Monthly Archives: February 2012

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.