Venture Deals PDF: Be Smarter Than Your Lawyer and Venture Capitalist

 Contents Cover Title Page copyright Dedication Foreword Preface Audience Overview of the Contents Additional Materials Acknowledgments Introduction: The Art of the Term Sheet Chapter 1: The Players The Entrepreneur The Venture Capitalist The Ang...

 Contents Cover Title Page copyright Dedication Foreword Preface Audience Overview of the Contents Additional Materials Acknowledgments Introduction: The Art of the Term Sheet Chapter 1: The Players The Entrepreneur The Venture Capitalist The Angel Investor The Syndicate The Lawyer The Mentor Chapter 2: How to Raise Money Do or Do Not; There Is No Try Determine How Much You Are Raising Fund-Raising Materials Due Diligence Materials Finding the Right VC Finding a Lead VC How VCs Decide to Invest Closing the Deal Chapter 3: Overview of the Term Sheet The Key Concepts: Economics and Control Chapter 4: Economic Terms of the Term Sheet Price Liquidation Preference Pay-to-Play Vesting Employee Pool Antidilution Chapter 5: Control Terms of the Term Sheet Board of Directors Protective Provisions Drag-Along Agreement Conversion Chapter 6: Other Terms of the Term Sheet Dividends Redemption Rights  Conditions Precedent to Financing Information Rights Registration Rights Right of First Refusal Voting Rights Restriction on Sales Proprietary Information and Inventions Agreement Co-Sale Agreement Founders’ Activities Initial Public Offering Shares Purchase No-Shop Agreement Indemnification Assignment Chapter 7: The Capitalization Table Chapter 8: Convertible Debt Arguments For and Against Convertible Debt The Discount Valuation Caps Interest Rate Conversion Mechanics Conversion in a Sale of the Company Warrants Other Terms Early Stage versus Late Stage Dynamics Can Convertible Debt Be Dangerous? Chapter 9: How Venture Capital Funds Work Overview of a Typical Structure  How Firms Raise Money How Venture Capitalists Make Money How Time Impacts Fund Activity Reserves Cash Flow Cross-Fund Investing Departing Partners Fiduciary Duties Implications for the Entrepreneur Chapter 10: Negotiation Tactics What Really Matters? Preparing for the Negotiation A Brief Introduction to Game Theory Negotiating in the Game of Financings Negotiating Styles and Approaches Collaborative Negotiation versus Walk-Away Threats Building Leverage and Getting to Yes Things Not to Do Great Lawyers versus Bad Lawyers versus No Lawyers Can You Make a Bad Deal Better? Chapter 11: Raising Money the Right Way Don't Ask for a Nondisclosure Agreement Don't Email Carpet Bomb VCs No Often Means No Don't Ask for a Referral If You Get a No Don't Be a Solo Founder Don't Overemphasize Patents Chapter 12: Issues at Different Financing Stages Seed Deals Early Stage Mid and Late Stages Other Approaches to Early Stage Deals Chapter 12: Letters of Intent—The Other Term Sheet Structure of a Deal Asset Deal versus Stock Deal Form of Consideration Assumption of Stock Options Representations, Warranties, and Indemnification Escrow Confidentiality/Nondisclosure Agreement Employee Matters Conditions to Close The No-Shop Clause Fees, Fees, and More Fees Registration Rights Shareholder Representatives Chapter 14: Legal Things Every Entrepreneur Should Know Intellectual Property Employment Issues State of Incorporation Accredited Investors Filing an 83(b) Election Section 409A Valuations Authors’ Note Appendix A: Sample Term Sheet Appendix B: Sample Letter of Intent Appendix C: Additional Resources Glossary About the Authors Index Excerpt from Startup Communities  Cover image: Light Ray © TEEKID/iStockPhoto; Ripped Paper © STOCKCAM/ iStockPhoto Cover design: C. Wallace Copyright © 2013 by Brad Feld and Jason Mendelson. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. 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For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572- 4002. Wiley publishes in a variety of print and electronic formats and by print-on- demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com. 978-1-118-44361-3  To the best fathers on the planet: Robert Mendelson and Stanley Feld.  Foreword I wish I'd had this book when I started my first company. At the time, I didn't know preferred stock from chicken stock and thought a right of first refusal was something that applied to the NFL waiver wire. Today, as the CEO of Twitter and the founder of three previous companies, the latter two acquired by public companies and the first acquired by a private company, I've learned many of the concepts and lessons in this book the hard way. While I had some great investors and advisers along the way, I still had to figure out all the tricks, traps, and nuances on my own. My partners and I in our first company, Burning Door Networked Media, were novices so we made a lot of mistakes, but we managed to sell the company in 1996 for enough money to keep ourselves knee-deep in Starbucks tall coffees every morning for a year. Several years later, my partners at Burning Door and I started a new company called Spyonit. This company did better and was sold to a public company called 724 Solutions in September 2000. Our stock was tied up for a year (we weren't that tuned into registration rights at the time) and when we got our hands on the stock in mid-September 2001, the collapse of the Internet bubble and the financial aftermath of 9/11 had caused our stock to decline to the point that it was worth enough money to keep us knee-deep in tall skim lattes at Starbucks every morning for a year. So, like all good entrepreneurs, we tried again. This time, armed with a lot more knowledge and humility, we started FeedBurner in 2004. We raised several rounds of venture capital, including a seed round from DFJ Portage, a Series A round from Mobius Venture Capital (the firm Brad Feld and Jason Mendelson were part of at the time) and Sutter Hill, and a Series B round from Union Square Ventures. FeedBurner grew quickly, and before we knew it we had attracted acquisition interest from several companies, including Google, which purchased us in 2007 and allowed me to stop using coffee-purchase analogies to quantify the payout. After spending several years at Google, I was recruited to join Twitter, where I now am the CEO. During my tenure with the company, Twitter has grown dramatically, from 50 people to more than 430 people, and has completed two major rounds of financing, having raised over $250 million.  When I reflect back on what I now know about VC deals, acquisitions, how VCs work, and how to negotiate, it's very satisfying to see how far I've come from that day back in the early 1990s when I co-founded Burning Door Networked Media. When I read through this book, I kept thinking over and over, “Where were you when I started out?” as the knowledge contained between these covers would have saved me a remarkable amount of time and money on my journey. Brad and Jason have written a book that is hugely important for any aspiring entrepreneurs, students, and first-time entrepreneurs. But it's not just limited to them—as I read through it I found new pearls of wisdom that even with all the experience I have today I can put to good use. And if you are a VC or aspire to be a VC, get in the front of the line to read this to make sure you are armed with a full range of understanding of the dynamics of your business. Finally, if you are a lawyer who does these deals for a living, do yourself a favor and read this also, if only to be armed with things to use to torture your adversaries. Dick Costolo Twitter CEO March 2011  Preface One of the ways to finance a company is to raise venture capital. While only a small percentage of companies raise venture capital, many of the great technology companies that have been created, including Google, Apple, Cisco Systems, Yahoo!, Netscape, Sun Microsystems, Compaq, Digital Equipment Corporation, and America Online (AOL) raised venture capital early in their lives. Some of today's fastest-growing entrepreneurial companies, such as Facebook, Twitter, LinkedIn, Zynga, and Groupon, were also recipients of venture capital. Over the past 17 years we've been involved in hundreds of venture capital financings. Seven years ago, after a particularly challenging financing, we decided to write a series of blog posts that would demystify the venture capital financing process. The result was the Term Sheet Series on Brad's blog (www.feld.com/wp/category/termsheet), which was the inspiration for this book. As each new generation of entrepreneurs emerges, there is a renewed interest in how venture capital deals come together. We encounter many of these first- time entrepreneurs through our activities as venture capitalists at our firm Foundry Group (www.foundrygroup.com), as well as our involvement in TechStars (www.techstars.com). We have been regularly reminded that there is no definitive guide to venture capital deals and as a result set out to create one. In addition to describing venture capital deals in depth, we've tried to create context around the players, the deal dynamics, and how venture capital funds work. We've tossed in a section on negotiation, if only to provide another viewpoint into the brains of how a venture capitalist (at least the two of us) might think about negotiation. We also took on explaining the other term sheet that fortunate entrepreneurs will encounter—namely the letter of intent to acquire your company. We've tried to take a balanced view between the entrepreneurs’ perspective and the venture capitalists’ perspective. As early stage investors, we know we are biased toward an early stage perspective, but we try to provide context that will apply to any financing stage. We've also tried to make fun of lawyers any chance we get. We hope you find this book useful in your quest to create a great company.  Audience When we first conceived this book, we planned to target it at first-time entrepreneurs. We both have a long history of funding and working with first- time entrepreneurs and often learn more from them than they learn from us. Through our involvement in TechStars, we've heard a wide range of questions about financings and venture capital from first-time entrepreneurs. We've tried to do a comprehensive job of addressing those questions in this book. As we wrote the book, we realized it was also useful for experienced entrepreneurs. A number of the entrepreneurs who read early drafts or heard about what we were writing gave us feedback that they wished a book like this had existed when they were starting their first company. When we asked the question “Would this be useful for you today?” many said, “Yes, absolutely.” Several sections, including the ones on negotiation and how venture capital funds work, were inspired by long dinner conversations with experienced entrepreneurs who told us that we had to write this stuff down, either on our blog or in a book. Well—here it is! Of course, before one becomes a first-time entrepreneur, one is often an aspiring entrepreneur. This book is equally relevant for the aspiring entrepreneur of whatever age. In addition, anyone in school who is interested in entrepreneurship—whether in business school, law school, an undergraduate program, or an advanced degree program—should benefit from this book. We've both taught many classes on various topics covered in this book and hope this becomes standard reading for any class on entrepreneurship. We were once inexperienced venture capitalists. We learned mostly by paying attention to more experienced venture capitalists, as well as actively engaging in deals. We hope this book becomes another tool in the tool chest for any young or aspiring venture capitalist. While we've aimed the book at entrepreneurs, we hope that even lawyers (especially those who don't have much experience doing venture capital deals) and experienced venture capitalists will benefit from us putting these thoughts down in one place. At the minimum, we hope they recommend the book to their less experienced colleagues. In an early draft, we varied gender on pronouns, using “she” liberally throughout the book. However, as we edited the book, we found that the mixed gender was confusing and made the book less readable. So we decided to use male pronouns throughout as a generic pronoun for both genders. We are sensitive to gender issues in both computer science and entrepreneurship in general—Brad has worked for a number of years as chair of the National Center for Women and Information Technology (www.ncwit.org). We hope our female readers are okay with this approach and hope someday someone comes up with a true gender-neutral set of English pronouns. Finally, unintended beneficiaries of this book are the spouses of venture capitalists, lawyers, and entrepreneurs, especially those entrepreneurs actively involved in a deal. While Brad's wife Amy is quick to say, “Everything I've learned about venture capital has come from overhearing your phone calls,” we hope other spouses can dip into this book every now and then. This can be especially useful when your spouse needs some empathy while complaining about how his venture capitalist is trying to jam a participating preferred down his throat. Overview of the Contents We start off with a brief history of the venture capital term sheet and a discussion of the different parties who participate in venture capital transactions. We then discuss how to raise money from a venture capitalist, including determining how much money an entrepreneur should raise and what types of materials one will need before hitting the fund-raising trail. Included in this section is a discussion about the process that many venture capitalists follow to decide which companies to fund. We then dive deeply into the particular terms that are included in venture capital term sheets. We've separated this into three chapters—terms related to economics, terms related to control, and all of the other terms. We strive to give a balanced view of the particular terms along with strategies to getting to a fair deal. Following the chapters on terms, we discuss how convertible works and then go into a frank discussion about how venture capital firms operate, including how venture capitalists are motivated and compensated. We then discuss how these structural realities can impact a company's chance of getting funded or could impact the relationship between the venture capitalist, his firm, and the entrepreneur after the investment is made. Since the process of funding involves a lot of negotiation, the book contains a primer on negotiations and how particular strategies may work better or worse in the venture capital world. We also attempt to help the entrepreneur learn ways to consummate a transaction in a venture capital financing while avoiding common mistakes and pitfalls. Since there is no such thing as a standard venture capital financing, we cover different issues to consider that depend on the stage of financing a company is raising. As a bonus, we've tossed in a chapter about the other important term sheet that entrepreneurs need to know about: the letter of intent to acquire your company. Finally, we end with tips concerning several common legal issues that most startups face. While not a dissertation on everything an entrepreneur needs to know, we've tried to include a few important things that we think entrepreneurs should pay attention to. Throughout the book we've enlisted a close friend and longtime entrepreneur, Matt Blumberg, the CEO of Return Path, to add his perspective. Whenever you see a sidebar titled “The Entrepreneur's Perspective,” these are comments from Matt on the previous section. Additional Materials Along with this book, we've created some additional materials that you may want to review. They are all on the AsktheVC web site at www.askthevc.com. AsktheVC started out several years ago as a question-and-answer site that we managed. We've recently added a new section called “Resources” where the reader can find many standard forms of documents that are used in venture financings. They include the term sheet as well as all of the documents that are generated from the term sheet as part of a venture financing. We have included the standard forms that we use at Foundry Group (yes, you can use these if we ever finance your company). We've also included links for the most popular standard documents that are used in the industry today, along with commentary about some of the advantages and disadvantages of using them. Additional resources for classroom use are available to professors. Please visit www.wiley.com/WileyCDA/WileyTitle/productCd-1118443616.html for more information. Jason Mendelson and Brad Feld October 2012  Acknowledgments We wouldn't have been able to write this book without the able assistance of many people. A huge thanks goes to Matt Blumberg, CEO of Return Path, for all of his insightful and entrepreneur-focused comments. Matt provided all of the sidebars for “The Entrepreneur's Perspective” throughout the book, and his comments helped focus us (and hopefully you) on the key issues from an entrepreneur's perspective. Our Foundry Group partners, Seth Levine and Ryan McIntyre, put up with us whenever Brad said, “I'm working on Jason's book again,” and whenever Jason said, “I'm working on Brad's book again.” Our assistants, Kelly Collins and Jill Spruiell, as always, were invaluable to us on this project, and we appreciate the support of the rest of the crew at the Foundry Group. You guys are the best team anyone could ever have. A number of friends, colleagues, and mentors reviewed early drafts of the book and gave us extensive feedback. Thanks to the following for taking the time to meaningfully improve this book: Amy Batchelor, Raj Bhargava, Jeff Clavier, Greg Gottesman, Brian Grayson, Douglas Horch, David Jilk, TA McCann, George Mulhern, Wiley Nelson, Heidi Roizen, Ken Tucker, and Jud Valeski. Jack Tankersley, one of the fathers of the Colorado venture capital industry, provided a number of his early deal books from his time at Centennial Funds. In addition to being fascinating history on some legendary early venture capital deals, they confirmed that the term sheet hasn't evolved much over the past 30 years. We'd also like to thank Jack for the extensive comments he made on an early draft of the book. Thanks to Bill Aulet and Patricia Fuligni of the MIT Entrepreneurship Center for helping track down the original Digital Equipment Corporation correspondence between Ken Olson and Georges Doriot. Our VC brethren, whether they realize it or not, have had a huge impact on this book. The ones we've learned from—both good and bad—are too numerous to list. But we want to thank them all for participating with us on our journey to help create amazing companies. We can't think of anything we'd rather be doing professionally, and we learn something new from you every day. We've worked with many lawyers over the years, many of whom have taken us to school on various topics in this book. We thank you for all of your help, advice, education, and entertainment. We'd especially like to thank our friends Eric Jensen and Mike Platt at Cooley LLP, who have consistently helped us during the fog of a negotiation. Eric was Jason's mentor, boss, and friend while at Cooley and originally taught Jason how all of this worked. We'd like to thank one of Brad's original mentors, Len Fassler, for creating the spark that initiated this book. Len's introduction to Matthew Kissner, a board member at John Wiley & Sons, resulted in a two-book contract with Wiley, which included Do More Faster: TechStars Lessons to Accelerate Your Startup by Brad and David Cohen. Although Do More Faster was published first, the idea for this book was the one that originally captured the attention of several people at Wiley. Brad would like to thank Pink Floyd for The Dark Side of the Moon and Wish You Were Here, two albums that kept him going throughout the seemingly endless “read through and edit this just one more time” cycle. He'd also like to thank the great staff at Canyon Ranch in Tucson for giving him a quiet place to work for the last week before the “final final draft” was due. Jason would like to thank the University of Colorado Law School and especially Brad Bernthal and Phil Weiser for letting him subject himself to both law and business students while teaching many of the subjects contained in this book. Special thanks to Herbie Hancock for providing the background music while Jason worked on this book. A number of friends and colleagues found errors in the first edition, which we dutifully listed at www.askthevc.com/wp/errata. Special thanks go to David Cohen, Anurag Mehta, Tom Godin, Philip Lee, Tal Adler, and Jason Seats, who were the first to identify each error. Finally, we thank all of the entrepreneurs we have ever had the chance to work with. Without you, we have nothing to do. Hopefully we have made you proud in our attempt to amalgamate in this book all of the collective wisdom we gained from working with you.  INTRODUCTION The Art of the Term Sheet One of the first famous venture capital investments was Digital Equipment Corporation (DEC). In 1957 American Research and Development Corporation (AR&D), one of the first venture capital firms, invested $70,000 in DEC. When DEC went public in 1968, this investment was worth over $355 million, or a return of over 5,000 times the invested capital. AR&D's investment in DEC was one of the original venture capital home runs. In 1957 the venture capital industry was just being created. At the time, the investor community in the United States was uninterested in investing in computer companies, as the last wave of computer-related startups had performed poorly and even large companies were having difficulty making money in the computer business. We can envision the frustration of DEC's co- founders, Ken Olson and Harlan Anderson, as the investors they talked to rejected them and their fledgling idea for a business. We can also imagine their joy when Georges Doriot, the founder of American Research and Development Corporation, offered to fund them. After a number of conversations and meetings, Doriot sent Olson and Anderson a letter expressing his interest in investing, along with his proposed terms. Today, this document is called the term sheet. Now, imagine what that term sheet looked like. There are three different possibilities. The first is that it was a typed one-page letter that said, “We would like to invest $70,000 in your company and buy 78 percent of it.” The next is that it was two pages of legal terms that basically said, “We would like to invest $70,000 in your company and buy 78 percent of it.” Or it could have been an eight-page typed document that had all kinds of protective provisions, vesting arrangements, drag-along rights, and Securities and Exchange Commission (SEC) registration rights. Our guess is that it was not the third option. Over the past 50 years, the art of the term sheet has evolved and expanded, reaching its current eight- (or so) page literary masterpiece. These eight pages contain a lot more than “We'd like to invest $X in your company and get Y percent of it,” but, as you'll learn, there really are only two key things that matter in the actual term sheet negotiation —economics and control. In DEC's case, by owning 78 percent of the company, AR&D effectively had control of the company. And the price was clearly defined—$70,000 bought 78 percent of the company, resulting in a $90,000 postmoney valuation. Today's venture capital investments have many more nuances. Individual venture capitalists (VCs) usually end up owning less than 50 percent of the company, so they don't have effective voting control but often negotiate provisions that give them control over major decisions by the company. Many companies end up with multiple venture capitalists who invest in the company at different points in time, resulting in different ownership percentages, varying rights, and diverging motivations. Founders don't always stay with the company through the exit and, in some cases, they end up leaving relatively early in the life of a company for a variety of reasons. Companies fail, and venture capitalists have gotten much more focused on protecting themselves for the downside as well as participating in the upside. Governance issues are always complex, especially when you have a lot of people sitting around the negotiation table. While it would be desirable to do venture capital deals with a simple agreement on price, a handshake, and a short legal agreement, this rarely happens. And while there have been plenty of attempts to standardize the term sheet over the years, the proliferation of lawyers, venture capitalists, and entrepreneurs, along with a steadily increasing number of investments, has prevented this from happening. Ironically, the actual definitive documents have become more standard over time. Whether it is the Internet age that has spread information across the ecosystem or clients growing tired of paying legal bills, there are more similarities in the documents today than ever before. As a result, we can lend you our experience in how venture financings are usually done. The good news is once you've negotiated the term sheet, you are done with the hard part. As a result, that's where we are going to focus our energy in this book. Let's begin our exploration of venture capital financings by discussing the various players involved.  CHAPTER 1 The Players While it might seem like there are only two players in the financing dance—the entrepreneur and the venture capitalist—there are often others, including angel investors, lawyers, and mentors. Any entrepreneur who has created a company that has gone through multiple financings knows that the number of people involved can quickly spiral out of control, especially if you aren't sure who actually is making the decisions at each step along the way. The experience, motivation, and relative power of each participant in a financing can be complex, and the implications are often mysterious. Let's begin our journey to understanding venture capital financings by making sure we understand each player and the dynamics surrounding the participants. The Entrepreneur Not all investors realize it, but the entrepreneur is the center of the entrepreneurial universe. Without entrepreneurs there would be no term sheet and no startup ecosystem. Throughout this book we use the words entrepreneur and founder interchangeably. While some companies have only one founder, many have two, three, or even more. Sometimes these co-founders are equals; other times they aren’t. Regardless of the number, they each have a key role in the formation of the company and any financing that occurs. The founders can't and shouldn't outsource their involvement in a financing to their lawyers. There are many issues in a financing negotiation that only the entrepreneurs can resolve. Even if you hire a fantastic lawyer who knows everything, don't forget that if your lawyer and your future investors don't get along you will have larger issues to deal with. If you are the entrepreneur, make sure you direct and control the process. The relationship between the founders at the beginning of the life of a company is almost always good. If it's not, the term sheet and corresponding financing are probably the least of the founders’ worries. However, as time passes, the relationship between co-founders often frays. This could be due to many different factors: the stress of the business, competence, personality, or even changing life priorities like a new spouse or children. When this happens, one or more founders will often leave the business— sometimes on good terms and sometimes on not such good terms. Some investors know that it's best to anticipate these kinds of issues up front and will try to structure terms that predefine how things will work in these situations. The investors are often trying to protect the founders from each other by making sure things can be cleanly resolved without disrupting the company more than the departure of a founder already does. We cover this dynamic in terms like vesting, drag-along rights, and co-sale rights. When we do, we discuss both the investor perspective and the entrepreneur perspective. You'll see this through the book—we've walked in both the investor's and the entrepreneur's shoes, and we try hard to take a balanced approach to our commentary. The Venture Capitalist The venture capitalist (VC) is the next character in the term sheet play. VCs come in many shapes, sizes, and experience levels. While most (but not all) profess to be entrepreneur-friendly, many fall far short of their aspirations. The first signs of this often appear during the term sheet negotiation. Venture capital firms have their own hierarchies that are important for an entrepreneur to understand. Later in the book we'll dive into all the deep, dark secrets about how VCs are motivated and paid, and what their incentives can be. For now, we'll consider VCs as humans and talk about the people. The most senior person in the firm is usually called a managing director (MD) or a general partner (GP). In some cases, these titles have an additional prefix— such as executive managing director or founding general partner—to signify even more seniority over the other managing directors or general partners. These VCs make the final investment decisions and sit on the boards of directors of the companies they invest in. Principals, or directors, are usually next in line. These are junior deal partners —they are working their way up the ladder to managing director. Principals usually have some deal responsibility, but they almost always require support from a managing director to move a deal through the VC firm. So, while the principal has some power, he probably can't make a final decision. Associates are typically not deal partners. Instead, they work directly for one or more deal partners, usually a managing director. Associates do a wide variety of things, including scouting for new deals, helping with due diligence on existing deals, and writing up endless internal memos about prospective investments. They are also likely to be the person in the firm who spends the most time with the capitalization table (also known as a cap table), which is the spreadsheet that defines the economics of the deal. Many firms have an associate program, usually lasting two years, after which time the associate leaves the firm to go work for a portfolio company, to go to business school, or to start up a company. Occasionally the star associates go on to become principals. Analysts are at the bottom of the ladder. These are very junior people, usually recently graduated from college, who sit in a room with no windows down the hall from everyone else, crunch numbers, and write memos. In some firms, analysts and associates play similar roles and have similar functions; in others, the associates are more deal-centric. Regardless, analysts are generally smart people who are usually very limited in power and responsibility. Some firms, especially larger ones, have a variety of venture partners or operating partners. These are usually experienced entrepreneurs who have a part-time relationship with the VC firm. While they have the ability to sponsor a deal, they often need explicit support of one of the managing directors, just as a principal would, in order to get a deal done. In some firms, operating partners don't sponsor deals, but take an active role in managing the investment as a chairman or board member. Entrepreneurs in residence (EIRs) are another type of part-time member of the VC firm. EIRs are experienced entrepreneurs who park themselves at a VC firm while they are working on figuring out their next company. They often help the VC with introductions, due diligence, and networking during the three-to 12- month period that they are an EIR. Some VCs pay their EIRs; others simply provide them with free office space and an implicit agreement to invest in their next company. In small firms, you might be dealing only with managing directors. For example, in our firm, Foundry Group, we have a total of four partners, all called managing directors, each of whom has the same responsibility, authority, and power. In large firms, you'll be dealing with a wide array of managing directors, principals, associates, analysts, venture partners, operating partners, EIRs, and other titles. Entrepreneurs should do their research on the firms they are talking to in order to understand who they are talking to, what decision-making power that person has, and what process they have to go through to get an investment approved. The best source for this kind of information is other entrepreneurs who have worked with the VC firm in the past, although you'd also be surprised how much of this you can piece together just by looking at how the VC firm presents itself on its web site. If all else fails, you can always ask the VC how things work, although the further down the hierarchy of the firm, the less likely you'll get completely accurate information. The Entrepreneur's Perspective Managing directors or general partners have the mojo inside venture capital firms. If you have anyone else prospecting you or working on the deal with you (associate, senior associate, principal, venture partner, or EIR), treat him with an enormous amount of respect, but insist on developing a direct relationship with an MD or a GP as well. Anyone other than an MD or a GP is unlikely to be at the firm for the long haul. The MDs and GPs are the ones who matter and who will make decisions about your company. The Angel Investor In addition to VCs, your investor group may include individual investors, usually referred to as angel investors (or angel for short). These angels are often a key source of early stage investment and are very active in the first round of investment, or the seed stage. Angels can be professional investors, successful entrepreneurs, friends, or family members. Many VCs are very comfortable investing along with angels and often encourage their active involvement early in the life of a company. As a result, the angels are an important part of any financing dance. However, not all angels are created equal, nor do all VCs share the same view of angels. While angels will invest at various points in time, they usually invest in the early rounds and often don't participate in future rounds. In cases where everything is going well, this is rarely an issue. However, if the company hits some speed bumps and has a difficult financing, the angels’ participation in future rounds may come into question. Some of the terms we discuss in the book, such as pay-to-play and drag-along rights, are specifically designed to help the VCs force a certain type of behavior on the angels (and other VC investors) in these difficult financing rounds. While angel investors are usually high-net-worth individuals, they aren't always. There are specific SEC rules around accredited investors and you should make sure that each of your angel investors qualifies as an accredited investor or has an appropriate exemption. The best way to ensure this is to ask your lawyer for help on the rules. Some angel investors make a lot of small investments. Recently, these very active, or promiscuous, angels have started to be called super angels. These super angels are often experienced entrepreneurs who have had one or more exits and have decided to invest their own money in new startups. In most cases, super angels are well known in entrepreneurial circles and are often a huge help to early stage companies. As super angels make more investments, they often decide to raise capital from their friends, other entrepreneurs, or institutions. At this point the super angel raises a fund similar to a VC fund and has actually become an institutionalized super angel, which is starting to be known as a micro VC. While these micro VCs often want to be thought of as angels instead of VCs, once they've raised money from other people they have the same fiduciary responsibility to their investors that a VC has, and as a result they are really just VCs. It's important to remember that there isn't a generic angel investor type (nor is there a generic VC type). Lumping them together and referring to them as a single group can be dangerous. Never assume any of these people are like one another. They will all have their own incentives, pressures, experiences, and sophistication levels. Their individual characteristics will often define your working relationship with them well beyond any terms that you negotiate. The Entrepreneur's Perspective Don't put yourself in a position where you can be held hostage by angels. They are important, but they are rarely in a position to determine the company's direction. If your angel group is a small, diffuse list of friends and family, consider setting up a special-purpose limited partnership controlled by one of them as a vehicle for them to invest. Chasing down 75 signatures when you want to do a financing or sell the company is not fun. Also, true friends and family need special care. Make sure they understand up front that (1) they should think of their investment as a lottery ticket, and (2) every time they see you at a holiday or birthday party is not an investor relations meeting. The Syndicate While some VCs invest alone, many invest with other VCs. A collection of investors is called a syndicate.  When VCs refer to the syndicate, they are often talking about the major participants in the financing round, which are usually but not always VCs. The syndicate includes any investor, whether a VC, angel, super angel, strategic investor, corporation, law firm, or anyone else that ends up purchasing equity in the financing. Most syndicates have a lead investor. Usually, but not always, this is one of the VC investors. Two VCs will often co-lead a syndicate, and occasionally you'll see three co-leads. While there is nothing magical about who the lead investor is, having one often makes it easier for the entrepreneurs to focus their energy around the negotiation. 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. Regardless of the lead investor or the structure of the syndicate, it is the entrepreneurs’ responsibility to make sure they are communicating with each of the investors in the syndicate. As the entrepreneur, even though the lead investor may help corral the other investors through the process, don't assume that you don't need to communicate with each of the investors—you do! The Entrepreneur's Perspective While you should communicate with all investors, you should insist that investors agree (at least verbally) that the lead investor can speak for the whole syndicate when it comes to investment terms. You should not let yourself be in a position where you have to negotiate the same deal multiple times. If there is dissension in the ranks, ask the lead investor for help. The Lawyer Ah, the lawyers—I bet you thought we'd never get to them. In deals, a great lawyer can be a huge help and a bad lawyer can be a disaster. For the entrepreneur, an experienced lawyer who understands VC financings is invaluable. VCs make investments all the time. Entrepreneurs raise money occasionally. Even a very experienced entrepreneur runs the risk of getting hung up on a nuance that a VC has thought through many times. In addition to helping negotiate, a great lawyer can help focus the entrepreneur on what really matters. While this book will cover all the terms that typically come up in a VC financing, we'll continue to repeat a simple mantra that the real terms that matter are economics and control. Yes, VCs will inevitably spend time negotiating for an additional S-3 registration right (an unimportant term that we'll discuss later) even though the chance it ever comes into play is very slight. This is just life in a negotiation—there are always endless tussles over unimportant points, sometimes due to silly reasons, but they are often used as a negotiating strategy to distract you from the main show. VCs are experts at this; a great lawyer can keep you from falling into these traps. However, a bad lawyer, or one inexperienced in VC financings, can do you a world of harm. In addition to getting outnegotiated, the inexperienced lawyer will focus on the wrong issues, fight hard on things that don't matter, and run up the bill on both sides. We've encountered this numerous times. Whenever entrepreneurs want to use their cousin who is a divorce lawyer, we take an aggressive position before we start negotiating that the entrepreneur needs a lawyer who has a clue. Never forget that your lawyer is a reflection on you. Your reputation in the startup ecosystem is important, and a bad or inexperienced lawyer will tarnish it. Furthermore, once the deal is done, you'll be partners with your investors; so you don't want a bad or inexperienced lawyer creating unnecessary tension in the financing negotiation that will carry over once you are partners with your investors. The Entrepreneur's Perspective At the same time that you don't want an inexperienced lawyer creating unnecessary tension in the negotiation, don't let a VC talk you out of using your lawyer of choice just because that lawyer isn't from a nationally known firm or the lawyer rubs the VC the wrong way. This is your lawyer, not your VC's lawyer. That said, to do this well, you need to be close enough to the communication to make sure your lawyer is being reasonable and communicating clearly and in a friendly manner. While lawyers usually bill by the hour, many lawyers experienced with VC investments will cap their fees in advance of the deal. As of this writing in 2012, a very early stage financing can be done for between $5,000 and $15,000 and a typical financing can be completed for between $25,000 and $40,000. Lawyers in large cities tend to charge more, and if your company has any items to clean up from your past, your costs will increase. If your lawyers and the VC lawyers don't get along, your bill can skyrocket if you don't stay involved in the process. If the lawyers are unwilling to agree to a modest fee cap, you should question whether they know what they are doing. In case you are curious, these numbers are virtually unchanged from a decade ago while billable rates have more than doubled in the same time. What this means is that document standardization is a reality, but it also means that the average lawyer spends less time per deal than in ancient times (the 1990s). Once again, the entrepreneur must take responsibility for the final results. The Entrepreneur's Perspective Don't be shy about insisting that your lawyer take a lower cap or even that the lawyer will only get paid out of the proceeds of a deal. There's no reason, if you are a solid entrepreneur with a good business, that even a top-tier law firm won't take your unpaid deal to its executive committee as a flier to be paid on closing. The Mentor Every entrepreneur should have a stable of experienced mentors. These mentors can be hugely useful in any financing, especially if they know the VCs involved. We like to refer to these folks as mentors instead of advisers since the word adviser often implies that there is some sort of fee agreement with the company. It's unusual for a company, especially an early stage one, to have a fee arrangement with an adviser around a financing. Nonetheless, there are advisers who prey on entrepreneurs by showing up, offering to help raise money, and then asking for compensation by taking a cut of the deal. There are even some bold advisers who ask for a retainer relationship to help out. We encourage early stage entrepreneurs to stay away from these advisers. In contrast, mentors help the entrepreneurs, especially early stage ones, because someone once helped them. Many mentors end up being early angel investors in companies or get a small equity grant for serving on the board of directors or board of advisers, but they rarely ask for anything up front. While having mentors is never required, we strongly encourage entrepreneurs to find them, work with them, and build long-term relationships with them. The benefits are enormous and often surprising. Most great mentors we know do it because they enjoy it. When this is the motivation, you often see some great relationships develop. The Entrepreneur's Perspective Mentors are great. There's no reason not to give someone a small success fee if they truly help you raise money (random email introductions to a VC they met once at a cocktail party don't count). Sometimes it will make sense to compensate mentors with options as long as you have some control over the vesting of the options based on your satisfaction with the mentor's performance as an ongoing adviser.  CHAPTER 2 How to Raise Money Your goal when you are raising a round of financing should be to get several term sheets. While we have plenty of suggestions, there is no single way to do this, as financings come together in lots of different ways. VCs are not a homogeneous group; what might impress one VC might turn off another. Although we know what works for us and for our firm, each firm is different; so make sure you know who you are dealing with, what their approach is, and what kind of material they need during the fund-raising process. Following are some basic but by no means complete rules of the road, along with some things that you shouldn't do. Do or Do Not; There Is No Try In addition to being a small, green, hairy puppet, Yoda was a wise man. His seminal statement to young Luke Skywalker is one we believe every entrepreneur should internalize before hitting the fund-raising trail. You must have the mind-set that you will succeed on your quest. 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. If you don’t, investors will smell this uncertainty on you; it'll permeate your words and actions. Not all entrepreneurs will succeed when they go out to raise a financing. Failure is a key part of entrepreneurship, but, as with many things in life, attitude impacts outcome and this is one of those cases. Determine How Much You Are Raising Before you hit the road, figure out how much money you are going to raise. This will impact your choice of those you speak to in the process. For instance, if you are raising a $500,000 seed round, you'll talk to angel investors, seed stage VCs, super angels, micro VCs, and early stage investors, including ones from very large VC funds. However, if you are going out to raise $10 million, you should start with larger VC firms since you'll need a lead investor who can write at least a $5 million check. While you can create complex financial models that determine that you need a specific amount of capital down to the penny to become cash flow positive, we know one thing with 100 percent certainty: these models will be wrong. Instead, focus on a length of time you want to fund your company to get to the next meaningful milestone. If you are just starting out, how long will it take you to ship your first product? Or, if you have a product in the market, how long will it take to get to a certain number of users or a specific revenue amount? Then, assume no revenue growth; what is the monthly spend (or total burn rate) that you need to get to this point? If you are starting out and think it'll take six months to get a product to market with a team of eight people, you can quickly estimate that you'll spend around $100,000 per month for six months. Give yourself some time cushion (say, a year) and raise $1 million, since it'll take you a few months to ramp up to a $100,000-per-month burn rate. The length of time you need varies dramatically by business. In a seed stage software company, you should be able to make real progress in around a year. If you are trying to get a drug approved by the Food and Drug Administration (FDA), you'll need at least several years. Don't obsess about getting this exactly right—as with your financial model, it's likely wrong (or approximate at best). Just make sure you have enough cash to get to a clear point of demonstrable success. That said, be careful not to overspecify the milestones that you are going to achieve—you don't want them showing up in your financing documents as specific milestones that you have to attain. Be careful not to go out asking for an amount that is larger than you need, since one of the worst positions you can be in during a financing is to have investors interested, but be too far short of your goal. For example, assume you are a seed stage company that needs $500,000 but you go out looking for $1 million. One of the questions that the VCs and angels you meet with will probably ask you is: “How much money do you have committed to the round?” If you answer with “I have $250,000 committed,” a typical angel may feel you're never going to get there and will hold back on engaging just based on the status of your financing. 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. Finally, we don't believe in ranges in the fund-raising process. When someone says they are raising $5 million to $7 million, our first question is: “Is it $5 million or $7 million?” Though it might feel comfortable to offer up a range in case you can't get to the high end of it, presumably you want to raise at least the low number. The range makes it appear like you are hedging your bets or that you haven't thought hard about how much money you actually need to raise. Instead, we always recommend stating that you are raising a specific number, and then, when you have more investor demand than you can handle, you can always raise more. Fund-Raising Materials While the exact fund-raising materials you will need can vary widely by VC, there are a few basic things that you should create before you hit the fund-raising trail. At the minimum, you need a short description of your business, an executive summary, and a presentation that is often not so fondly referred to as “a PowerPoint.” Some investors will ask for a business plan or a private placement memorandum (PPM); this is more common in later stage investments. Once upon a time, physical form seemed to matter. In the 1980s, elaborate business plans were professionally printed at the corner copy shop and mailed out. Today, virtually all materials are sent via email. Quality still matters a lot, but it's usually in substance with appropriate form. Don't overdesign your information—we can't tell you the number of times we've gotten a highly stylized executive summary that was organized in such a way as to be visually appealing, yet completely lacking in substance. Focus on the content while making the presentation solid. 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. Short Description of Your Business You'll need a few paragraphs that you can email, often called the elevator pitch, meaning you should be able to give it during the length of time it takes for an elevator to go from the first floor to your prospective investor's office. Don't confuse this with the executive summary, which we discuss next; rather, this is between one and three paragraphs that describe the product, the team, and the business very directly. It doesn't need to be a separate document that you attach to an email; this is the bulk of the email, often wrapped with an introductory paragraph, especially if you know the person or are being referred to the person, and a concluding paragraph with a very clear request for whatever next step you want. Executive Summary The executive summary is a one-to three-page description of your idea, product, team, and business. It's a short, concise, well-written document that is the first substantive document and interaction you'll likely have with a prospective investor with whom you don't have a preexisting relationship. Think of the executive summary as the basis for your first impression, and expect it to be passed around within a VC firm if there's any interest in what you are doing. Work hard on the executive summary—the more substance you can pack into this short document, the more a VC will believe that you have thought critically about your business. It also is a direct indication of your communication skills. A poorly written summary that leaves out key pieces of information will cause the VC to assume that you haven't thought deeply about some important issues or that you are trying to hide bad facts about the business. In the summary, include the problem you are solving and why it's important to solve. Explain why your product is awesome, why it's better than what currently exists, and why your team is the right one to pursue it. End with some high-level financial data to show that you have aggressive, but sensible expectations about how your business will perform over time. Your first communication with a VC is often an introductory email, either from you or from someone referring you to the VC, that is a combination of the short description of your business along with the executive summary attached to the email. If your first interaction was a face-to-face meeting either at a conference, at a coffee shop, or in an elevator, if a VC is interested he'll often say something like “Can you send me an executive summary?” Do this the same day that it is requested of you to start to build momentum to the next step in the process. Presentation Once you've engaged with a VC firm, you'll quickly be asked either to give or to email a presentation. This is usually a 10-to 20-page PowerPoint presentation consisting of a substantive overview of your business. There are many different presentation styles and approaches, and what you need will depend on the audience (one person, a VC partnership, or 500 people at an investor day type of event). Your goal with the presentation is to communicate the same information as the executive summary, but using a visual presentation. Over time, a number of different presentation styles have em-erged. A three- minute presentation at a local pitch event is just as different from an eight- minute presentation at an accelerator's investor day as it is from a 30-minute presentation to a VC partnership. Recognize your audience and tune your presentation to them. Realize also that the deck you email as an overview can be different from the one you present, even if you are covering similar material. Regardless, spend time on the presentation flow and format. In this case, form matters a great deal—it's amazing how much more positive a response is to well- designed and well-organized slides, especially if you have a consumer-facing product where user experience will matter a lot for its success. If you don't have a good designer on your team, find a friend who is a freelance designer to help you turn your presentation into something visually appealing. It will pay off many times over. The Entrepreneur's Perspective “Less is more” when it comes to an investor presentation. There are only a few key things most VCs look at to understand and get excited about a deal: the problem you are solving, the size of the opportunity, the strength of the team, the level of competition or competitive advantage that you have, your plan of attack, and current status. Summary financials, use of proceeds, and milestones are also important. Most good investor presentations can be done in 10 slides or fewer. Business Plan We haven't read a business plan in over 20 years. Sure, we still get plenty of them, but it is not something we care about as we invest in areas we know well, and as a result we much prefer demos and live interactions. Fortunately, most business plans arrive in email these days, so they are easy enough to ignore since one doesn't have to physically touch them. However, realize that some VCs care a lot about seeing a business plan, regardless of the current view by many people that a business plan is an obsolete document. The business plan is usually a 30-ish-page document that has all sorts of sections and is something you would learn to write if you went to business school. It goes into great detail about all facets of the business, expanding on the executive summary to have comprehensive sections about the market, product, target customer, go-to-market strategy, team, and financials.  While we think business plans prepared specifically for fund-raising are a waste of time, we still believe that they are a valuable document for entrepreneurs to write while they are formulating their business. There are lots of different approaches today, including many that are user-or customer-centric, but the discipline of writing down what you are thinking, your hypotheses about your business, and what you believe will happen is still very useful. Now, we aren't talking about a conventional business plan, although this can be a useful approach. Rather, if you are a software company, consider some variant of the Lean Startup methodology that includes the creation, launch, and testing of a minimum viable product as a starting point. Or, rather than writing an extensive document, use PowerPoint to organize your thoughts into clear sections, although recognize this is very different from the presentation you are going to give potential investors. Regardless, you will occasionally be asked for a business plan. Be prepared for this and know how you plan to respond, along with what you will provide, if and when this comes up. Private Placement Memorandum A private placement memorandum (PPM) is essentially a traditional business plan wrapped in legal disclaimers that are often as long as the plan itself is. It's time-consuming and expensive to prepare, and you get the privilege of paying lawyers thousands of dollars to proofread the document and provide a bunch of legal boilerplate to ensure you don't say anything that you could get sued for later. Normally PPMs are generated only when investment bankers are involved and are fund-raising from large entities and banks that demand a PPM. That being said, we've seen plenty of early stage companies hire bankers and draft PPMs. To us, this is a waste of money and time. When we see an email from a banker sending us a PPM for an early stage company, we automatically know that investment opportunity isn't for us and almost always toss it in the circular file. Our view is that if an early stage company has hired a banker to help with fund-raising, either it has been unsuccessful in its attempt to raise money and is hoping the banker can help it in a last-ditch effort or it is getting bad advice from its advisers (who may be the ones making a fee from marketing the deal via the PPM). While many later stage investors like to look at all the stuff they get from investment bankers, we generally think this is a pretty weak approach for an early stage company. Detailed Financial Model The only thing that we know about financial predictions of startups is that 100 percent of them are wrong. If you can predict the future accurately, we have a few suggestions for other things you could be doing besides starting a risky early stage company. Furthermore, the earlier stage the startup, the less accurate any predications will be. While we know you can't predict your revenue with any degree of accuracy (although we are always very pleased in that rare case where revenue starts earlier and grows faster than expected), the expense side of your financial plan is very instructive as to how you think about the business. You can't predict your revenue with any level of precision, but you should be able to manage your expenses exactly to plan. Your financials will mean different things to different investors. In our case, we focus on two things: (1) the assumptions underlying the revenue forecast (which we don't need a spreadsheet for—we'd rather just talk about them) and (2) the monthly burn rate or cash consumption of the business. Since your revenue forecast will be wrong, your cash flow forecast will be wrong. However, if you are an effective manager, you'll know how to budget for this by focusing on lagging your increase in cash spend behind your expected growth in revenue. Other VCs are much more spreadsheet driven. Some firms (usually those with associates) may go so far as to perform discounted cash flow analysis to determine the value of your business. Some will look at every line item and study it in detail. Others will focus much less on all the details, but focus on certain things that matter to them. For instance, what is your head count over the next few quarters and how fast do you expect to acquire users/customers? Although none of us know your business better than you do, VCs are in the business of pattern recognition and will apply their experience and frame of reference to your financial model as they evaluate how well you understand the financial dynamics of your business. The Demo Most VCs love demos. In the 48 hours before we wrote this section we got to play with an industrial robot, wear a device that tracked our anxiety level, interact with software that measured the number of times we smiled while we watched a video, saw a projection system that worked on curved walls with incredible fidelity, and played around with a Web service that figured out the news we were interested in based on a new approach to leveraging our social graphs. We learned more from the demos, especially about our emotional interest in the products we played with, than any document could communicate. Each of these demos also gave us a chance to talk directly to the entrepreneurs about how they thought about their current and future products, and we got a clear read of the enthusiasm and passion of the entrepreneurs for what they are working on. We believe the demo, a prototype, or an alpha is far more important than a business plan or financial model for a very early stage company. 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. We expect demos to be underfeatured, to be rough around the edges, and to crash. We know that you'll probably throw away the demo on the way to a final product and what we are investing in will evolve a lot. But, like 14-year-old boys, we just want to play. Demos are just as important in existing companies. If you have a complex product, figure out a way to show it off in a short period of time. We don't need to see every feature; use your demo to tell us a story about the problem your product addresses. And give us the steering wheel—we want to play with the demo, not just be passive observers. While we are playing, watch us carefully because you'll learn an enormous amount about us in that brief period of time while you see how comfortable we are, whether our eyes light up, and whether we really understand what you are pursuing. Due Diligence Materials As you go further down the financing path, VCs will ask for additional information. If a VC firm offers you a term sheet, expect its lawyers to ask you for a bunch of things such as capitalization tables, contracts and material agreements, employment agreements, and board meeting minutes. The list of documents requested during the formal due diligence process (usually after signing of the term sheet, but not always) can be long. For an example, see the “Resources” page on AsktheVC.com. The number of documents you will actually have will depend on how long you have been in business. Even if you are a young company just starting up, we recommend that before you go out to raise money you organize all of these documents for quick delivery to a potential funding partner so you don't slow down the process when they ask for them.  Keep in mind that you should never try to hide anything with any of these fund-raising materials. Although you are trying to present your company in the best light possible, you want to make sure any issues you have are clearly disclosed. Deal with any messy stuff up front, and if a VC forgets to ask for something early on, assume you will be asked for it before the deal is done. If you happen to get something past a VC and get funded, it will eventually come out that you weren't completely transparent and your relationship will suffer. A good VC will respect full disclosure early on and, if they are interested in working with you, will actively engage to help you get through any challenges you have, or at least give you feedback on why there are showstoppers that you have to clear up before you raise money. Finding the Right VC The best way to find the perfect VC is to ask your friends and other entrepreneurs. They can give you unfiltered data about which VCs they've enjoyed working with and who have helped build their businesses. It's also the most efficient approach, since an introduction to a VC from an entrepreneur who knows both you and the VC is always more effective than you sending a cold email to [email protected]. But what should you do if you don't have a large network for this? Back in the early days of venture capital, it was very hard to locate even the contact information for a VC and you rarely found them in the yellow pages, not even next to the folks that give payday loans. Today, VCs have web sites, blog, tweet endlessly, and even list their email addresses on their web sites. Entrepreneurs can discover a lot of information about their potential future VC partner well beyond the mundane contact information. You'll be able to discover what types of companies they invest in, what stage of growth they prefer to invest in, past successes, failures, approaches and strategies (at least their marketing approach), and bios on the key personnel at the firm. If the VC has a social media presence, you'll be able to take all of that information and infer things like their hobbies, theories on investing, beer they drink, instrument they play, and type of building or facility—such as a bathroom —they like to endow at their local universities. If you follow them on Foursquare, you can even figure out what kind of food they like to eat. 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. Do your homework. When we get business plans from medical tech companies or somebody insisting we sign a nondisclosure agreement (NDA) before we review a business plan, we know that they did absolutely zero research on our firm or us before they sent us the information. At best, the submission doesn't rise to the top compared to more thoughtful correspondences, and at worst it doesn't even elicit a response from us. A typical VC gets thousands of inquiries a year. The vast majority of these requests are from people that the VC has never met and with whom the VC has no relationship. Improve your chances of having VCs respond to you by researching them, getting a referral to them, and engaging with them in whatever way they seem to be interested in. Finally, don't forget this works both ways. You may have a super-hot deal and as a result have your pick of VCs to fund your company. Do your homework and find out who will be most helpful to your success, has a temperament and style that will be compatible with yours, and will ultimately be your best long-term partner. Finding a Lead VC Assuming that you are talking with multiple potential investors, you can generally categorize them into one of three groups: leaders, followers, and everyone else. It's important to know how to interact with each of these groups. If not, you not only will waste a lot of your time, but also might be unsuccessful in your fund-raising mission. Your goal is to find a lead VC. This is the firm that is going to put down the term sheet, take a leadership role in driving to a financing, and likely be your most active new investor. It's possible to have co-leads (usually two, occasionally three) in a financing. It's also desirable to have more than one lead VC competing to lead your deal, without them knowing whom else you are talking to. As you meet with potential VCs, you'll get one of four typical vibes. First is the VC who clearly is interested and wants to lead. Next is the VC who isn't interested and passes. These are the easy ones—engage aggressively with the ones who want to lead and don't worry about the ones who pass. The other two categories—the “maybe” and the “slow no”—are the hardest to deal with. The “maybe” seems interested, but doesn't really step up his level of engagement. This VC seems to be hanging around, waiting to see if there's any interest in your deal. Keep this person warm by continually meeting and communicating with him, but realize that this VC is not going to catalyze your investment. However, as your deal comes together with a lead, this VC is a great one to bring into the mix if you want to put a syndicate of several firms together. The “slow no” is the hardest to figure out. These VCs never actually say no, but are completely in react mode. They'll occasionally respond when you reach out to them, but there is no perceived forward motion on their part. You always feel like you are pushing on a rope—there's a little resistance but nothing ever really moves anywhere. We recommend you think of these VCs as a “no” and don't continue to spend time with them. How VCs Decide to Invest Let's explore how VCs decide to invest in a company and what the process normally looks like. All VCs are different, so these are generalizations, but more or less reflect the way that VCs make their decisions. The way that you get connected to a particular VC affects the process that you go through. Some VCs will fund only entrepreneurs with whom they have a prior connection. Other VCs prefer to be introduced to entrepreneurs by other VCs. Some VCs invest only in seasoned entrepreneurs and avoid working with first-time entrepreneurs, whereas others, like us, will fund entrepreneurs of all ages and experience and will try to be responsive to anyone who contacts us. Whatever the case is, you should determine quickly if you reached a particular VC through his preferred channel or you are swimming upstream from the beginning. Next, you should understand the role of the person within the VC firm who is your primary connection. If an associate reached out to you via email, consider that his job is to scour the universe looking for deals, but that the associate probably doesn't have any real pull to get a deal done. It doesn't mean that you shouldn't meet with him, but also don't get overly excited until there is a general partner or managing director at the firm paying attention to and spending real time with you. Your first few interactions with a VC firm will vary widely depending on the firm's style and who your initial contact is. However, at some point it will be apparent that the VC has more than a passing interest in exploring an investment in you and will begin a process often known as due diligence. This isn't a formal legal or technical diligence; rather it's code for “I'm taking my exploration to the next level.” You can learn a lot about the attitude and culture of a VC firm by the way it conducts its diligence. For example, if you are raising your first round of financing and you have no revenue and no product, a VC who asks for a five- year detailed financial projection and then proceeds to hammer you on the numbers is probably not someone who has a lot of experience or comfort making early stage investments. As mentioned before, we believe the only thing that can be known about a prerevenue company's financial projections is that they are wrong. During this phase, a VC will ask for a lot of things, such as presentations, projections, customer pipeline or targets, development plan, competitive analysis, and team bios. This is all normal. In some cases the VCs will be mellow and accept what you've already created in anticipation of the financing. In other cases, they'll make you run around like a headless chicken and create a lot of busywork for you. In either case, before you jump through hoops providing this information, again make sure a partner-level person (usually a managing director or general partner) is involved and that you aren't just the object of a fishing expedition by an associate. The Entrepreneur's Perspective If you feel like your VC is a proctologist, run for the hills. While the VC firm goes through its diligence process on you, we suggest you return the favor and ask for things like introductions to other founders they've backed. Nothing is as illuminating as a discussion with other entrepreneurs who've worked with your potential investor. Don't be afraid to ask for entrepreneurs the VC has backed whose companies haven't worked out. Since you should expect that a good VC will ask around about you, don't be afraid to ask other entrepreneurs what they think of the VC. The Entrepreneur's Perspective The best VCs will give you, either proactively or reactively, a list of all the entrepreneurs they've worked with in the past and ask you to pick a few for reference checks. The best reference checks are ones you can do where the company went through hard times, maybe swapped out a founder for another CEO, or even failed, as you will learn from these how the VC handled messy and adversarial situations. You'll go through multiple meetings, emails, phone calls, and more meetings. You may meet other members of the firm or you may not. You may end up going to the VC's offices to present to the entire partnership on a Monday, a tradition known by many firms as the Monday partner meeting. In other cases, as with our firm, if things are heating up you'll meet with each of the partners relatively early in the process in one-on-one or group settings. As the process unfolds, either you'll continue to work with the VC in exploring the opportunity or the VC will start slowing down the pace of communication. Be very wary of the VC who is hot on your company, then warm, then cold, but never really says no. While some VCs are quick to say no when they lose interest, many VCs don't say no because either they don't see a reason to, they want to keep their options open, they are unwilling to affirmatively pass on a deal because they don't want to have to shut the door, or they are just plain impolite and disrespectful to the entrepreneur. Ultimately VCs will decide to invest or not invest. If they do, the next step in the process is for them to issue a term sheet. The Entrepreneur's Perspective If a VC passes on a deal with you, whether graciously or by not returning your emails and your calls, do your best to politely insist on feedback as to why. This is one of the most important lessons an entrepreneur can learn and is especially useful during the fund-raising cycle. Don't worry that someone is telling you that your baby is ugly. Ask for the feedback, demand it, get it, absorb it, and learn from it. Closing the Deal The most important part of all of the fund-raising process is to close the deal, raise the money, and get back to running your business. How do you actually close the deal?  Separate it into two activities: the first is the signing of the term sheet and the second is signing the definitive documents and getting the cash. This book is primarily about getting a term sheet signed. In our experience, most executed term sheets result in a financing that closes. Reputable VCs can't afford to have term sheets signed and then not follow through; otherwise they don't remain reputable for long. The most likely situations that derail financings are when VCs find unexpected bad facts about the company after term sheet signing. You should assume that a signed term sheet will lead to money in the bank as long as there are no smoking guns in your company's past, the investor is a professional one, and you don't do anything stupid in the definitive document drafting process. The second part of closing the deal is the process of drafting the definitive agreements. Generally, the lawyers do most of the heavy lifting here. They will take the term sheet and start to negotiate the 100-plus pages of documentation that are generated from the term sheet. In the best-case scenario, you respond to due diligence requests and one day you are told to sign some documents. The next thing you know, you have money in the bank and a new board member you are excited to work with. In the worst case, however, the deal blows up. Or perhaps the deal closes, but there are hard feelings left on both sides. 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.  CHAPTER 3 Overview of the Term Sheet At the end of 2005, we participated in a financing that was much more difficult than it needed to be. All of the participants were to blame, and ignorance of what really mattered in the negotiation kept things going much longer than was necessary. We talked about what to do and, at the risk of giving away super-top- secret VC magic tricks, decided to write a blog series on Brad's blog (Feld Thoughts—www.feld.com) that deconstructed a venture capital term sheet and explained each section. That blog series was the inspiration for this book. The next few chapters cover the most frequently discussed terms in a VC term sheet. Many VCs love to negotiate hard on every term as though the health of their children depended on them getting the terms just right. Sometimes this is inexperience on the part of the VC; often it's just a negotiating tactic. The specific language that we refer to is from actual term sheets. In addition to describing and explaining the specific terms, we give you examples of what to focus on and implications from the perspectives of the company, VCs, and entrepreneurs. The Entrepreneur's Perspective 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. The Key Concepts: Economics and Control In general, there are only two things that VCs really care about when making investments: economics and control. Economics refers to the return the investors will ultimately get in a liquidity event, usually either a sale of the company or an initial public offering (IPO), and the terms that have direct impact on this return. Control refers to the mechanisms that allow the investors either to affirmatively exercise control over the business or to veto certain decisions the company can make. If you are negotiating a deal and investors are digging their heels in on a provision that doesn't impact the economics or control, they are often blowing smoke, rather than elucidating substance.  The Entrepreneur's Perspective Economics and control are important things to pay attention to, in and of themselves. They rule the day. An inexperienced VC will harp on other terms needlessly. You can give in on them or not, but the mere fact that a VC focuses on unimportant terms is a sign of what that VC will be like to work with as an owner, board member, and compensation committee member. When companies are created, the founders receive common stock. However, when VCs invest in companies, they purchase equity and usually receive preferred stock. In the following chapters we'll be referring to terms that the preferred shareholders are receiving. Separate financings are usually referred to as a series designated by a letter, such as Series A. The first round is often called the Series A financing, although recently a new round occurring before the Series A has appeared called the Series Seed financing. The letter is incremented in each subsequent financing, so Series B financings follow Series A, and Series C financings follow Series B. You'll occasionally see a number added onto the letter for subsequent rounds, such as Series A-1 or Series B-2. This is generally done to try to limit how far into the alphabet you go and is often used when the same investors do subsequent rounds in a company together. While we aren't aware of the world record for number of financings in a private company, we have seen a Series K financing. In each of the following sections, we walk you through language for each term and detailed examples. Let's get started by exploring the economic terms.  CHAPTER 4 Economic Terms of the Term Sheet When discussing the economics of a VC deal, one often hears the question “What is the valuation?” While the valuation of a company, determined by multiplying the number of shares outstanding by the price per share, is one component of the deal, it's a mistake to focus only on the valuation when considering the economics of a deal. In this chapter we discuss all of the terms that make up the economics of the deal, including price, liquidation preference, pay-to-play, vesting, the employee pool, and antidilution.  Price The first economic term, and the one most entrepreneurs focus on more than any other, is the price of the deal. Following is the typical way price is represented in a term sheet. Price: $______ per share (the Original Purchase Price). The Original Purchase Price represents a fully diluted premoney valuation of $ __ million and a fully diluted postmoney valuation of $__ million. For purposes of the above calculation and any other reference to fully diluted in this term sheet, fully diluted assumes the conversion of all outstanding preferred stock of the Company, the exercise of all authorized and currently existing stock options and warrants of the Company, and the increase of the Company's existing option pool by [X] shares prior to this financing. A somewhat different way that price can be represented is by defining the amount of the financing, which backs into the price. For example: Amount of Financing: An aggregate of $X million, representing a __ percent ownership position on a fully diluted basis, including shares reserved for any employee option pool. Prior to the Closing, the Company will reserve shares of its Common Stock so that __ percent of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees, and consultants. While price per share is the ultimate measure of what is being paid for the equity being bought, price is often referred to as valuation. 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 investment, while the postmoney valuation is simply the premoney valuation plus the contemplated aggregate investment amount. With this, you've encountered the first trap that VCs often lead entrepreneurs into. When a VC says, “I'll invest $5 million at a valuation of $20 million,” the VC usually means the postmoney valuation. In this situation, the VC's expectation is that a $5 million investment will buy 25 percent of a $20 million postmoney company. At the same time, an entrepreneur might hear a $5 million investment at a premoney valuation of $20 million, which would buy only 20 percent of the $25 million postmoney company. The words are the same but the expectations are very different.  The term sheet language usually spells this out in detail. However, when you are starting the negotiation with the VC, you'll often have a verbal discussion about price. How you approach this sets the tone for a lot of the balance of the negotiation. By addressing the ambiguity up front, you demonstrate that you have knowledge about the basic terms. The best entrepreneurs we've dealt with are presumptive and say something like “I assume you mean $20 million premoney.” This forces the VC to clarify, and if in fact he did mean $20 million premoney, it doesn't cost you anything in the negotiation. The next part of price to focus on is the phrase fully diluted. Both the company and the investor will want to make sure the company has sufficient equity (or stock options) reserved to compensate and motivate its workforce. This is also known as the employee pool or option pool. The bigger the pool the better, right? Not so fast. Although a large option pool will make it less likely that the company will run out of available options, the size of the pool is taken into account in the valuation of the company, thereby effectively lowering the actual premoney valuation. This is common valuation trap number two. Let's stay with our previous example of a $5 million investment at $20 million premoney. Assume that you have an existing option pool that has options representing 10 percent of the outstanding stock reserved and unissued. The VCs suggest that they want to see a 20 percent option pool. In this case, the extra 10 percent will come out of the premoney valuation, resulting in an effective premoney valuation of $18 million. There is no magic number for the option pool, and this is often a key point of the pricing negotiation. The typical option pool ends up in a range of 10 percent to 20 percent, but if the investors believe that the option pool of the company should be increased, they will insist that the increase happens prior to the financing. You have several negotiating approaches. You can fight the pool size, trying to get the VCs to end up at 15 percent instead of 20 percent. Or you can negotiate on the premoney valuation; accept a 20 percent pool but ask for a $22 million premoney valuation. Or you can suggest that the increase in the option pool gets added to the deal postmoney, which will result in the same premoney valuation but a higher postmoney one. The Entrepreneur's Perspective VCs will want to minimize their risk of future dilution as much as possible by making the option pool as large as possible up front. When you have this negotiation, you should come armed with an  option budget. List out all of the hires you plan on making between today and your next anticipated financing date and the approximate option grant you think it will take to land each one of them. You should be prepared to have an option pool with more options than your budget calls for, but not necessarily by a huge margin. The option budget will be critical in this conversation with your potential investor. Another economic term that you will encounter, especially in later stage financings, is warrants associated with financings. As with the stock option pool allocation, this is another way for an investor to sneak in a lower valuation for the company. A warrant is similar to a stock option; it is a right for an investor to purchase a certain number of shares at a predefined price for a certain number of years. For example, a 10-year warrant for 100,000 shares of Series A stock at $1 per share gives the warrant holder the option to buy 100,000 shares of Series A stock at $1 per share anytime in the next decade, regardless of what the stock is worth at the moment in time the investor avails himself of (or exercises) the warrant. Warrants as part of a venture financing, especially in an early stage investment, tend to create a lot of unnecessary complexity and accounting headaches down the road. If the issue is simply one of price, we recommend the entrepreneur negotiate for a lower premoney valuation to try to eliminate the warrants. Occasionally, this may be at cross-purposes with existing investors who, for some reason, want to artificially inflate the valuation, since the warrant value is rarely calculated as part of the valuation even though it impacts the future allocation of proceeds in a liquidity event. There is one type of financing—the bridge loan—in which warrants are commonplace. A bridge loan occurs when an investor is planning to do a financing, but is waiting for additional investors to participate. In the bridge loan scenario the existing investor will make the investment as convertible debt, which will convert into equity at the price of the upcoming financing. Since the bridge loan investor took additional risk, he generally gets either a discount on the price of the equity (usually up to 20 percent) or warrants that effectively grant a discount (again usually up to 20 percent, although occasionally more). In bridge round cases, it's not worth fighting these warrants as long as they are structured reasonably. The best way for you to negotiate a higher price is to have multiple VCs interested in investing in your company. This is Economics 101; if you have more demand (VCs interested) than supply (equity in your company to sell), then price will increase. In early rounds, your new investors will likely be looking for the lowest possible price that still leaves enough equity in the founders’ and employees’ hands. In later rounds, your existing investors will often argue for the highest price for new investors in order to limit the dilution of the existing investors. If there are no new investors interested in investing in your company, your existing investors will often argue for a price equal to (flat round) or lower than (down round) the price of the previous round. Finally, new investors will always argue for the lowest price they think will enable them to get a financing done, given the appetite (or lack thereof) of the existing investors for putting more money into the company. As an entrepreneur, you are faced with all of these contradictory motivations in a financing, reinforcing the truism that it is incredibly important to pick your early investors wisely, since they can materially help or hurt this process. The Entrepreneur's Perspective The best Plan A has a great Plan B standing behind it. The more potential investors you have interested in investing in your company, the better your negotiating position is. Spend as much time on your best alternative to a negotiated agreement (BATNA) as possible. By now you may be wondering how VCs really value companies. It is not an exact science regardless of the number of spreadsheets involved. VCs typically take into account many factors when deciding how to value a potential investment—some are quantifiable whereas others are completely qualitative. Following are some of the different factors, along with brief explanations of what impacts them. Stage of the company. Early stage companies tend to have a valuation range that is determined more by the experience of the entrepreneurs, the amount of money being raised, and the perception of the overall opportunity. As companies mature, the historical financial performance and future financial projects start to have impact. In later stage companies, supply and demand for financing combined with financial performance dominate, as investors are beginning to look toward an imminent exit event. Competition with other funding sources. The simple time-tested rule for the entrepreneur is “more is better.” When VCs feel like they are competing with other VCs for a deal, price tends to increase. However, a word of caution—don't overplay competition that doesn't exist. If you do and get caught, you'll damage your current negotiating position, potentially lose the existing investor that you have at the table, and, if nothing else, lose all of your leverage in other aspects of the negotiation. Our belief is that you  should always negotiate honestly. Overrepresenting your situation rarely ends well. Experience of the entrepreneurs and leadership team. The more experienced the entrepreneurs, the less risk, and, correspondingly, the higher the valuation. The VC's natural entry point. Some VCs are early stage investors and will invest only at low price points. For example, we know of one well-known early stage investor who publicly states the intention not to invest at a valuation above $10 million postmoney. Later stage investors tend to be much less focused on a specific price level and are more focused on the specific status of the company. While VC firms often have stated strategies, it's often the case that they will diverge from these strategies, especially when markets heat up. Numbers, numbers, numbers. The numbers matter also. Whether it is past performance; predictions of the future; revenue; earnings before interest, taxes, depreciation, and amortization (EBITDA); cash burn; or head count, they each factor into the determination of price. That being said, don't believe everything your MBA professor told you about DCF (discounted cash flow, for those of you without an MBA), especially for early stage companies. Remember, the only thing you know for sure about your financial projections at the early stages is that they are wrong. Current economic climate. Though this is out of the control of the entrepreneur, it weighs heavily on pricing. When the macroeconomy is in the dumps, valuations are lower. When the macroeconomy is expanding, valuations go up. Specifically, valuations often expand quickly when there is future optimism forecasted about the macroeconomy. However, these events are not tightly correlated, especially in the technology sector. Our best advice to entrepreneurs on maximizing pr