Ever thought about getting investments for your startup? Ever thought about investing in a startup?
Whether you are an entrepreneur, an investor, a lawyer or just a stakeholder in the venture capital market, this book is for you!
In it, renowned investor Brad Feld addresses some topics within the Venture Capital ecosystem, explaining in a practical and didactic way how things work. You’ll understand a bit more about raising money, how to get away from some legal issues, who are the top players in VC deals, and how to deal with investors.
Want to understand about this world and get ready to close your business the best way?
Buy the book here:
WHO ARE THE MAIN INVOLVED IN THE VENTURE CAPITAL BUSINESS
To better understand the Venture Capital (VC) ecosystem, it is important to understand who are the key players in this market. Many people believe that in venture capital, the entrepreneur and the VC investor are the only two major players. But this is not true since there are some other players who play important roles in the VC business and we will list them below:
The Angel Investor: The angel investor usually acts in the seed stage. He may be a professional investor, a successful entrepreneur, a friend, or a family member. If you are going to capture from an angel investor, you need to find out if the VC is comfortable investing with angels as each VC has a different point of view on the subject. Already the super angels are angels that make big money with small investments. These people generally went out of startups. When a super angel raises funds on his own, he is called a micro VC and has the same fiduciary responsibilities as a VC fund. Angels should never be in a position to determine the direction of the company. That’s why you need to set clear rules for a healthy partnership and give the angels little control over the company. This will prevent you from having to collect many signatures in the next round of investments or during a sale.
The Union: A union is a group of investors who invest together. It includes any of the investors who buy a stake in a round of financing. Each round made by a union has a leading investor who is typically one of the VCs, and there may also be two or three co-leaders in a union. The leader is responsible for negotiating terms for the entire union with the founder of the startup. And it is the founder’s responsibility to communicate with each of the investors during the process – do not expect the leader to do so. Finally, the founder needs to get investors to agree that the leader speaks for them as a representative.
Lawyers: The value of an experienced VC finance lawyer is invaluable. The founder needs to have a lawyer to guard against asymmetry of information of the nature of VC, after all, VCs deal with finance all the time and even the most experienced founders do not know much about finance and investments. Having a lawyer also prevents the founder from having to worry about the details of a VC investment. Good lawyers prevent the founder from distracting himself with insignificant negotiating terms, and inexperienced lawyers will focus on the wrong issues and delay the deal. Also, having a good lawyer affects the reputation of the founder. So you have to choose carefully. And finally, a good entrepreneur must ensure that the lawyer is paid with the income of the business, not hourly, avoiding costs if the business does not materialize.
Mentors: It is recommended that every entrepreneur have a group of mentors, preferably who know about VCs who may be interested in the company. On the other hand, it is important that you stay away from “counselors” who offer help to raise money and then take a part of the settlement as compensation. Most great mentors do this because they like it and not for short-term gains. Having fees is not a requirement for mentors, although giving action to them can help ensure greater commitment. If you are giving actions, keep your control over the actions that are given, and do so based on the mentor’s performance. Make it clear what you expect in exchange for stock compensation.
IMPORTANT ECONOMIC AND CONTROL CONCEPTS
In general, VCs care about two things: economy and control. Economics, here, represents the financial return that investors will receive in a liquidity event, that is, in the sale of the company or an IPO. Control refers to the mechanisms that ensure that investors have power in the management of the business.
When a startup is created, the founders receive ordinary shares of the company. However, when VCs invest in the business, they buy a stake and usually receive the so-called preferred shares. Preferred shares usually have different rights to common shares, often giving more control to the investor than if he had a common share.
HOW TO GET MONEY FOR YOUR STARTUP
To prepare to capture a round of investments, you need to take a few steps. Your goal at this time is to get many term sheets, which are the documents that explain the investment offer for the company. It is important to know that there is no standard to follow here, each VC is different. What impresses one may not impress the other.
First, determine how much money you want to raise. Define a time frame in which you want to invest these resources in the business and know clearly how far that capital will take the company. Do not exceed your need for capital.
In some cases, a VC will be interested, but you will not want to invest all the value you need. And if you are not able to prove that you can get the rest of the value, they probably will not proceed with the investment. That’s why it’s very important that you talk to multiple investors.
When talking to a VC how much you are capturing, give a specific number and not ranges of values. Never say something like “we’re getting 5 to 7 million.” It makes you look immature in front of you. Determine how much you need and be direct. Of course, you can always manage to get more.
Another important point is that the amount sought will determine who you should talk to in that process. For example, if you need a smaller amount – say, $ 500,000 for a seed round, you’ll talk to angel investors, seed stage VCs, micro VCs, and early-stage investors. If you need a larger amount – say $ 10 million, you should start looking for larger VCs, as you need some investor who invests at least $ 5 million and works in Series A and Series B.
The investment capturing period can also vary greatly depending on your business.
Also, before you start capturing resources, you need to create some basic materials:
Your elevator pitch: These are some paragraphs that you can email by describing your idea. You should be able to make this presentation thinking about the time it takes for an elevator to get off the first floor to the prospector’s office. Do not confuse this document with the executive summary, here we are talking about one to three paragraphs that describe the product, the team, and the business quite directly. Your pitch should also have a completion paragraph that specifies what you are looking for and what are the company’s next steps;
Executive Summary: It’s a 1 to 3-page document with the idea, time, product and business. Work hard on this summary as it is your first impression. You can add content such as high-level financial data and the answer to questions like What problem do you want to solve? Why is it important? Why is your product better than the ones already on the market? Why do you have the right team to achieve this vision?
PowerPoint presentation: The quality of presentation is important, but do not overdo it! It should be a presentation of 10 to 20 slides, with an overview of the business. Your goal should be to communicate the same information present in the executive summary, but using a visual presentation. Understand your audience and make a personalized presentation. Remember to spend some time thinking about the flow and the format; it is important that the slides are well organized and designed – it pays to pay someone to help you transform your presentation or ask for help from a friend designer.
Business Plan: These are most common in advanced stages of investment. It is no longer as used as it once was in the initial rounds, but some VCs care a lot about it and want to see a good business plan. The business plan is a document of more or less 30 pages with many sessions and information about the business. It functions as an extension of the executive summary, going into details about the market, product, customers, strategies, and finances.
Demos / Prototypes: Good VCs always like and prefer to see the product working. You can learn much more from a demo version of software than from a formal document. Many VCs believe that the demo, a prototype, is far more important than any business plan or financial model, especially for companies in the early stages. It is normal and even expected that the demos do not have all the functions and have some initial problems. This happens because the product will probably still evolve much from the demo to the final version. If you have a complex product, find a way to demonstrate it quickly and easily. Use the demo to tell a story, to demonstrate how your product solves the problem it proposes to solve. VCs do not just want to watch; it’s important that they can use the demo to validate their business.
Pre-filing: If a VC offers you a term sheet, it is normal for his attorneys to request some documents such as shareholder tables, customer contracts, work contracts, and minutes of board meetings. The list of documents is usually requested during the due diligence process – usually after the signature of the term sheet – and it can be very extensive. And if you have a recent company that is starting, it is recommended that you organize all the documents before trying to raise the money, this way the process will not be so time to consume.
After that, you’ll start looking for the right VCs. The best way to do this is by asking friends and other entrepreneurs whom they know, they might be interested in. These people can give you information about the VCs they know and have helped build their businesses. Also, introducing yourself to a VC with the help of an entrepreneur is much better than sending an email to the company without knowing anyone.
But if you do not have a good network yet, look for the websites, blogs, social networking accounts, and email lists of the VCs that you want to address. You can find out a lot of information about potential investors using the internet. Do your part and find out which VCs will be most useful for you to achieve success, find out which styles and temperaments resemble yours!
If you have more than one potential investor, you can categorize them into one of three groups: potential leaders, followers, and others. You need to know how to interact with each of these groups, so you do not waste your time and fail to raise money.
Ideally, you should find a VC with a leader profile. The lead investor is the one who makes the biggest paycheck in that round and usually takes a leading role in driving the round pickup.
When meeting with potential VCs, you will come across four possible feelings:
The first is the VC that is interested and wants to lead;
The second is not interested and passes the opportunity;
The third one falls into the category “maybe,” because it seems interested but does not advance with the relationship;
The fourth is the profile of “not slow,” he says no and only responds sporadically. In the case of the third category, maintain a relationship with them. When you find a leading VC, it can help you grow your mix of potential follower investors. In the case of the fourth category, do not waste your time with them.
HOW YOU DECIDE TO INVEST
Some VCs only invest in entrepreneurs they already know from previous experiences. Others prefer to be introduced to entrepreneurs by other VCs. Some of them do not like working with beginners while others do not care about age and experience and try to respond to any entrepreneur who comes in contact. Regardless of the case, you need to find out the profile of each investor’s interest and if you are using the appropriate channels of communication.
You also need to understand what the role of your primary contact within VC is. Your first interactions with the company will vary greatly depending on the style and your initial contact with it. Over time, they will make clear the interest in investing in you and will begin the due diligence process. During this phase, the VC will ask you for lots of information and documents, and this is normal. But before passing the required information, ensure that someone from a more senior level is involved (a director or a member of the fund). And as you go through the due diligence process, you can ask to be introduced to other entrepreneurs who have already been invested by that VC. Do not be afraid to ask other entrepreneurs about VC; they will reveal good things and show you what it’s like to work with it!
You can check VC references by asking some key questions:
Who am I talking to?
What kind of decision-making power does that person have?
What is the process for having the investment approved?
To get this information, talk to other VC-supported entrepreneurs, gather information, talk to people from different hierarchical levels who work in the background, and insist on a relationship with a director or partner.
To close a round of investments, signing the term sheet is the first step. The term sheet determines the final structure of the agreement and represents what your future relationship with the investor will look like.
There are two very important points in the term sheet that need to be observed: the economic side, that is, what the VC earns in case of liquidity; and control, that is, how the VC exercises control over the business or vetoes certain decisions that the company makes. Anyone who does not care about these two points will not make a good deal.
Some very important points of the term sheet need special attention:
Price: The agreement price is usually represented on the term sheet regarding ‘price per share.’ Another way to represent it is by setting the size of the investment round. For example, the amount invested will represent the purchase of X% of the company’s shares. The price is also sometimes referred to as the ‘valuation’ of the company. The valuation is separated into money and post-money. The pre-money valuation represents how the investor is valuing the company at that time before the investment, and the post-money valuation is the sum of the pre-money valuation with the amount to be invested.
Preference for settlement: This term is also very important and impacts how profits are shared if there is liquidity, i.e., in case of sale of the company. Preference can be defined as: an amount of the original investment per share is returned to the investor before ordinary shares receive any attention. For example: If an investor has a liquidation preference, in case of sale of the company, he first receives the amount he invested in the company and only then does the sharing of the other dividends of the sale occur.
Vesting: This concept, though simple, can have many unexpected implications. Vesting is meant to ensure that entrepreneurs will stay with the company over time. That is, suppose you own 50% of a company’s stock. If your company adopts vesting for four years, if you quit before the end of the four years, you lose the right to a percentage of your shares. If you leave at the end of the second year, for example, you would only have 25% of the company. This is an important resource to ensure long-term commitment between partners and the company.
Antidilution: Antidilution is a clause that protects investors in cases where a company issues new shares at a value lower than the value of the round. This clause serves to protect investors and keep control percentages constant. If an investor has antidilution rights, and the company draws funds at a valuation below the valuation of the last round, only the common shares of the founders will be diluted.
THE TERM SHEET CONTROL PARAMETERS
Although VCs typically seek to have less than 50% of company control, they typically use various terms of control to exercise authority over the company’s activities. Some of them are:
Board of Directors: Electing a board of directors is a key control element in companies. The entrepreneur needs to think about the balance of board members: investors, founders, employees and external representation. Typically, companies in the early stages have five members on the board: the founder, the CEO, the VC, a second VC, and an external member. This configuration is balanced and gives the VC enough influence to be comfortable without having control of the board. In the case of more mature companies, the board usually has more than five members and is attended by other external members. Each board member usually has equal voting power in making decisions.
Provisions of protection: They are veto rights that investors have to block certain actions taken by the company.
‘Drag-along’ agreements: this arrangement gives some investors the ability to force all other investors and founders to sell the company should an offer arise.
Conversion: Preferred shareholders have the right to convert their participation in common shares. This allows these shareholders to be paid in shares rather than having to wait for a liquidity event.
HOW DOES VC WORK?
VCs are organized in companies that raise funds to invest in startups, setting up a fund.
There are three basic entities that make up the fund. The first is the fund management company, and it employs all of the employees with whom you interact, such as the partners, associates and the administrative staff of that fund. This company is, in essence, the brand of the firm. The second entity is made up of Limited Partners (LPs), i.e., the people and companies that invest in the fund.
The agreement between the VCs and their investors (LPs) is governed by a long and complicated contract, called the Limited Partners Agreement. VC businesses usually need to consult limited partners (LP) every time they need more money for investment. This action is called ‘capital call,’ and LPs are required to respond to call capital within two weeks by submitting the funds.
Capital calls may fail or result in lower than expected values. And why would investors refuse to finance a call capital? There are many reasons, one because they believe that VC is not making good decisions.
The VCs have a well-defined hierarchy composed of:
General Director / General Partner / GP: they make the final decisions and are part of the boards of the companies in which they invest.
Directors have responsibility for negotiations, need a chief executive involved to make the final decision. These directors are the junior partners.
Associates: work for members. They are looking for new business; they are responsible for the previous diligence in the existing businesses, they write internal memorandums about possible investments.
Analysts: the first step of the hierarchy, do the math and write memos.
Other: Partners: Experienced entrepreneurs working part-time in VC companies; Entrepreneurs in residence: Experienced entrepreneurs who stay in VC companies while looking for the next business.
HOW THE VENTURE CAPITALISTS MAKE MONEY
VC salaries are paid through administrative fees. These fees are charged as a percentage of the total amount of money in the fund, usually between 1.5 and 2.5% of the fund’s managed value per year.
In most funds, the average management fee over a ten year period is 15% of the fund. Fund investors, of course, expect VCs to generate capital gains from their investments to fund these rates. In the VC business, members typically see their salaries increase with each additional fund they raise. And because rates are guaranteed for ten years in each fund, it may take a decade for a fund to be liquidated. Additional funds and additional rounds can be collected while the performance of early funds is still unclear.
Although administrative fees are considerable, in success stories most of the money VCs earn comes from the performance of the fund, also called carry. The carry is the profit that the VC receives after it returns the money to the investors (the LPs). Most VCs receive 20% of profits after returning the invested capital, although some successful funds can reach a 30% carry.
Normally, the funds do not allocate the distribution of carry features among partners equally. In the VC industry, home time is important. A younger member, for example, may not receive a carry. LPs typically want VCs to invest a portion of their money in the fund as well – that means 99% of the money comes from LPs and 1% from fund executives.
UNDERSTAND HOW TIME INFLUENCES FUND ACTIVITIES
The VC fund arrangements have two concepts to invest over time. The concept of the commitment period and the concept of the disinvestment period. The commitment period, which is usually five years, is the period that a VC has to identify and invest in new companies in the fund. After that period is over, the fund can no longer invest in new businesses, but can invest more money in the businesses that already make up the portfolio. And that is why, typically, VC companies raise new funds every three to five years. The term of divestment is the period in which the fund may remain active until it liquidates its companies and returns the capital of the LPs. A typical VC fund has a duration of 10 years.
It is important to understand this, especially if you are trying to raise money for a fund that is close to finalizing your commitment period. At the end of a fund cycle, there is a lot more pressure for you to go out and sell the company. Sometimes, funds that have already passed their commitment period meet with good new entrepreneurs to invest, but end up not investing. To avoid this risk, ask how long the fund’s last investment happened. When the fund comes to an end, VCs can also redistribute the portfolio of companies to their LPs, or even extend the duration of the fund.
SOME IMPORTANT FINANCIAL CONCEPTS ON VCS
The following are some important concepts that you as an entrepreneur should know and observe when seeking investments with VCs.
Reserves: Reserves represent the amount of investment capital allocated to each company in which a VC invests. VCs have a bottom fraction of 30 to 50% in reserves. Normally, the more initial the stage of the company, the more reserves the VC will allocate for possible future investments. In the case of investments in advanced stages, a VC may have no allocated reserves, whereas a first-round investment may have millionaire reserves.
Cash Flow: VCs need to pay close attention to the bottom cash flow. How does VC maintain its cash flow? They recycle the ‘carry’ from previous funds and also make capital calls to their LPs.
The Key Person Clause: Most VC companies have a key clause to define what happens if a particular partner moves away from the business. In some cases, for example, when the key clause is used, LPs have the right to suspend the fund’s ability to make new investments, or even close the fund.
Fiduciary duties: The VCs have fiduciary duties, that is, commitments with the other shareholders of the investees. It is very important to understand what these fiduciary duties are since you need to respond to your LPs and they have a set of legal responsibilities. Some VCs are transparent about these issues, but some can be confusing and keep secrets. Understand your investors’ financial incentives to understand their duties and terms. Have an open and frank conversation with them, this can avoid any surprise or trauma in the future.
NEGOTIATING WITH A VC
Three things are very important when negotiating a round of investments: achieve a good and fair outcome, do not end your relationships with it, and understand very well the agreement you are making. Both parties need to feel satisfied with the agreement and must believe that the results were fair. Talk to the investor about what their main concerns are and what their main concerns are, as all of these details need to be resolved and discussed in advance.
The biggest mistake made during any negotiation is lack of preparation.
PROBLEMS FACING EACH STAGE OF DEVELOPMENT
Each stage of funding has different types of problems. We must know them to avoid them:
Stage Seed: agreements at this stage have the greatest potential for failures. The sooner the investment is made, the better the chances of the company breaking, right? It’s ironic, but if you can do a great deal at this stage, you may have problems in the future. If you can not justify this great investment with your performance, you may have problems in the next rounds and not get a good valuation of your company. At this stage, ordinary shares are usually traded.
Early Stage Stage: At this stage, be careful about liquidity preferences, as the preferences set are likely to be the precedents of the next rounds. Avoid giving too much control too soon and stay tuned to your company’s board of directors.
Mid / Late Stage Stages: In more advanced stage deals, problems often arise with the company’s board of directors and voting control. At this stage, it is necessary to negotiate very well the control and voting provisions to ensure that the company can move forward without management conflicts.
ANOTHER TYPE OF TERM-SHEET
The letter of intent or Letter of Intent (LOI) is also very important to the entrepreneur. The first formal step that a fund is interested in your business is the creation of a letter of intent. On the first page of the LOI, the probable purchase price of the shares is defined. This value is usually not the actual price, but rather the best scenario for the price. Also, the escrow value is also displayed in the LOI. This escrow usually corresponds to 10 to 20% of the purchase price. It is used to solve any problem that arises after the investment and which has not been disclosed in the purchase agreement.
While the valuation of the company or the value at which the fund is evaluating the same at that time is the main problem in the mind of any entrepreneur, the second most important point is the terms of the agreement. The terms have a great impact on the company, after all, a high valuation with terms that give a lot of control to the VCs is not always a good idea. Before you capture, you need to ask yourself what matters most to you: a high valuation or keep as much control as possible about your company?
GIVE ACTIONS TO YOUR EMPLOYEES
Although corporate board members have fiduciary obligations to employees and shareholders of the business, often these businesses are not as involved in the company as their employees. Everyone has heard a story about business acquisitions, where board members care about their interests at the expense of their shareholders’ interests. It is therefore important that companies have stock distribution plans for their key employees. The more employees the company’s shareholders, the lower the fiduciary risk of the company. It is important to have the so-called “stock pool” or treasury shares, which are an allocation of shares to be distributed to company employees.
Many startups offer their employees the option to buy company stock, which is a great opportunity for employees to have greater earnings in the future and can also be used as a retention tool for key professionals.
LEGAL TIPS FOR THE FOUNDERS
Some legal issues are common to entrepreneurs and can lead to major headaches and countless financial implications. Therefore, it is important to pay attention to these problems rather than assume that your lawyer will take care of everything alone:
Have a termination term in your employees’ employment contracts – this way you will avoid too much headache if you need to fire someone;
Have a good labor lawyer – problems always arise in this area; you need to protect yourself;
Raise money from accredited investors – unverified investors may force you to buy your shares at any time (right of withdrawal);
Be careful and even a bit paranoid in the beginning. Problems with intellectual property can slow down your business and your ability to raise investments. Keep your idea carefully or have the people involved sign “confidentiality agreements” to ensure that your secrets do not leak into the marketplace.
The venture capital industry began in the mid-1950s in the United States and continued to grow. The challenges are still many, and if you, as an entrepreneur, want to take advantage of this rising market, the tips in this book are essential.
Do not forget to hire a good lawyer; raise money from accredited investors, and check all the terms of the most important documents. Have a good pitch and good luck!