Book Summary of ‘Venture Deals’​ by Jason Mendelson and Brad Feld

There are many ways to get funding for your new business. You could try and get a loan from a bank, get paying and profitable customers from day 1 or approach family and friends for some seed capital.

However, in many instances, and for many reasons, you might want to consider raising money from a venture capital firm.

As the authors of Venture Deals point out, fundraising is an incredibly complex topic, made even more complicated by the fact that you’ll probably only go through the process once or twice in your entire lifetime.

Being smart about how you do it, and avoiding the many pitfalls that might come back to haunt you later on, is critical.

Join me for the next 10 minutes as we explore what venture capital is and how to approach it once you decide it’s the path you want to take.

The Players In Venture Capital

If you’ve seen The Shark Tank or Dragons Den, you get the gist. VCs are people who make bets on companies in return for a percentage of the equity in a company. Most of the VCs expect to see a return on their money in 5-7 years, usually in the form of a distribution from the sale of your company.

Venture Capital Firms

When you approach a venture capital firm, you are likely to be introduced to a number of people and it helps to know who is who. We’ll start from the least important and end at the most important:

  • Analysts are at the bottom of the ladder and they crunch numbers and write memos to give to the more important people.
  • Associates don’t make decisions on who to fund, but they do a lot of the legwork when sourcing and structuring deals.
  • Principles and Directors have “deal responsibility,” which means that they are decision makers in the process. However, they usually need formal sign-off on a deal from the people at the top of the food chain, who are…
  • Managing Directors (or General Partners) make the final decisions and typically sit on the boards of the companies they invest in. These are the people who will make the most important decisions.

Not all venture capital firms are created equal, and just like they will be doing due diligence on whether or not to fund your company, you should be doing your due diligence on them.

Here are some questions that you’ll want to ask:

  • Who are you talking to in the firm (referring back to the descriptions above)?
  • What process do you need to go through to get the investment approved?
  • Who else have they funded?

Then, armed with the answers to those questions, go talk to the people they have funded in the past and ask them a lot of questions about what it was like to deal with them.

Angel Investors

Angel investors are typically high net worth individuals who are active in the seed stage of venture capital. These people can range from professional investors, to other successful entrepreneurs, to family and friends.

Angels will typically take a more passive role in the investment, viewing their investment as a lottery ticket that will hopefully one day pay off.

Lawyers

If you are going to do a deal with a venture capital firm, make sure to find a lawyer who has a lot of experience in the area.

Like most areas in the law, you’ll pay a higher per-hour fee for their work, but you’ll ultimately end up paying less overall for better quality work. Mistakes up front in the venture capital process can cost you millions of dollars on the back end.

There are other players in the space that we don’t have time to cover formally like how to deal with syndicates (make sure that all members agree that the lead in the syndicate speaks for the whole), mentors (don’t give them equity), and formal advisors (maybe give them equity).

How To Raise Money

Now that you know the lay of the land, it’s time to cover how to actually go about raising money.

How much should you raise?

The first step is to determine how much money you need to raise. You’ll do this by looking at your monthly burn rate (how much your bank account balance will decrease each month) and determining how long you’ll need in order to get to (a) cash flow positive or (b) your next funding milestone. Add on a few months to that number and that’s how much you should be raising.

You should be approaching the VCs with a specific number and not a range.

Most VCs will not give you the entire amount you are looking for, which means you’ll usually need to find multiple investors in order to generate the full amount.

So, keep in mind that the more of your funding round you already have committed, the easier it will be to close further investors.

Your fundraising materials

VCs get pitched by companies every day, so you’ll need to make sure that you create a pitch that they can digest quickly, while making your case in the strongest way possible.

Here are some things that you should consider creating:

  • An elevator pitch that contains a few paragraphs that you can email to investors if they ask for it.
  • An executive summary of your pitch, which includes information on your product (the problem it solves), the team (why you are the one to solve it), the market (how big of an opportunity is it?) and the financial projections of the business. Keep it between one and three pages.
  • A business plan that shows you grasp the financials of your business. A couple of points here. First, they are not interested in revenue projections, because these are always wrong. Second, make sure you show a grasp of your big ticket expenses and that your funding request has taken them into account properly.
  • A presentation that walks the VC through all of the above during an in-person meeting. Make sure that the slides are well designed and that your presentation includes 10 slides or less.
  • A demo that allows the VC to see your product in action. The demo should tell the story of how it solves your end customers’ problems. Watch the VCs very carefully as they use the product.

The Term Sheet

If all goes well in the pitch process and the due diligence process, you’ll need to get a term sheet created that determines the two most important factors of any deal – the economic terms (who gets what when the company is sold) and the control terms (who controls what in the operations of the company).

The Economics of the Term Sheet

There are a number of items to be aware of when it comes to the economics of the term sheet.

Valuation

The most obvious item is how much the company is worth, which will determine how much equity the investor is getting for their share of the investment.

There are two valuations done here. A pre-money valuation is the company’s agreed-upon worth before it receives the financing and the post-money valuation is the value immediately after receiving the financing. Obviously the statement “invest X at Y valuation” has very different meanings based on whether Y is pre or post money. Make sure everybody is on the same page.

Option Pool

Typically, investors will want to see an option pool of stock that is reserved for future employees you’ll try and get to join your company. This means that you’ll be giving up more equity in the company than just the equity going to the VC.

The VC will typically want to see it in the 10-20% range and will want this to come out of the pre-money valuation so that their % of the company is not diluted in the process.

Liquidation Preference

In many situations, the company is sold for less than the valuation in the funding round. To account for this, they will want to see a clause determining who gets what out of the proceeds.

Typically, the investors will own preferred stock and ask for a clause stating that they’ll get back X times the amount of money they invested (usually X=1) before common stock holders are compensated.

Pay To Play

This is a clause that states that an investor has to participate in a future funding round at a pro-rata basis in order to continue to keep their shares preferred shares. If they don’t participate, their preferred shares get turned into common shares.

Anti-Dilution

Another clause a VC will likely want to see is an anti-dilution clause, which means that if a future funding round is raised at a lower valuation, the total amount of their ownership of the company does not go down.

There are many examples of how these terms could play out in the book that you’d be wise to read in full before going down the VC path.

Control Terms of the Term Sheet

Just like in the previous section, there are a number of things you’ll need to be aware of when it comes to the control terms of the agreement.

Board of Directors

Many VCs will demand a board seat as part of their investment. In a younger company, a typical board configuration might look like this: Founder, CEO, VC1, VC2 and outside board member.

The founder and CEO seats are from inside the company, the VC seats are from the VCs, and the outside board member is there to resolve any disputes between the two.

When the company grows and the board matures, you’ll typically see 7-9 seats with the additional seats coming from the outside and usually in the form of experienced executives from the same domain.

Protective Provisions

These types of provisions are designed to give the VCs the ability to block certain company actions that would harm their interests in the company.

Some examples would include changing the company by-laws, selling the company, paying dividends, purchasing major assets and changing the stock option plan.

When you are negotiating these terms, try and get all of your investors to agree to the same protective provisions and try and stay away from the term “materially” because it is usually a legal rabbit hole (as in, nobody knows exactly what it means).

Drag-Along Rights

These provisions allow a majority shareholder to force a minority shareholder to join in the sale of the company, as long as the minority shareholder gets the same price, terms and conditions that the other sellers get.

In the beginning, this clause will be protecting the founder, but don’t lose sight of the fact that you are negotiating this on behalf of the company, which in the future might have a different majority shareholder (it’s not uncommon for founders to give up the majority of their equity in future funding rounds).

Other Terms

There are other terms that will likely be in the term sheet that you should be aware of, including:

  • Dividend provisions: these are more common when dealing with private equity transactions. VCs typically aren’t looking for dividends from their investments.
  • Information rights: these clauses will determine what information the VC has legal access to and what timeframe you have to deliver it to them when requested.
  • Right of first refusal: these clauses give the VC the right to participate in future rounds. You should only give this to major investors.
  • Founders activities: unless you are a very experienced founder, there will be a clause in the agreement saying you need to focus 100% of your time on the company (i.e. you can’t treat it as a part-time job).

Conclusion

There is a lot to think about and consider when raising money from a venture capital firm. Spending the time up front getting the details right will save you a lot of time and money in the future.

If you are seriously considering going down the VC path, I strongly suggest you buy the book and take a deeper dive into the details.

Hope you enjoyed this summary. As always leave me a comment if you did.

P.S. I need a business coach (willing to train [at my expense] the right individual with some get up and go / sales/ marketing/ business prowess) to facilitate demand for my coaching business. I will cover all start up costs for the right person. If you, or someone you know, is interested, please click http://business-coaching.com/andy/ for more information

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