Venture Finance Terms: What is Reverse Vesting?

Fighting Over DollarIf your startup company is seeking venture capital funding, one major factor to consider is the impact the financing will have on the value of equity held by founders and management. Many VC term sheets include a provision requiring reverse vesting. In this post, I’ll explain what this means and the impact it can have on your equity stake.

Founders and management of startup companies typically receive their shares / options on a vesting schedule. This mean that instead of receiving all of their shares at onces, they are given the option to purchase shares a little at a time. For example, a founder with 16,000 shares might receive them on quarterly intervals over four years, meaning he gets 1,000 shares each quarter. After 4 years, he is fully vested, meaning he has received all of his shares or options.

Now suppose that the above founder, after he is already fully vested, decides to seek VC funding. The investors may include a term requiring reverse vesting, meaning the founder must relinquish his shares and then re-earn them on a new vesting schedule.

At first, such clauses may seem extremely unfair to founders and management. Sometimes these clauses do indeed cause problems, but a lot depends on the specifics. Generally, the purpose of reverse vesting is to prevent founders at newly funded startups from leaving the company with their shares. This helps VCs protect their investment, but it also helps the co-founders and the company in general. The loss of a founder or other key person can often doom a company, leaving the investors and other company founders in the lurch.

On the other hand, fairly written reverse vesting terms should have some indication of the conditions under which a founder can or can’t leave with his shares. Such conditions are known as “good-leaver” clauses. Generally under such clauses, if a founder leaves on his own or is fired with cause, he loses some or all of his non-vested shares. If he is asked to leave without cause, he keeps his shares. Without such clauses, the founder can be fired at will, and the other shareholders (VCs and other management) will reclaim his shares.

In summary, reverse vesting may seem unfair to founders or management, but if structured fairly such terms can benefit both investors and the company itself. As with every term in a VC deal, the devil is in the details.

Venture Capital Fundraising: Closing the Deal!

champagneIf you’re following along with our series of posts on the venture capital fundraising process, the next step in the process is closing the deal!

This is the fun part. After all documents have been finalized and signed, maintain close contact with your bank to ensure that the funds have arrived. The deal is never over until the money has hit the bank. A closing dinner to celebrate getting things across the finish line is customary with the investors, management team, bankers and attorneys. (For inside rounds—rounds led and completely financed by current investors—a closing dinner is generally not done.)

Pat yourself on the back and realize that your work is only beginning. Now you have to execute on the plan that was outlined in your business plan and turn the money received into tangible value. The measure of whether or not the financing was successful is if the value created is greater than the money that was spent.

The VC Fundraising Process: Drafting Legal Documents

signingIf you’re following along with our series of posts on the venture capital fundraising process, the next step in the process is the drafting of legal documents.

This part is generally led by the legal team for both the counsel and company. While the VCs and management teams need to stay involved and negotiate remaining business items, generally much of the detail gets resolved between attorneys. It is to a CEO’s peril to abdicate their responsibility at this stage. The details can often come back to bite. Strong attention to detail by at least one member of the management team is a necessity.

Sample legal documents can be found at the National Venture Capital Association website.

Venture Fundraising Strategy: Planning for the Exit

exitIf you’re an entrepreneur planning to raise venture capital funding, you’re probably focused on the fundraising process itself, and rightly so. It’s often difficult to get the funding you need at the terms you’re looking for. However, even before you raise any funding, you should also be giving serious thought to your exit strategy.

VCs never make an investment without considering the exit – in other words, how, what and when they will get paid for the equity they own. This generally occurrs when the company is acquired through an M&A deal or goes public in an IPO. Entrepreneurs seeking VC funding should also think about the potential value of the company, and the founders and management equity stakes, in a variety of reasonable exit scenarios. In particular, you must consider how a proposed term sheet will impact your equity value given a reasonable exit scenario.

For example, consider the effect of dividends. In a recent post, we discussed the effect dividends can have on the upside for VCs and entrepreneurs. Specifically, in a downside situation (an unfavorable exit), dividends strongly favor VCs, particularly if the exit is delayed. Depending on the timing and terms, the effect is often significant.

Similarly, other VC terms such as liquidation preference and participation may have a huge imact on the amount recovered by entrepreneurs at exit, or no impact at all depending on the nature of the exit. If the company goes public, these terms do not affect the value of the equity owned, while in an M&A deal they are vitally important.

In summary, even before raising VC funding, you should consider the effect that your planned exit strategy has on the value of


The VC Fundraising Process: Negotiation of Term Sheets

Thumbs up or down?If you’re following along with our series of posts on the venture capital fundraising process, the next step in the process is the negotiation of deal terms.

The process by which negotiations happen is determined by several factors, including how badly the company needs the money, how many term sheets have been received and what other alternatives are available. If there is more than one term sheet, you can play hard ball—with the caveat that you still will need to work with the investors after the transaction is closed. There is a fine line between negotiating hard and being antagonistic. Keeping things respectful is important. This is an area where having a banker help lead the negotiation can preserve the relationship with the investors while still pushing hard for the best possible deal.

A company that already has money in the bank is obviously better positioned in a negotiation than a company without money. Companies that are raising money to increase their war chests for acquisitions, product expansion or to prepare for an M&A event have more leverage than companies that need the money to survive.

Often companies will need more money than one VC can provide either in the present round or at least later in the development cycle. It’s essential to build an investor syndicate to make sure there is enough money around the table when the time inevitably comes to raise more capital. Not having enough money from current investors for future, larger rounds can be a major mistake. It can also prove the downfall of otherwise successful companies.

Finding other VCs that the lead investor and CEO can work with is important and a collaborative process. By this point, presumably all economics for the transaction have been agreed upon and the signed term sheet can be “shopped” to fill out the round.

Attorneys should be involved in the term sheet negotiation but not around business issues, unless they have a particular perspective.  The company must decide on these items.

Syndicates are often constructed by the lead investor, not the company.  That being said, companies can veto investors that they do not believe they can successful work with.

Venture Capital Terms: Dividends

Dividends: Time is moneyWhen negotiating a VC term sheet, dividends are often not the main focus. This is because compared to other terms like liquidation preference and valuation, they do not always have as large an impact on the payout to VCs and company management. However, dividends should not be overlooked, as they have the potential to have a significant impact under the right circumstances.

Dividends are often considered a downside protection for VCs. In other words, if the company does well and has a large and favorable exit, the dividends do not have a large impact on the payout to the VCs or management. In contrast, if the company underperforms and has a less-than-hoped-for exit, the negotiated dividends are often a significant factor in determining the payout.

For example, consider the simple case of a company with a single VC investor. The VC purchases 50% of the company for a $10M investment. Although the company initially projected a $50M exit, after 5 years things are not going well and they decide to sell for $20M. If the deal includes no dividends, the VC will be entitled to $10M of the proceeds (assuming a 1X liquidation preference -see our post on this topic), and the management will get the other $10M.

Now consider the above scenario with the addition of a somewhat typical 10% dividend. In this case, the VC would be entitled to 10% of its investment, or $1M, for each year that has passed. Since it’s been 5 years, the VC gets a total of $15M of the $20M sale ($10M for the liquidation prefence and $5M for the dividends), while the management are left with only $5M.

Things can get further complicated when you consider the issue of compounding. Some dividends come with a compound rate, further increasing the amount owed to the VC upon exit. Some dividends are also payable in stock instead of cash, meaning the VC will own a larger percentage of the company the longer the exit is delayed.

So although dividends may not have a huge impact on the proceeds of a successful exit, they can have a large impact on payouts when the company exits for less than expected, or if the exit is significantly delayed.

The VC Fundraising Process: Receipt of Term Sheets

Term sheetIf you’re following along with our series of posts on the venture capital fundraising process, the next step in the process is the receipt of term sheets from prospective investors.

This is where it all starts to happen. All of the hard work you’ve put in to this point starts to pay off with the first non-binding term sheet. These can often be exploding or expiring in anywhere from 24 hours to 45 days. (This is done to minimize your ability to shop the term sheet to other investors to get a better deal.)

If your company is particularly strong, you can often overcome these provisions with confidence and the knowledge of your company’s true value. VCs don’t like to compete for a deal and they often try to strong-arm companies into accepting their term sheet. If they do this to you now before you have a formal business relationship, imagine how they will act once they have even more control over your future.

Understanding what a VC can bring to the table in a deal beyond their capital is important regardless of whether the deal is in tech or health care. A good VC can provide a network of potential partners, key employees, potential acquisitions, top-tier service providers and other key advice all “free of charge,” in return for their percentage of the company and all of the preferred terms that come with it.

In addition to legal review of the business plan/PPM, this should be the stage where more heavy involvement with your attorney should start.  Make sure to have any incoming term sheets reviewed by counsel before returning to the investor.  Trying to renegotiate a term sheet with provisions that you previously agreed to is difficult, bad form, and avoidable.

The VC Fundraising Process: Investor Follow-up and Due Diligence

phoneKeypadIf you’re following along with our series of posts on the venture capital fundraising process, the next step in the process is to follow-up with prospective investors.

The three most important words in fundraising are follow-up, follow-up and follow-up. Venture capitalists are working on a million things simultaneously, including managing the fund and their Limited Partner investors, helping their current portfolio companies and sourcing and conducting due diligence on new investments. As such, keeping their attention focused on your deal is imperative. Don’t bug them but do be consistent and regular with your follow-up.

A focused due diligence effort will not only answer all of the investors’key questions, it will anticipate most of them.Responding quickly to a due diligence list shows your professionalism and will leave the investors with a positive impression of your company.

Here’s one more piece of advice: This stage can often involve investors conducting a site visit or calling your company’s advisors or other key opinion leaders.Having a common story between your company and your advisors ensures you leave a consistent message with the investors.

The VC Fundraising Process: Management Presentation

Management presentationIf you’re following along with our series of posts on the venture capital fundraising process, the next step in the process is the management presentation.

The slide presentation and potential demo that was prepared during the pre-launch phase is now presented to the targeted VC, often at a meeting of the entire VC partnership.This first impression is critical to deal success. In other cases, the partner who sourced the deal will take the first pitch and your company will need to return to pitch the full partnership. This first impression is critical to deal success as most investors will form their impression quickly after the start.

Here are a few pointers for putting together a solid presentation:

  • Your first slide should be a list of investment highlights or an overview of the opportunity.
  • In general, don’t take 20 minutes to build up to what you actually do as a business.
  • Introduce members of the team early instead of putting that information last. Often VCs prioritize the team above everything else so it’s important to get this right and have the right people at the pitch.
  • Market opportunity should be next and should introduce why there is an opportunity for a new company or product like yours.
  • Next is the overview of product/service/data. This is where you provide the meat of the presentation.
  • The commercial opportunity section should lay out how you plan to capture revenue and market your product/service.
  • While financials are often very speculative, they are required. The fundraising plan is almost more important, at least in the short run, than the projected revenues because that is what the new investors will be “on the hook” for.

The VC Fundraising Process: Outreach

If you’re following along with our series of posts on the venture capital fundraising process, the next step in the process is to reach out to VC firms.

Reaching out to VCsThe outreach process is where the rubber meets the road. Once all of the materials have been prepared and the due diligence virtual data room is ready, you can begin to reach out to venture capitalists (VC).Depending upon if your company is using a placement agent, the outreach may be done by your banker, the CEO, CFO or another member of the senior management team designated as the point person for the transaction or for that investor relationship.Regardless of who is managing the process, the CEO will be involved in every pitch, unless the roadshow requires two teams to simultaneously conduct management meetings.

The initial outreach can be via phone or email to introduce the opportunity but any emails should be followed up by a phone call to make sure the executive summary was received and properly understood.A phone call can also help establish the initial interest and setup a management meeting.

Before sending the first email or making the first phone call, you need to establish the investment rationale behind your pitch to a particular firm and why your company is a good fit.The more tailored your pitch to a VC is, the more likely he or she will be convinced to take the meeting.

Another important point is that you must really understand the point and purposes of an initial email/first call.Your objective should be to get the VC to review your business plan/PPM and agree to listen to the management presentation (discussed next).

Trying to close the transaction at this stage is pointless so make sure your call script is oriented only towards getting the meeting.Many companies don’t make it to the management presentation so if you receive that opportunity, your odds of investment are much higher and you are in the game.