Monthly Archives: June 2011

Venture Capital Fundraising: Kickoff Meeting

Kicking things offIf you’re following along with our series of posts on the venture capital fundraising process, the next step in the process is to hold a “kickoff” meeting.

Any good process needs a formal beginning and end. The organizational meeting—as many placement agents call it—gets all the people involved with the transaction on the same page. All roles and responsibilities should be sorted out at this meeting and you should formalize the timeline for the transaction and who should be doing what by when.

 

Who should attend these meetings?

  • Company management team
  • Banker or placement agent (if applicable)
  • Lawyer (potentially by phone)
  • Accountant (potentially by phone)

Often companies put together a fundraising plan and run it past their board of directors before starting the process. Sometimes companies establish a fundraising/transaction committee with a subset of board members who will keep in closer contact with the process than the broader board. (This is a good idea so that you don’t get more cooks than the kitchen can hold.) The level of communication with the board is generally established here and it’s important to have a clear expectation of how this communication will work.

Venture Capital Terms: Warrant Coverage

Warrant CoverageLast week I posted a short description of some common terms that are used to describe a company’s valuation on a venture capital term sheet. While everyone who negotiates a term sheet is likely aware of the importance of valuation during the negotiation, many other terms have a large impact on the deal and yet are often overlooked by entrepreneurs raising capital.

When a term sheet includes warrants issued to investors, the equity held by entrepreneurs and other common stockholders at the company will be further diluted. Therefore, the effect of warrant coverage should be carefully considered while negotiating the terms of a venture financing.

What is warrant coverage?

Warrants are additional shares that are issued to VCs on top of the shares they purchase with their invested dollars. The issued warrants typically carry the same terms and privileges as the purchased shares (e.g. liquidation preference). The warrants that are issued as part of a financing can be expressed as a flat share count, but they are often expressed as a percentage of the purchased shares, called warrant coverage. For example, if a VC invests $1M in a company at $1 / share, they will purchase 1M shares. If the terms of the financing include 30% warrant coverage, the VC will also receive an additional 300,000 shares in the form of warrants.

The effect of warrant coverage

As described in my last post, valuation is, and should be, a main focus of any term sheet negotiation. Even if a company is able to negotiate a favorable valuation, the benefit can be largely offset by other terms. Warrant coverage is no exception to this rule. For example, suppose a VC initially proposes a $5M pre-money valuation. The company pushes back, and eventually manages to get the investors to accept a $6M pre-money. This means that if the VCs invest $5M, they will own only about 45% of the company, rather than the 50% they would own at the originally proposed pre-money.

However, even with the $6M pre-money, if the term sheet includes 20% warrant coverage, then the VCs will effectively receive 20% more shares than were actually purchased with their investment. Thus, even though they invest only $5M, they will receive $6M worth of shares. Including the issued warrants, the VCs will own 50% of the company, effectively negating the benefit from the negotiated $6M valuation.

Summary:

  • Warrants are shares that are issued on top of those purchased by VCs during a venture financing.
  • Warrant coverage can offset the effect of a negotiated valuation.

Venture Capital Fundraising: Get the Right Team and Advisors in Place

Team meetingAn entrepreneur needs to have the right team in place, and this step must be done even before starting the venture fundraising process.   A fully formed management team is not always a requirement depending on the stage of the company in question.  Generally the later the stage of the company the more fully formed the management team expected.

In addition to the management team, the selection of advisors is critical to deal success.  Choosing the wrong banker or wrong attorney can cost a company significantly more money, end in a much lower valuation, take a lot more time, or a combination of all three.  Some items to consider:

 

Bankers:

  1. Number of deals.  Many people fixate on how many deals a banker has completed.  Doing a lot of deals likely means that they have a big team and often a large support system doing most of the execution.  When a banker is spread too thin, there is only so much time he/she can dedicate to your deal.  League tables are largely irrelevant.  Not completing enough deals is equally worrisome as it makes you wonder how effective they really are.
  2. Deal team.  The corollary to the number of deals is how involved the senior bankers are.  The most successful deals are led by experienced senior bankers who play an active and material role in the transaction.
  3. Network.  Any banker worth their salt has a good network and knows the investors/venture capitalists who might invest in your deal, sothis is rarely a differentiator.
  4. Cost.  Most bankers charge 6% for a capital raise depending on the size of the transaction and many get warrant coverage.  This should not be a differentiator, since if they do a good job, the cost will be offset by a better valuation.

 

Attorneys:

  1. Number of deals.  The number of transactions completed by an attorney is important; too many deals over too short a period of time makes you question how much time is dedicated to each deal; too few deals demonstrates a lack of experience.
  2. Fixed fee arrangement.  This is generally a good idea in many circumstances, since itallows the entrepreneur to know upfront what the costs for the transaction will be.  The firm’s willingness to offer a fixed costshould be a prerequisite.
  3. Relationships.  Familiarity with the potential investors, potential investors counsel, and the specific deal type in question are all important.  Working with a no-name might save money, but also might cost additional hours of negotiation frustration.
  4. Positive references.  Check references before you hire an attorney.  Make sure that you interview at least 3 prior to making a decision.

 

Please leave a comment or email me if you have any thoughts or things that we should include.  Have you had a different experience than this?

Venture Capital Terms: Valuation

Purchase priceA company’s valuation at the time it receives venture capital financing is probably the most important factor influencing the outcome of a deal. Although some semi-quantitative methods for valuing a startup company are used, the valuation is largely a product of negotiation between the company and the investors. If a VC can negotiate a smaller valuation on a term sheet, it means they can purchase a larger percentage of the company for their investment.

Although multiple terms exist for discussing a company’s valuation, they are all derivable from one another, and are thus really just different ways of expressing the same underlying valuation.

 

 

  • Price per share: The price per share is perhaps the most familiar valuation term to those used to dealing with public companies. As in the stock market, the share price is the price paid by the VC for each share purchased. Thus, the number of shares purchased by a VC can be computed as the amount of the investment divided by the price per share.
  • Pre-money valuation: The pre-money valuation is defined as the value of the company prior to the financing. It can be computed as the price per share multiplied by the number of shares outstanding before the current round of financing.
  • Post-money valuation: The post-money valuation is defined as the value of the company after the current round of financing. It is calculated as the pre-money valuation plus the amount invested in the current round.

 

How the terms are related

It should be clear from the above definitions that these three valuation terms are very closely related, and have a very important impact on the deal’s outcome for the VCs as well as the common shareholders. For example, suppose a company has 1M shares outstanding and is raising a series A. Let’s further suppose that the VCs are investing $4M.

At a negotiated share price of $1, the investors will purchase 4M shares. This means that the investors will own 80% of the company (4M out of the total outstanding 5M shares). It also means that the implied pre-money valuation of the company is $1M (1M shares outstanding before the financing times the $1 share valuation). The post-money valuation in this case would be $5M: the $1M pre-money valuation plus the $4M investment.

Now suppose that instead of the above $1M pre-money valuation, the company successfully negotiates a $2M pre-money. This means that the price per share is $2 (1M outstanding shares before the financing, valued at $2M). It also means that the $4M VC investment will only buy 2M shares, or roughly 66.7% of the company.

 

Summary

  • The negotiated valuation on a VC term sheet has a huge impact on the deal value for the investors and the common stockholders.
  • There are multiple ways of expressing valuation (pre-money, share price, post-money), but they all express the same underlying company value.