator.
Saying that "its market" is like your parents telling you, "Because I said so," and you responding, "But everyone's doing it." These are elementary negotiating tactics that should have ended around the time you left for college.
In the world of financings, you'll hear this all the time. Rather than getting frustrated, recognize that it's not a compelling argument since the concept of market terms isn't the sole justification for a negotiation position.
Instead, probe on why the market condition applies to you. In many cases, the other party won't be able to justify it and, if they can't make the argument, you'll immediately have the higher ground.
The Entrepreneur's Perspective
Understanding market terms and whether they apply to your situation is important. You can quickly get context on this by talking to other entrepreneurs in similar positions.
Remember, you do only a few of these deals in your lifetime, and your VC does them for a living. Understand what market really is, and you'll be able to respond to an assertion that something is market with fact rather than with emotion.
Finally, never assume that the other side has the same ethical code as you. This isn't a comment against VCs or lawyers; rather, it's a comment about life and pertains to every type of negotiation you'll find yourself involved in.
Everyone has a different acceptable ethical code and it can change depending on the context of the negotiations. For instance, if you were to lie about the current state of a key customer to a prospective VC and it was discovered before the deal closed, you'd most likely find your deal blown up.
Or perhaps the deal would close, but you'd be fired afterward and it's likely that some of your peers would hear about it. As a result, both parties (VC and entrepreneur) have solid motivation to behave in an ethical way during a financing.
Note that this is directly in contrast to most behavior, at least between lawyers, in a litigation context where lies and half-truths are an acceptable part of that game. Regardless of the specific negotiation context, make sure you know the ethical code of the party you are negotiating against.
Great Lawyers versus Bad Lawyers versus No Lawyers
Regardless of how much you think you know or how much you've read, hire a great lawyer. In many cases, you will be the least experienced person around the negotiating table.
VCs negotiate for a living, and a great lawyer on your side will help balance things out. When choosing a lawyer, make sure he not only understands the deal mechanics but also has a style that you like working with and that you are comfortable sitting alongside.
This last point can't be overstated—your lawyer is a reflection of you, and if you choose a lawyer who is inexperienced, is ineffective or behaves inconsistently, it will reflect poorly on you and decrease your negotiating credibility.
So choose a great lawyer, but make sure you know what great means. Ask multiple entrepreneurs you respect whom they use.
Check around your local entrepreneurial community for the lawyers with the best reputations. Don't limit your exploration to billing rates, responsiveness, and intellect, but also check style and how contentious negotiations were resolved.
Furthermore, it's completely acceptable to ask your VC before and after the funding what the VCs thoughts are about your lawyer.
The Entrepreneur's Perspective
Choosing a great lawyer doesn't mean hiring an expensive lawyer from a firm that your VC knows or recommends. Often for start-ups, going to a top-tier law firm means dealing with a second-tier or very junior lawyer, not well supervised, with high billing rates.
You can hire a smaller firm with lower rates and partner attention just as well; but be sure to do your homework on them, make sure they're experienced in dealing with venture financings and get references—even from VCs they've negotiated against in the past.
Can You Make a Bad Deal Better?
Let's say you screw up and negotiate a bad deal. You had only one term sheet, the VC was a combination bully and technocrat, and you are now stuck with deal terms that you don't love. Should you spend all of your time being depressed? Nope, there are plenty of ways to fix things after the fact that most entrepreneurs never think about.
First of all, until an exit—either an acquisition or an IPO—many of the terms don't matter much. But more important, if you plan to raise another round led by a new investor, you have a potential ally at the time to clean up the things you negotiated poorly in the first investment.
The new VC will be motivated to make sure you and your team are happy (assuming the company is performing), and if you talk to your new potential financing partner about issues that are troubling you, in many cases the new VC will concentrate on trying to bring these back into balance in the new financing.
In the case where a new VC doesn't lead the next round, you still have the option of sitting down with your current VCs after you've had some run time together (again, assuming success). We've been involved in numerous cases in which these were very constructive conversations that resulted in entrepreneur-friendly modifications to a deal.
Finally, you can wait until the exit and deal with your issues then.
Most acquisition negotiations include a heavy focus on retention dynamics for the management team going forward, and there are often cases of reallocating some of the proceeds from the investors to management.
The style of your VCs will impact how this plays out. If they are playing a single-round game with the negotiation and they don't really care what happens after the deal closes, they will be inflexible.
However, if they want to be in a position to invest with you again in the future, they'll take a top-down view of the situation and be willing to work through modifications to the deal terms to reallocate some consideration to management and employees, especially in a retention situation for the acquirer.
Recognize, however, that this dynamic cuts both ways—many acquirers take the approach that they want to recut the economics in favor of the entrepreneur. Remember that as an entrepreneur you signed up for the deal you currently have with your investors and you have a corresponding responsibility to them.
If you end up playing a single-round game with your investors where you team up with the acquirer, you run the risk of blowing up both the acquisition and your relationship with your investors. So, be thoughtful, fair, and open with your investors around the incentives and dynamics.
The Entrepreneur's Perspective
Having an open and collaborative approach with your VC in the context of an acquisition may sound a bit like a game of chicken—but it can work.
Being clear with your investors about what is important to you and your team early in the negotiation can help set a tone where you and your investors are working together to reach the right deal structure, especially when the acquirer is trying to drive a wedge between you and those investors. Negotiation in a state of plenty is much easier than negotiation in a state of scarcity.
In our experience, openness in these situations of both the entrepreneur and the VC generally results in much better outcomes. It's hard enough to engage in a negotiation, let alone one in which there are multiple parties in a negotiation at cross-purposes (e.g., acquirer, entrepreneur, and VC).
We always encourage entrepreneurs and their VC backers to keep focused on doing what is right for all shareholders in the context of whatever is being offered, and as a result to continue to constructively work through any issues, especially if one party is uncomfortable with where they previously ended up.
Raising Money the Right Way
While most people ask themselves "What should I do?" when seeking VC financing, there are also some things that a person should not do.
Doing any of the following at best makes you look like a rookie (which is okay, we were all rookies once, but you don't want to look like one) and at worst kills any chance that you have of getting funded by the VC you just contacted. We encourage you to avoid doing the following when you are raising money from VCs.
Don't Ask for a Nondisclosure Agreement
Don't ask a VC for a nondisclosure agreement (NDA). Although most VCs will respect how unique your idea, innovation, or company is to you, it's likely that they've seen similar things due to the sheer number of business plans that they get.
If they sign an NDA regarding any company, they'd likely run afoul of it if they ended up funding a company that you consider a competitor. An NDA will also prevent a VC from talking to other VCs about your company, even ones who might be good co-investors for your financing.
On the other hand, don't be too scared about approaching a reputable VC with your idea without an NDA. The VC industry is small and wouldn't last long if VCs spoke out of turn sharing people's knowledge with one another.
And don't think that VCs will steal your idea and start a company, as reputational constraints, as well as limits on a VCs time, will eliminate this risk in most cases. Though you might occasionally run into a bad actor, do your homework and you'll generally be fine.
Don't Email Carpet Bomb VCs
You might not know VCs personally, but the way to get to know them is not by buying a mailing list and sending personalized spam. And it's not good to hire an investment adviser who will do the same. VCs know when they are getting a personal pitch versus spam, and we don't know any VCs who react well to spam.
Spamming looks lazy. If you didn't take the time to really think about who would be a good funding partner, what does that say about how you run the rest of the business? If you want to contact us, just email us, but make it personal to us.
No Often Means No
While most VCs appreciate persistence, when they say they aren't interested, they usually mean it. We aren't asking you to try again.
We might be saying no because your idea isn't personally interesting to us, doesn't fit our current investment themes, or is something that we think is a bad idea—or just because we are too busy. One thing to know is that us saying no doesn't mean that your idea is stupid; it just means it isn't for us.
Don't Ask for a Referral If You Get a No
VCs get a lot of inbound email from entrepreneurs (and bankers and lawyers) pitching new investments. At our firm, we try to look at all of them and always attempt to respond within a day. We say no to most of them, but we are happy to be on the receiving end of them (and encourage you, dear reader, to send us an email anytime).
When we say no, we try to do it quickly and clearly. We try to give an explanation, although we don't attempt to argue or debate our reason. We are sure that many of the things we say no to will get funded and some will become incredibly successful companies.
That's okay with us; even if we say no, we are still rooting for you.
However, if we say no, please don't respond and ask us to refer you to someone. You don't really want us to do this, even if you don't realize it. By referring you to someone else, at some level we are implicitly endorsing you.
At the same time, we just told you that we are not interested in exploring funding your deal. These two constructs are in conflict with each other. The person we refer you to will immediately ask us if we are interested in funding your deal.
We are now in the weird position of implicitly endorsing you on one side while rejecting you on the other. This isn't necessarily comforting able for us, and it's useless to you, as the likelihood of the person we have just referred you to take you seriously is very low. In fact, you'd probably have a better shot at it if we weren't in the mix in the first place!
The Entrepreneur's Perspective
There's one exception to it not being suitable to ask for a referral. If you have a relationship with the VC (e.g., it's not a cold request), ask why the answer is no.
If the response to that question is something about the VC firm rather than your company, then you may ask for a referral to another firm that might be a better fit. However, be respectful here—if the VC doesn't want to make a referral, don't push it.
Don't Be a Solo Founder
Outside of some very isolated examples, most entrepreneurs will have little chance of raising money unless they have a team. A team can be a team of two, but the solo entrepreneur raising money can be a red flag.
First, no single person can do everything. We've not met anyone who can do absolutely everything from product vision to executing on a plan, engineering development, marketing, sales, operations, and so on.
There are just too many mission-critical tasks in getting a successful company launched. You will be much happier if you have a partner to back you up.
Second, it's not a good sign if you can't get others to get excited about your plan. It's hard enough to get VCs to write checks to fund your company; if you can't find other team members with the same passion and beliefs as you have, this is a warning sign to anyone who might want to fund your company.
Last, if you don't have a team, what is the VC investing in? Often, the team executing the idea is more important than the idea itself. Most VCs will tell you that they've made money on grade B ideas with grade A teams but that many an A idea was left in the dustbin due to a substandard team.
The one exception would a repeat entrepreneur. If the venture fund has had a good experience with an entrepreneur before and believes they can build a solid team post-funding, then the person has a chance to get funded as a solo entrepreneur.
Don't Overemphasize Patents
Don't rely on patents. We see a lot of entrepreneurs basically hinge their entire company's worth on their patent strategy. If you are in biotech or medical devices, this might be entirely appropriate.
When you are working on software, realize that patents are, at best, defensive weapons for others coming after you. Creating a successful software business is about having a great idea and executing well, not about patents, in our opinion.
In fact, we wish that all business method and software patents didn't exist (and make a lot of noise about this on our personal blogs, so if you think you are winning us over for investment in a software company by relying on your patent portfolio, you aren't.
Instead, you just proved to us that you did no homework on us as investors and don't really understand the value of patents versus a rock-star management team and amazing software engineers going after a big idea.
Issues at Different Financing Stages of all financings are created equal. This is especially true when you factor in the different stages that your company will evolve through over its lifetime. Each financing stage—seed, early, mid, and later stage—has different key issues to focus on.
While seed deals have the lowest legal costs and usually involve the least contentious negotiations, seed deals often allow for the most potential mistakes. Given how important precedent is in future financings, if you reach a bad outcome on a specific term, you might be stuck with it for the life of your company.
Ironically, we've seen more cases where the entrepreneur got too good a deal instead of a bad one.
What's wrong with getting great terms? If you can't back them up with performance when you raise your next round, you may find yourself in a difficult position with your original investor. For example, assume you are successful getting a valuation that is significantly ahead of where your business currently is.
If your next round isn't at a higher valuation, you are going to be diluting your original shareholders—the investors who took a big risk to fund you during the seed stage.
Either you'll have to make them whole or, worse, they'll vote to block the new financing. This is especially true in cases with unsophisticated seed investors who were expecting that, no matter what, the next round price would be higher.
As with seed deals, precedent is important in early-stage deals. In our experience, the terms you get in your first VC-led round will carry over to all future financings. One item that can haunt you forever is the liquidation preference.
While it may not seem like a big deal to agree to a participating preferred feature given that most early-stage rounds aren't large dollar amounts, if you plan to raise larger rounds one day, these participation features can drastically reduce return characteristics for the common stockholders.
Another term to pay extra attention to at the early stage is the protective provisions. You will want to try to collapse the protective provisions so that all preferred stockholders, regardless of series, vote together on them.
If by your second round of financing you are stuck with two separate votes for protective provisions, you are most likely stuck with a structure that will give each series of stock a separate vote and thus separate blocking rights. This can be a real pain to manage when you have multiple lead investors in multiple rounds that each have their own motivations to deal with.
Mid and Late Stages
Later stage deals tend to have two tough issues—board and voting control. The voting control issues in the early stage deals are only amplified as you wrestle with how to keep control of your board when each lead investor per round wants a board seat.
Either you can increase your board size to seven, nine, or more people, or more likely the board will be dominated by investors. If your investors are well behaved, this might not be a problem; but you'll still be serving a lot of food at board meetings.
There isn't necessarily a good answer here. Unless you have massive negotiating power in a super-hot company, you are likely to give a board seat to each lead investor in each round. If you raise subsequent rounds, unless you've worked hard to manage this early, your board will likely expand and in many cases, the founders will lose control of the board.
The Entrepreneur's Perspective
There are ways to mitigate issues of board and voting control, such as placing a cap (early on) on the number or percentage of directors who can be VCs as opposed to independent directors, preemptively offering observer rights to any director who is dethroned, or establishing an executive committee of the board that can meet whenever and wherever you'd like without everyone else around the table.
The last thing to consider is valuation. Much like issues that we've seen in seed deals, there have been some deals that have been too good and have forced the VCs to hold out for a huge exit price.
The net effect was that by raising money at such a high valuation, the entrepreneurs forfeited the ability to sell the company at a price they would have been happy with, because of the inherent valuation- creation desires of the VCs who paid such a high price.
Other Approaches to Early Stage Deals
We've spent a lot of time on classic preferred stock financings, but there are other options. Over the past few years, we've seen the proliferation of seed-preferred or light preferred term sheets as well as the use of convertible debt in seed and early-stage deals. Let's take a quick look at these.
In a seed or light preferred deal, the parties are agreeing to a class of preferred stock that doesn't have all the protections and rights that typically preferred shareholders have. Why would investors agree to this?
Well, for one, the company may be raising money from angel investors who don't require things like a board seat or protective provisions. In fact, it might not be appropriate given their financial commitment for these investors to have these rights.
Due to IRS tax regulation 409A (Section 409A is an IRS rule that we will discuss later), you don't want to sell common stock to investors; otherwise, you'll peg the price of your common stock at a higher valuation than you want.
Since you want to incentivize your early employees by granting them low-priced common stock options, a light preferred deal is a way to sell stock to investors while maintaining a low regular common stock price with which to grant stock options.
A financing round comes together.
Most fans of convertible debt argue that it's a much easier transaction to complete than an equity financing. Since no valuation is being set for the company, you get to avoid that part of the negotiation.
Because it is debt, it has few, if any, of the rights of preferred stock offerings and you, can accomplish a transaction with a lot less paperwork and legal fees. Note, however, the legal fee argument is less persuasive these days with the many forms of standardized documents.
The debate goes on endlessly about which structure is better or worse for entrepreneurs or investors. We aren't convinced there is a definitive answer here but are convinced that those who think there is a definitive answer are wrong.
Since investors usually drive the decision whether to raise an equity or a debt round, let's look at their motivations first. One of the primary reasons for an early stage investor to purchase equity is to price the round.
Early stage investing is a risky proposition and investors will want to invest at low prices, although smart investors won't invest at a price where founders are demotivated. As a result, most early stage deals get priced in a pretty tight range.
With a convertible debt structure, the price is not set and is determined at a later date when a larger financing occurs. By definition, if there is a later round the company must be doing something right and the valuation will be higher.
Having a discount is nice, but the ultimate price for the early convertible debt investors may still be more than they would have paid if they had bought equity.
First of all, the investors coming into the next round may not like the idea that they are paying that much more than the convertible debt investors paid. Unlike equity, which is issued and can't be changed, the new equity investors could refuse to fund unless the debt investors remove or change the cap.
From the entrepreneur's standpoint, the choice isn't clear, either. Some argue that the convertible debt structure by definition leads to a higher ultimate price for the first round.
We won't go as far as to say they are right, but we can see the argument that with a convertible debt feature you are allowing an inflated price based on time to positively impact the valuation for the past investors.
We'd argue that this is missing half of the analysis in that a founder's first investors are sometimes the most important.
These were the people who invested in you at the riskiest stage before anyone else would. You like them, you respect them, and you might even be related to them. Assume that you create a lot of value along the way and the equity investor prices the round at a number that is higher than even you expected.
Your first investors will own less than anyone anticipated. At die end of the day, your biggest fans are happy about the financing but sad that they own so little.
But does it really set a higher price? Let's go back to the example of a convertible debt round with a cap. If we were going to agree to this deal, our cap would be the price that we would have agreed to in an equity round.
So, in effect, you've just sold the same amount of equity to us, but we have an option for the price to be lower than we would have offered you since there are plenty of scenarios in which the equity price is below the cap amount.
Why on earth would I agree to a cap that is above the price that I'm willing to pay today? The cap amounts to a ceiling on your price.
The Entrepreneur's Perspective
To attract seed stage investors, consider a convertible debt deal with two additional features: a reasonable time horizon on an equity financing and a forced conversion if that horizon isn't met, as well as a floor, not a ceiling, on the conversion valuation.
There's also some dissonance here since VCs spend a lot of their time valuing companies and negotiating on price. If your VC can't or won't do this, what is this telling you?
Do you and the VC have a radically different view of the value proposition you've created? Will this impact the relationship going forward or the way that each of you strategically thinks about your company?
One final issue with convertible debt is a technical legal one.
You'll have to forgive us, but Jason is an ex-lawyer and sometimes we can't keep him in a box.
If a company raises cash via equity, it has a positive balance sheet. It is solvent (assets are greater than obligations), and the board and executives have fiduciary duties to the shareholders in the efforts to maximize company value.
The shareholders are all the usual suspects: the employees and VCs. Life is good and normal.
However, if a company is insolvent, the board and company now owe fiduciary duties to the creditors of the company. By definition, if you raise a convertible debt round, your company is insolvent.
You have cash, but your debt obligations are greater than your assets. Your creditors include your landlord, anyone you owe money to, and founders who have lawyers.
How does this change the paradigm? To be fair, we have had no personal war stories here, but it's not hard to construct some weird situations.
Let's look at the hypothetical situation.
Assume the company is not a success and fails. In the case of raising equity, the officers and directors only owe a duty to the creditors (e.g., your landlord) at such time that cash isn't large enough to pay their liabilities. If the company manages it correctly, even on the downside scenario creditors are paid off cleanly.
But sometimes it doesn't happen this way and there are lawsuits. When the lawyers get involved, they'll look to try to establish the time in which the company went insolvent and then try to show that the actions of the board were bad during that time. If the time frame is short, it's hard to make a case against the company.
However, if you raise debt, the insolvency time lasts until your debt converts into equity. As a result, if your company ends up failing and you can't pay your creditors, their ability for a plaintiff lawyer to judge your actions has increased dramatically. And don't forget, if you have any outstanding employment litigation, all of these folks count as creditors as well.
The worst part of this is that many states impose personal liability on directors for things that occur while a company is insolvent. This means that some states will allow creditors to sue directors personally for not getting all of the money they are owed. Now, we don't want to get too crazy here.
We are talking about early stage and seed companies, and hopefully, the situation is clean enough that these doomsday predictions won't happen; but our bet is that few folks participating in convertible debt rounds are actually thinking about these issues.
While we don't know of any actual cases out there, we've been around this business long enough to know that there is constant innovation in the plaintiff's bar as well
Legal Things Every Entrepreneur Should Know
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.
We aren't your lawyers or giving you legal advice here (our lawyers made us write that), but we encourage you to understand these issues rather than just assume that your lawyer got them right.
Intellectual property (IP) issues can kill a start-up before you even really begin. Following is an example. You and a friend go out and get some beers. You start telling him about your new company that will revolutionize X and makes you a lot of money.
You spend several hours talking about the business model, what you need to build, and the product requirements. After one beer too many, you both stumble home happy.
Your friend goes back to work at his job at Company X-like. You picked this particular friend to vet your idea because you know that your company is similar to some cutting-edge work he does at X-like.
There is even a chance that you'd want to hire this friend one day. You spend the next six months bootstrapping your company and release the first version of your product. A popular tech blog writes about it and you start getting inbound calls from VCs wanting to fund you. You can't stop smiling and are excited about how glorious
life as an entrepreneur is.
The next day your beer buddy calls and says that he's been laid off from Company X-like and wants to join your company. You tell him as soon as you get the funding you'd love to hire him. Your friend says, "That's okay—I can start today for no pay since I own 50 percent of the company." You sit in stunned silence for a few seconds.
As you discuss the issue, your friend tells you that he owns 50 percent of the IP of your company since you guys went out and basically formed the company over beers. You tell him that you disagree and he doesn't own any of the company. He tells you his uncle is a lawyer.
As strange as this sounds, this is a real example. While we think the claim by your so-called friend is ridiculous, if he takes action (via his uncle, who is likely working for him for free) he can slow down your VC financing. If he stays after you and you don't give him something, it's possible that he'll end up completely stifling your chance to raise money.
If you happen to get lucky (for instance, if your so-called friend accidentally gets hit by a bus), you still have the outstanding issue that Company X-like may also have a claim on the IP if there is an actual lawsuit filed and X-like happens to stumble upon piecing the story together.
There are endless stories like this in start-up land, including the history of the founding of Facebook popularized (and fictionalized) by the movie The Social Network.
Our example is one extreme, but there are others, like students starting a company in an MBA class where two go on to actually start the business while the other two don't, but terrorize the company for ownership rights later due to their claimed IP contributions.
Or the entrepreneur who hired a contractor to write code for him paid the contractor, but still ended up in litigation with the contractor who claimed he owned IP above and beyond what he was paid for. When things like this come up, even the most battle-hardened VC will pause and make sure that there are no real IP issues involved.
Responsible VCs who want to invest in your company will work with you to solve this stuff, especially when absurd claims like the examples we just gave are being made. In our experience, there's often a straightforward resolution except in extreme circumstances.
The key is being careful, diligent, and reasonably paranoid up front. When friends are involved, you can usually work this stuff out with a simple conversation. However, when talking to random people, be careful of unscrupulous characters, especially those you know nothing about.
Some entrepreneurs and many lawyers think the right solution is to carefully guard your idea or have everyone you talk to sign a nondisclosure agreement. We don't agree with this position. Instead, we encourage entrepreneurs to be very open with their ideas, and we generally believe NDAs aren't worth very much.
However, be conscious of whom you are talking to and, if you start heading down the path of actually creating a business, make sure you have competent legal counsel help you document it.
The most common lawsuits entrepreneurs are on the receiving end of are ones around employment issues. These are never pleasant, especially in the context of an employee you've recently fired, but they are an unfortunate result of today's work context.
There are a few things you can do to protect against this. First, make sure that everyone you hire is an at-will employee. Without these specific words in the offer letter, you can end up dealing with state employment laws (which vary from state to state) that determine whether you can fire someone.
We've encountered some challenging situations in states that made firing people in the United States almost as challenging as firing them in France.
Next, consider whether you want to prebake severance terms into an offer letter. For instance, you might decide that if you let someone go, they will receive additional vesting or cash compensation.
If you don't decide this at the outset, you may be left with a situation where you are able to fire someone, but they claim that you owe them something on the way out.
On the other hand, determining upfront severance is about as much fun as negotiating a prenuptial agreement, and the downside to it is that it limits your flexibility, especially if the company is in a difficult financial situation and needs to fire people to lower its burn rate in order to conserve cash to survive.
Every entrepreneur should know at least one good employment lawyer. Dealing with these particular issues can be stressful and unpredictable, especially given the extensive rules around discrimination that again vary from state to state, and a knowledgeable employment lawyer can quickly help you get to an appropriate resolution when something comes up.
Though this isn't a blog about securities laws, much of it is actually about selling securities to investors. There are lots of laws that you need to comply with in order to not get in trouble with the SEC, and thus that is one of the major reasons that you need to have a good lawyer.
Most of the issues can be avoided by following one piece of advice. Do not ask your hairdresser, auto mechanic, and bag boy at the grocery store to buy stock in your company unless they are independently wealthy.
There are laws that effectively say that only rich and sophisticated people are accredited investors allowed to buy stock in private companies.
If you try to raise money from people who do not fit this definition, then you've probably committed a securities violation. Normally, the SEC doesn't catch most people who do this, but it does happen sometimes.
If you ignore this advice and sell stock in your private company to people who don't fit the SEC's definition of an accredited investor, then you have a lifelong problem on your hands.
Specifically, these non-accredited investors can force you to buy back their shares for at least their purchase price anytime they want, despite how your company is doing.
This right of rescission is a very real thing that we see from time to time. It is particularly embarrassing when the person forcing the buyback is a close family friend or relative who should not have been offered the stock in the first place.
Filing an 83(b) Election
This is another "if you don't do it right, in the beginning, you can't fix it later" issue. The punch line of not filing an 83(b) election within 30 days after receiving your stock in a company will almost always result in you losing capital gains treatment of your stock when you sell it.
We refer to this as the mistake that will cause you to pay three times the amount of taxes that you should pay.
The 83(b) election is a simple form that takes two minutes to execute. Most lawyers will provide the standard form as part of granting your stock. Some will even provide a stamped and addressed envelope, and the most client-friendly lawyers will even mail the form for you.
Or you can just Google "83(b) election" and download the form yourself. Note that you must send the form to the appropriate IRS service center.
We've had firsthand experience with this and it's a bummer when you are in the middle of an acquisition and you realize the 83(b) election is unsigned under a pile of papers on your desk. For a firsthand account of this, take a look at the blog tided "To 83(b) or Not to 83(b)" in Brad's and David Cohen's blog Do More Faster
Section 409A Valuations
Our last random legal topic that often rears its ugly head around an acquisition is Section 409A of the tax code, also known as the 409A valuation. Section 409A says that all stock options given to employees of a company need to be at fair market value.
In the old days before the turn of the millennium (pre-409A), the board of a private company could determine what the fair market value of a share of common stock was and this was acceptable to the IRS.
It became common practice that the share price for the common stock, which is also the exercise price for the stock options being granted, was typically valued at 10 percent of the price of the last round of preferred stock.
The exception was when a company was within 18 months of an IPO, in which case the price of the common stock converged with the price of the preferred stock as the IPO drew nearer.
For some reason, the IRS decided this wasn't the right way to determine fair market value, came up with a new approach in Section 409Aof the tax code, and created dramatic penalties for the incorrect valuation of stock options. The penalties included excise taxes on the employee and potential company penalties.
In addition, some states, such as California, instituted their own penalties at the state level. When Section 409A was first drafted, it sounded like a nightmare.
However, the IRS gave everyone a way out, also known throughout the legal industry as a safe harbor. If a company used a professional valuation firm, the valuation would be assumed to be correct unless the IRS could prove otherwise, which is not an easy thing to do.
In contrast, if die company chose not to use a professional valuation firm, then the company would have to prove the valuation was correct, which is also a hard thing to do.
The predictable end result of this was the creation of an entirely new line of business for accountants and a bunch of new valuation firms. Section 409A effectively created new overhead for doing business that helped support the accounting profession.
Although we have a bunch of friends who work for 409A valuation firms, we don't believe that any of this is additive in any way to the company or to the value-creation process.
While the costs are not steep, the $5,000 to $15,000 per year that a typical private company will pay for 409A valuations could easily be spent on something more useful to the company, such as beer or search engine marketing.
An unfortunate side effect is that the 10 percent rule, where the common stock was typically valued at 10 percent of the preferred stock, is no longer valid. We often see 409A valuations in early-stage companies valuing common stock at 20 percent to 30 percent of the preferred stock.
As a result, employees make less money in a liquidity event, as options are more expensive to purchase since their basis (or exercise price) is higher.
Ironically, the IRS also collects fewer taxes, as it receives tax only on the value of the gain. In this case, the accountants are the only financial winners.