Early Stage Venture Funding - Not All About Valuation
Article Thesis
Raising venture capital is a time consuming and arduous process, even for the serial entrepreneur. For the less experienced founder, it can be tempting to focus on the valuation that potential investors place on the business. However, this focus can detract from other important terms of a deal - particularly as they relate to liquidation preferences. Even if there is a limit on the negotiability of these terms, the founder should understand their potential impact.
Introduction
Starting a new business is not for the faint of heart! The initial product idea, the long days and longer nights required to get a product ready to go to market take real tenacity and a refusal to give in to the inevitable obstacles. Eventually the company has a product ready to take to the market but the founder has tapped out his friends and families financial resources and must now get serious about external fundraising. There are lots of well funded venture capital firms out there and it seems like your peers have wonderful stories of being courted, have over-subscribed offerings and must turn away eager investors as they head to the land of unicorns!
I am sure that such stories exist but for the majority of novice entrepreneurs the fund raising process is laborious and time-consuming. Unless you’ve been through the process before and have a rolodex of contacts and a track record of success you’ll be starting from scratch and undertaking something for which you have little to no experience.
That said, boundless optimism is in the DNA of the entrepreneur. The founder can see opportunity where others do not and has the grit and determination to push ahead no matter the hurdle. These are wonderful attributes but it pays to maintain a healthy dose of reality when embarking on the fundraising journey. A venture capital partner is invested in your success and can bring some valuable skills and relationships to the table and if your company is ultimately sold at a premium valuation all parties will be happy and you likely have a ready-made investor for your next startup. However, if your company is not the runaway success that everyone hopes for, your options become more limited and your investors may become more active. At this point the terms of the investment will become more real. Many venture capitalists have a background as one-time entrepreneurs with expertise in operations or marketing rather than a finance or investment banking background and therefore are more adept at isolating the underlying issues and opportunities that impact the financials. A nice summary of the attributes of good VC’s is listed at the website: https://www.thebusinessofvc.com/blog/attributes-of-successful-vcs
Getting a great valuation is a wonderful result and augers well for the company. However, there are other terms in a funding agreement beyond valuation that could have meaningful implications for the founder and his employees. There is probably not much that you can do about these terms - they are fairly standard - but it pays to understand the implications of the downside as well as the rewards of the upside. At this point, and to state the obvious, it pays to have good advice. Many law firms have deep expertise in assisting startups in their fundraising endeavors and it pays to have good legal representation in your corner. A list of the best law firms for venture capital is included at:
In addition to good legal advice,, it can be reassuring if you are able to tap into the experience of a business advisor and mentor who knows the ropes and has been there, done that on your side.
A quick primer on the venture funding process
The funding progression for venture backed companies is well established. Funding rounds typically follow a series of stages as a company matures and its needs for external capital evolve.
Seed Round - The founder/s and their friends and family typically provide the initial funding to support a company from its inception before it has a product and is generating cash. This funding can also be provided by angel investors and crowdfunding platforms
Angel Round - In this round, the company has made some progress (perhaps to a beta release or more) and early outside investors buy common stock in the company. Typically these investors may be retired executives looking to put some capital to work in an area that is familiar to them or it may be a venture firm that understands the risk profile of this early stage investment.
Series A - This round generally denotes the first serious external funding round
Series B - and on will fund ongoing growth as the company has a mature product and marketplace traction and requires growth capital to support and accelerate its growth
Of course venture funding represents more than just money. Sure - the immediate need is for cash so that you can start investing in the people and resources that can make your vision real. But, it would be short sighted to think this is where the game ends. A venture partner is just that - a partner, who can help the business in a myriad of ways:
• has relationships that can be leveraged to help find good executives needed to fill out the management team (sales, finance, business development, legal etc),
• make introductions to prospective customers, partners and external service providers,
• act as a sounding board as you wrestle with the inevitable issues of the day (hopefully of the good kind!)
The right venture partner will understand the dynamics of your industry if not the nitty gritty, and can help you sort through the issues that may ultimately be the difference between you purchasing a Prius or a Tesla! The partner may have gone to an Ivy League college but they would probably claim that their real education came from the school of hard knocks. The lesson is that the best valuation may not represent the best course of action. The rapport you have with the venture partner and the full breadth of assistance s/he can provide should not be underestimated.
The Table Stakes
It goes without saying that you need to be well prepared prior to going to the financing market. Taking the time to prepare and stress test the documents and underlying assumptions that will be delivered to prospective investors will likely force you to revisit and revise some elements of the business plan and result in a more robust and defensible plan. The key documents include:
The Teaser
A teaser - a one pager that hits the highlights of the pitch deck that is designed to capture a reader’s attention in 30 seconds or less and encourage them to learn more. It can include a single sentence metaphor that captures the essence of the opportunity but it should have a little more meat on the bones in terms of the size of the addressable market, the team’s experience and the size of the investment being sought.
The Pitch Book
This document should capture the attention of prospective investors, whilst not overwhelming them with extraneous detail that is better left till subsequent discussions. Much has been written about the best way to prepare a pitch deck (see http://www.adamwaaramaa.com/fundraising/writing-your-pitch-deck/) but the general consensus is that it should be about around 15 pages long and address the following key issues:
• The value proposition of the company / the business problem being solved.
• The company’s solution.
• The target market and size of the market.
• The competitive landscape. How big is the market?
• What is the solution and why is it different and better (evidence of validation)?
• What is the business model (how do you make money)?
• What progress has been made thus far / what is the product roadmap?
• How deep and experienced is the team?
• Summary financial projections
• How are you going to use the proceeds of the investment?
AirBnb is highly regarded as an example of a succinct, understandable and entertaining overview of its business
More examples of publicly available pitch books have been collated on the Startup Grind website at:
The Financial Model
The financial model should represent a realistic view of the company’s outlook and:
• Have clear and realistic assumptions
• Be consistent with the assumptions implicit in the pitch book
• Correlate to the size of the investment you are seeking
Some other considerations
In addition to the pitch deck and the financial model it is prudent to have other information available including:
In addition to the pitch deck, a more detailed investment memorandum may be preferred that spells out the key elements of the proposal in written form and can be provided to parties in lieu of a presentation deck.
Have slides showing screenshots of the solution (if applicable)
A venture firm will not sign an NDA (no matter how proprietary and revolutionary you may believe your product to be) so better not to go there. A venture firm that behaves unethically in this regard will not be around for long, so there is no reason to get hung up on this matter.
Good legal representation is an investment - they have done this before and know the pitfalls and are on your side. Many firms defer fees in lieu of taking equity in startups given the cash flow issues of a young company.
The term sheet will likely contain a no-shop agreement to protect the investment of time the investor is making in the process. It may also incorporate term related to liquidation preferences which are discussed in more detail below. The more comprehensive the final term sheet, the easier it should be to document the Stock Purchase Agreement.
Remember the need to have a pool of options available for new hires (ESOP) but note that the larger the pool the greater the dilutive impact on existing shareholders.
Getting the Message Out
This is a good news, bad news story. The good news is that there is plenty of money out there waiting for a home but the bad news is that venture capital firms get lots and lots of pitches - so, in the absence of a track record and existing relationships, it can be difficult to attract the attention of potential investors and even get to first base.
That said, there are some things to do that can help the company gain visibility with the investor community and establish relationships that can be leveraged down the track. Here’s a hit list of some things to consider doing (in no particular order):
Work your relationships for their contacts in the investment community (and start early - before you need anything).
Leverage your relationships with lawyers, accounting firms and other advisors as they typically have contacts in the space
Take advantage of any opportunities to tell the company story at industry and networking events
Know how your competitors are funded and who their investors are. A venture firm typically does not want to have competing investments in its portfolio.
Look for VC’s and partners that have expressed an interest in your space.
If you are emailing a venture firm, keep it short and sweet and entice them to take a look at the teaser.
The Term Sheet
With luck you will be in the enviable position of receiving multiple term sheets and negotiating the terms of an agreement from a position of relative strength. The more comprehensive the term sheet, the easier it should be to complete the final purchase agreement but, at a minimum, it should address the key terms such as the amount to be raised, the price per share, the pre-money valuation and the company capitalization post the financing. It should also detail the main rights of the shares being issued, including liquidation preferences (discussed below), dividend terms, voting rights and the like.
A couple of things to keep in mind when negotiating the term sheet include which party’s attorney will be responsible for drafting the purchase agreement as well as whether the investor will require the company to assume responsibility for their legal fees. These may not sound like big deals but the first draft sets the baseline for the document and it is far easier to review markups of the same baseline than review multiple different versions in the event that multiple term sheets are received. Likewise, legal fees may not sound material relative to the overall financing, but they can come as an ugly surprise come reckoning day, so a cap may be warranted. An investor will also likely require additional burdens on the founders to protect their (potential) investment, including a no-shop clause, keyman insurance for the founders, non-competition and solicitation agreements and D&O insurance protecting all directors. Consequently, any such hard costs should be factored into the financial model.
In my experience it also pays to establish and maintain a shared (and password protected) drive for file important documents that will be requested by any and all parties undertaking due diligence. Having all such documents in a central repository will make life easier when you are inevitably asked for a specific document and will help demonstrate good process and internal discipline.
As noted above, the company’s business plan and financial model should incorporate an employee option pool. In fact, it is important to spend some time thinking about how this program should be structured. Stock options are a powerful incentive for employees who join a startup, with all of the risk that entails. Option plans can take many forms and your legal counsel should provide wise counsel in this area. It is not the purpose of this article to discuss option plans in detail, with all of the accounting and tax ramifications. However, it is worth noting that stock options may have time and/or performance based vesting criteria that can become a burdensome administrative task to manage - if not accounted for on an ongoing basis then it will rear its ugly head when a liquidation event occurs.
Therefore, properly maintaining the capitalization table is time well spent, as events will likely complicate it over time. For example:
new, option eligible employees are hired,
employees with partially vested options will leave and unvested (and vested) options are returned to the pool,
additional venture rounds take place, potentially with existing and new venture capital firms,
performance based option criteria must be evaluated, especially if there are subjective elements involved,
acquisitions may be undertaken with new provisions for acquired employees,
option grants may have different rights attached to them, such as accelerated vesting upon certain specified events (e.g. performance milestones, company sale).
Generally speaking, a simple spreadsheet will suffice for the early stages of a company’s life, however as the capital structure becomes more complex, it may be worth considering investing in a capitalization table management software solution. These software solutions help manage the day to day administrative tasks, ensure compliance and provide a tool to easily compare future rounds and perform analyses. In addition, they typically provide a central repository for all the paperwork and also provide a portal to allow employees with an update to date view of their holdings. The respected law firm Cooley LLP has developed a web resource dedicated to entrepreneurs at Cooley GO which includes some valuable information on cap tables:
The Stock Purchase Agreement
After all the hard work of preparing and refining the pitch, approaching investors and receiving (multiple) expressions of interest from venture firms and agreeing on the key valuation terms of the offer, the time arrives for the lawyers to get involved and get the paperwork finalized so that you can get back to the real business of running the business. The National Venture Capital Association has a useful website that includes sample agreements at https://nvca.org/resources/model-legal-documents/
The Stock Purchase Agreement is the key legal document memorializing the terms of the investment. Importantly, it details key valuation terms including the number of shares to be acquired and the price paid for those shares as well as other matters such as the proposed use of proceeds, board representation rights and more. Just as important, however, is the type of security that venture capital investors employ in their funding agreements. There are two important elements to consider with respect to the form of the venture firm’s investment - the liquidation preference and the extent to which the investor participates in the proceeds subsequent to the preference
Liquidation Preference
Venture firms typically receive preferred stock; so called because they receive a preference upon a sale (or similar liquidity event) of the company - the so called liquidation preference. In other words, the venture investor will receive proceeds on a sale before the rest of the (common) shareholders - typically a multiple of the original purchase price. If an venture firm invests (say) $5 million at a pre-money valuation of $5 million and therefore owns 50% of the company at a 1X preference and the company is sold for $7 million, the investor will recoup his $5 million (plus accrued dividends) before the common shareholders, whose 50% share will total the remaining balance of $2 million. The multiple typically ranges from 1X up to 3X.
Participation Rights
Non participating preference
using this instrument, the preferred stockholder does not participate in the proceeds of a sale beyond the liquidation preference unless he converts to common stock and shares ratably in the proceeds with all shareholders. Consequently, there is a inflection point at which it makes sense for the investor to convert to common stock.
this preference is most favorable to the company
This is the typical instrument used in early funding rounds
Participating preference
using this instrument, the investor would receive his share of the sale proceeds according to the liquidation preference and then also participate in the remaining proceeds along with the common stockholders - effectively a double dip. In some cases there may be a cap on the amount of common stock sale proceeds to which they are entitled.
this preference is most favorable to the investor
As can be seen, there are a number of moving parts in the way a venture capital firm may structure an investment - which can be somewhat abstruse in the abstract. It is helpful to look at the some examples to more clearly understand the impact. Let’s assume the following simple fact pattern.
Year 0
The company is founded by a couple of entrepreneurs with a great idea and they get to work
Year 1 - 3
The company starts generating revenue and new employees are hired and granted options in the company
Year 4
The company is growing and seeks external financing and a venture capital firm invests $ 5 million in convertible preferred Series A shares with an 8% cumulative dividend
Year 7
The company accepts a purchase offer from a large industry player:
the company has struggled and the offer is for $7 million
the company has been moderately successful and the offer is for $12 million
the company has been successful and the offer is for $40 million
It is at this point that the terms of the preferred stock investment become real to the founders and employees. The simple assumption that the founders and employees are entitled to 50% of the sale price does not factor in the terms of the liquidation preference. Let’s look at several different scenarios.
PREFERENCE SHARE TABLE
As can be noted, at a lower valuation the venture firm’s liquidation preference take effect and the common stockholders receive a lower proportionate share of the sale proceeds. In this example, the conversion option begins to make economic sense at a sale price of about $12 million at which point the other shareholders begin to share ratably in the proceeds.
It is also worth noting that the buyer of the company will typically hold a percentage of the purchase price in escrow with an agent to accommodate any post-closing events, including a working capital adjustment to account for changes to the net working capital balance between the signing of the deal and the formal closing of the transaction and any potential concerns a buyer may have regarding potential liabilities, such as unresolved lawsuits and the like. There is no hard and fast rule but the typical holdback terms are in the 10% to 15% of purchase price and released 6 months post-closing.
Conclusion
Raising capital at a high valuation speaks volumes for an investor’s confidence in the progress and future prospects of a startup especially if the founders are relatively new to the game. However, as this article has attempted to show, there is more to the fundraising process than simply getting the best valuation. The interests of all parties are aligned in executing on the vision and growing the business and if the company succeeds than everyone succeeds. That said, venture capital firms look to protect their downside - the risk capital comes at a price. Therefore, understanding that risk perspective and the impact of different potential outcomes is just good business sense. When the term sheet is being negotiated, it pays to have an understanding of all the levers in the deal even if there are limits as to what can be realistically achieved. At the end of the day, it is better to own 50% of something than 100% of nothing. In other words, understand the impact of how the company is to be financed, negotiate for the best outcome you can manage; but keep the focus on running the business, both on the short-term imperatives and on the longer term risks and opportunities. It’s easy!!!!
