I recently re-read Venture Deals by Brad Feld & Jason Mendelson. I decided to write a long summary/review, with my book club as the intended audience, comprised mostly of quotes. Before I dig in, I want to share my own piece of advice for all of you fundraising: don’t get intoxicated by fundraising, don’t make the mistake of thinking investment is success, and remember that revenue is the goal of your business and it’s the best form of capital. Everything else in this post does not necessarily mimic my own beliefs! If you see any issues drop me a line at ephekt<at>gmail.com.
I loved this book. It was concise and short… 173 pages. That’s it. Sure there is an appendix and stuff but it’s easily a day at the beach or two nights on your couch. It’s worth it.
If you want to get a super fast summary of the book then just go read all of “The Entrepreneur’s Perspective” blocks. There is about 1 every page. Obviously you will lose a lot of context and insight but it is a quick way to nab a lot of points. Here are a few example quotes from various parts of the book:
- “If you do not have a great financially oriented founder, find someone who knows what he’s doing to help you with the cap table?—?not just someone who knows math (a good starting point!), but someone who knows cap tables and VC financing.”
- “Managing directors or general partners have the mojo inside the venture capital firms… The MDs and GPs are the ones who matter and who will make decisions about your company.”
- “I encourage entrepreneurs not to take valuation personally. Just because VC’s say their take is that your business is worth $6 million, when your take is that your business is worth $10 million, doesn’t mean that they lack appreciation for you as a CEO or your business’s future potential. It means they are negotiating a deal to their advantage, just as you would.”
The entire book is laid out into chapters that can be read independent of each other. Table of contents (with my favorites bolded). I will mostly focus on (and flow with) the bolded topics as they were most interesting to me.
- The Players
- How to Raise Money
- Overview of the Term Sheet
- Economic Terms of the Term Sheet
- Control Terms of the Term Sheet
- Other Terms of the Term Sheet
- The Cap Table
- How Venture Capital Funds Work
- Negotiation Tactics
- Raising Money the Right Way
- Issues at Different Financing Stages
- Letters of Intent- The other Term Sheet
- Legal Things Every Entrepreneur Should Know
The skinny on this skinny book is that fundraising is incredibly complex. You’ve got humans, lawyers, venture capitalists, and co-founders to name a few. VCs are extremely smart and they are essentially gamblers trying to hedge bets and get favorable table odds. You’re selling off chunks of your company to hire talent, get legal aid, raise money, etc. And that is OK! But be smart about knowing your role and the role of every player. It’s your job to know. Don’t expect anyone else to exceed your own level of effort (you are, after all, the biggest owner both financially and emotionally).
From here on out: quotes & thoughts
“Rather than having one-off negotiations with each investor, the lead in the syndicate will often take the role of negotiating terms for the entire syndicate”(10). If you can get an investment lead you should. Agree to terms with them. From then on, every other investor should come in at the same terms set between you and your lead. No special treatment. A syndicate is a group of investors.
“VCs make investments all the time. Entrepreneurs raise money occasionally”(11). The same is true for lawyers and you.
Mentors should not get equity. They’re your mentors. Advisors should get very little, but make them earn it first. Sometimes you’ll give an advisor equity just to associate their name with you?—?but think hard about whether or not having them in your business will be helpful.
“When we meet people who say they are ‘trying to raise money,’ ‘testing the waters,’ or ‘exploring different options,’ this not only is a turnoff, but also often shows they’ve not had much success. Start with an attitude of presuming success” (15).
“However, being able to say ‘I’m at $400,000 on a $500,000 raise and we’ve got room for one or two more investors’ is a powerful statement to a prospective angel investor since most investors love to be part of an oversubscribed round”(17). Keep in mind when you’re fundraising that the story and picture matters. If you go out and say you’ve got $250K committed on a $1M funding round the investor may think you’ll never get there. Whereas if you say you’ve got $400K on a $500K round then you’re in good shape.
To figure out what you need you must look at your burn rate, or monthly spend. You should raise whatever amount of $ you need to get to your next inflection point + a few months to raise your next round. So if you need 12 months at 100K/mo burn then you likely will get 12–16 months from a $1.2M funding round (it’ll take time to ramp up to 100K/mo).
On Fund-Raising Materials, “Finally, while never required, many investors (such as us) respond to things we can play with, so even if you are a very early stage company, a prototype, or demo is desirable” (17). Having a pitch deck is necessary in my opinion. It does not need to be entirely thought through and perfect but it shows both respect for the audience and that you’re taking things seriously. A prototype is great too. I would say a prototype is more powerful than a pitch deck… But remember a deck is required in my mind so basically both are necessary.
“The only thing that we know about financial predictions of startups is that 100% of them are wrong” (21). Just let them go. You can predict how much you’ll spend on people and big ticket items, however, so don’t assume you can get out of everything related to finance. 80/20 rule with respect to spending: identify the big items and plan accordingly.
Demo’s matter. “The demo shows us your vision in a way we can interact with. More important, it shows us that you can build something and then show it off”(22). The demo is far more important than any business model or financial prediction.
“While it may seem obvious, engaging a VC that you don’t know via social media can be useful as a starting point to develop a relationship. In addition to the ego gratification of having a lot of Twitter followers, you’ll start to develop an impression and, more important, a relationship if you comment thoughtfully on blog posts the VC writes. It doesn’t have to be all business?—?engage at a personal level, offer suggestions, interact, and follow the best rule of developing relationships, which is to ‘give more than you get.’ And never forget the simple notion that if you want money, ask for advice” (24). That last line is probably one of the most valuable pieces of advice.
A lead VC does not need to write the biggest check. Any VC that says no or appears to slow-roll you, walk away from and revisit in 3–6 months. Not hearing a “yes” is often hearing a “no.”
Before deciding to take an investment from an investment group make sure you do your own diligence. Ask for, if not provided, a list of portfolio company CEOs (or founders) to talk to. Talk to companies that have been successful and a few that have not been. Learn how the investor dealt with both. How involved were they? Did they write the company off on failure?
On closing the deal, keep tabs on the investment process and make sure everything is going smooth. Signing the term sheet is the first step. The second and final step is money getting into the bank. And keep in mind that relationships matter…
“As we restate in several parts of this book, always make sure that you are keeping tabs on the process. Don’t let the lawyers behave poorly, as this will only injure the future relationship between you and your investor. Make sure that you are responsive with requests, and never assume that because your lawyer is angry and says the other side is horrible/stupid/evil/worthless that the VC even has a clue what is going on. Many times, we’ve seen the legal teams get completely tied up on an issue and want to kill each other when neither the entrepreneur nor the VC even cared about the issue or had any notion that there was a dustup over the issue. Before you get emotional, just place a simple phone call or send an email to the VC and see what the real story is” (29).
Lawyers are doing their jobs and they’re paid to get tied up on the details. VCs want deals to happen and are often out of the loop. Keep this in mind!
“The term sheet is critical. What’s in it usually determines the final deal structure. Don’t think of it as a letter of intent. Think of it as a blueprint for your future relationship with your investor” (p. 31).
“There are two different ways to discuss valuation: premoney and postmoney. The premoney valuation is what the investor is valuing the company at today, before the investment, while the postmoney valuation is simply the premoney valuation plus the contemplated aggregate investment amount” (36). Or in simple math: if I give you a $1 and say the company is worth $4 before my investment then the company is $4 premoney and $5 postmoney. It’s a big different so clarify.
Another thing to look out for is the employee option pool?—?let’s say it’s 5% right now. That is, you have allocated 5% of your company to give out to employees. Most investors will want you to move that up and they’ll want you to do it before they invest. This is essentially diluting you before they take a cut. Most of the time the option pool will be 10% after each round, so if you’re at 5% going into a Series A investment and the investor wants you to move your pool to 10% then they’re likely asking you to dilute everyone 5% before they invest. It’s hard to get them to agree to do that 5% dilution after the investment. The key here is to just watch out for that request and be prepared. You should have a healthy pool for new hires so increasing the pool is not a bad thing.
As with all of these requests you should keep in mind everything is a bargaining chip. If the VC wants you to increase the option pool to 20% from 5% then maybe you negotiate to split the difference and do 7.5% premoney and 7.5% postmoney. Again, going back to my earlier point, your relationship with the VC will heavily impact their willingness to take risk, get diluted, or agree to terms not as favorable to them.
The authors touch very briefly on convertible debt (bridge loans). It’s pretty weak. It is around pages 38–40. No pro or con, really. Just another technique to get money quickly.
Liquidation preferences are important and the second most to price of the round. They decide how proceeds are shared. The general and standard number is 1x. That means the investor gets paid back first from the proceeds of the company. The remaining money is split amongst common stockholders. The other tricky term that folks often link to liquidation preferences is participation preference. In simple terms, after the proceeds pay out to the preferred stockholders, the participation preference states (in varying levels based on negotiation and agreements) that the preferred stock will convert to common stock. So if you have 1 preferred share worth 2x a common share and had 9 common shares then upon sale of the company for $10, $1 goes to the preferred share owner and the remaining $9 is spread over 11 common shares (9 original common shares and the 1 preferred:2 common stock conversion). There are different agreements around preferred shares, including full, capped, and none. It’s just another term to negotiate but watch out for it. Investors could end up taking most of your proceeds!
Chapter 8 (where we’re about to go) is probably the most interesting part of the entire book and is all about How Venture Capital Funds Work. If you want to know how to negotiate better the first step is to understand your counterpart. What are they thinking? What do they care about? What’s their hot buttons you can or can not push?
A VC fund is basically broken into three entities: the management company, the limited partnership, and the general partnership. Put simply: the management company (Firm) is the entity that pays the employees and general bills, the limited partnership (LP) are the major investors putting their money up to be invested by the general partners, and the general partnership (GP) are a series of relationships between general partners and funds. When a VC raises a fund they’re really saying “these general partners are managing the money in this new $X million fund.” A general partner may or may not be tied to every fund raised. So it’s totally possible to have 2 funds and 4 general partners where 2 general partners manage the first fund and 2 manage the second; they may consult each other before doing deals but it’s ultimately up to the general partner(s) who are responsible for that fund to make investment decisions.
General partners invest in the fund, as well. So don’t think that a GP just gets a bunch of money and then invests it. That’s partly true but they typically pay to play.
General partners, and everyone else employed by a management company, and all of the expenses to wine and dine entrepreneurs come out of a “management fee,” which is typically 1.5–2.5% annually. In general, the management company will take 10 years to invest and reinvest that fund and take an ever decreasing management fee from the principal invested in that fund. So a $100M fund will result in roughly a $15M management fee over ten years. If a VC raises a $100M fund every year then they’d basically stack up their management fees and could be earning 1/10 of $15M times the number of funds raised every year. So if you raise 3 funds at $100M each then you’d get $4.5M/year to pay for everything that is involved in investing the remaining principal capital.
Carry, which is the term that means the % of money VCs get after they pay back their LPs invested principal. By the way, this is similar to a liquidation preference of 1x or the LPs?—?they get their money first. Most venture firms have a 20% carry… so once the $100M money is paid back to LPs, the remainder is split 20% for the VC fund and 80% for the LPs.
There is another thing called the investment period (also called commitment period) per fund. Basically each fund has a period in which the management company can invest money from that fund and it’s typically 3–5 years. If a fund is nearing the end of it’s commitment period, you may have investors trying to get money out for a number of reasons (maybe they want to spread the money more widely, maybe some of the initial investments failed and they want the capital to work for them instead of going back to investors eventually, etc). This also is helpful in knowing where your VC is at: have they raised a fund in the last three years? Have they done a deal in the last year? If not, they could be riding on old funds and not able to make new investments or looking to invest quickly to get you into their about-to-close-commitment-window fund.
Once the commitment period is up, the money in the fund stays active only to be invested in the companies that were invested in by that fund during the commitment period. The “Re-up” window, after the commitment window, typically is around 5 years. Keep in mind all of these year counts are different at different firms?—?the better your relationship (back to an earlier point I made) the more intel you may have about each firm which may help you in getting a deal done with favorable terms to both parties.
In Chapter 8 there are other topics that dig more into Reserve Funding (how much money is set aside after an initial investment is made by a VC in your company), cross-funding investing, and how things work when VC partners depart. On that last point, keep in mind that you’re making a deal with the VC firm not a partner (in reality)?—?so if they leave the firm you will likely be getting a new board partner and partner from the firm.
There are some great things in Chapter 9 on negotiating, especially if you’re new to negotiating, game-theory, or just being good w/ people. I won’t go into this stuff because I believe I believe you should buy the book and read this section. However, it’s not exhaustive in so I’d still go search Amazon from good negotiating books. Keep in mind that negotiations happen every day to you in small ways. There is nothing more important (both in this part of the book and in life) than the simple fact that you have to understand what matters to the person you’re negotiating with. Many of us have hired engineers, raised money, bought homes, etc?—?these are all negotiations. So here are some high levels:
- Know what matters to your counterpart
- Do research on whoever you negotiate with
- Go read about game theory
- Be prepared to walk away but only for good reason
- Have a plan B
“One successful negotiating tactic is to ask VCs up front, before the term sheet shows up, what the three most important terms are in a financing for them. You should know and be prepared to articulate your top three wants as well” (119). Look, one of the most interesting reasons to do this is to see how the VC reacts. This is a person you’re essentially marrying for the next 5–10 years?—?don’t you want them to approach important topics with grace and directness?
In terms of closing a financing deal quickly, if you can get a feeding frenzy going you’re in the best position. The fear of missing out, pressure to invest, etc are good ways to get a VC walking towards you. (Though you may scare them off just as well)
Keep your terms sheet private but be upfront about where you’re at with other investors and the process. It may also be best to not mention names?—?but that’s a line you’ll have to walk. Make sure you pace the negotiations, as well, as you don’t want offers coming in too quickly (you want them all at the same time).
A big point in Chapter 10 is to not be a solo founder. Having a co-founder proves you can convince at least one other person to join your cause. It’s just too hard to fly solo.
“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 investors. 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” (138).
Finally, make sure you do your 83(b) elections. This is essentially buying your shares now and prepaying for them (even though they have or have not vested yet). You’ll write a letter to the IRS and pay your company (in the form of IP or cash). It’s very easy and saves you a lot later down the road. Your lawyers will know how to do this?—?or look online.