How to Raise Venture Capital: Due Diligence and Process Preparation

starting line smallIf you’re following along with our series of posts on the venture capital fundraising process, the next step in the process is to prepare your due diligence material.

This step is often skipped in the fundraising process, but the more you prepare for the offering before starting outreach, the quicker and more seamlessly it can go. However, since many companies desperately need the capital they’re trying to raise, company management often tries to jump the gun here.

One of the best pieces of advice related to raising money is to prepare thoroughly before you make the first call or send the first email.

For instance, it can take several weeks to prepare for due diligence so it is important to start preparation early. Create a virtual data room (VDR) to organize all relevant documents in a way that will make it easy for investors to conduct their due diligence.A VDR can protect the confidentiality of your company’s important data by ensuring that potential investors cannot print, save, or download the documents. Be sure to get all of your documents loaded into the VDR in advance and permissioned properly so that specific groups are able to access only the information you give them permission to see.

Keeping track of the process is also crucial to stay organized and in regular communication with potential investors. If you are not using a banker, you should consider purchasing a deal flow management tool to stay on top of the process.  Sometimes these fundraising could entail outreach to 70+ investors, which is difficult to keep straight without a tool of some kind.

Venture Capital Fundraising: Prepare a Business Plan Presentation

Present your companyIf you’re following along with our series of posts on the venture capital fundraising process, the next step in the process is to prepare a business plan and/or executive summary.

The Executive Summary is the short, non-confidential version of the business plan. It is usually the first document that is sent to prospective investors to attract initial interest in a management presentation. A private placement memorandum (PPM) is a fancy way of saying “business plan.” PPMs are generally prepared as part of a private placement using an agent.

Basically, your company needs to put together a plan for how it plans to make money; what it plans to use the money being raised for, and how it plans to return capital to its investors. Generally these documents are shared under confidentiality agreements, depending on the interest level of the investors and the sector being investigated. Life science companies generally require a CDA/NDA (Confidential Disclosure Agreement/Non-Disclosure Agreement) prior to sharing confidential data, but tech companies do not use this as frequently.

The management presentation is usually a Microsoft PowerPoint® slideshow that management presents to investors. It is usually safe to assume that an entrepreneur will have about an hour for each meeting and that the presentation will be frequently interrupted during the pitch. As such, the presenter’s prepared remarks should last no more than 40 minutes. You should also have an alternate, 20-minute version of your presentation with you in case only half an hour is available for some meetings.

As you prepare for the fundraising presentation, part of the process should be to practice in front of a friendly audience to get pointers and to help revise the message as appropriate. This “friends and family pitch” can be a big help in refining the story.

The management presentation should support the story but the presenter should not simply read from the slides. Visually, the presentation should contain plenty of white space.

The right business plan, well presented, can have a huge impact on your odds of getting funded, so doing this step well is very important.

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.

Venture Capital Terms: Common Types of Anti-Dilution Provisions

Calculating Anti-Dilution ProtectionLast week, I posted a general discussion of anti-dilution protection, and how it’s included by VCs in term sheets to help mitigate the dilutive effects of a down round. As we saw last week, while such provisions help protect a VC’s investment when a company’s valuation drops, they provide no protection for common stockholders such as founders and company management. In fact, when VCs exercise such provisions, it actually magnifies the dilution experienced by the common.

This week, I wanted to expand this discussion by describing some common types of anti-dilution protection and what they mean. In last week’s post, I said that the mechanism by which anti-dilution provisions protect VCs is by altering the price at which their original investment converts to shares, thus allowing them to purchase shares at a price lower than the originally negotiated share valuation. The new conversion price depends on the type of anti-dilution provision that was in the original term sheet.

 

Full Ratchet

Full Ratchet is the form of anti-dilution protection that most strongly favors VCs. In this type of provision, the conversion price is set to be equal to the share valuation at the current down round. For example, if a venture firm called XYZ Ventures initially invests $2M at a share price of $2 per share in a Series A, the firm expects to own 1M shares in the company at the original purchase price. Now imagine the company fails to perform as expected, and when it raises the Series B, it receives a share valuation of only $1 per share. If the Series A term sheet included full ratchet anti-dilution, then the conversion price for the Series A investment is reset to the new valuation of $1. This means that XYZ venture’s initial $2M investment will actually buy them 2M shares instead of the original 1M.

Since full ratchet protection allows previous rounds to be re-priced at the same price as any future down rounds, it effectively prevents any dilution to the protected VCs. It is essentially a “low price guarantee” for VC firms, since it allows their original investment to purchase shares at the lowest price offered at any point in the future. Conversely, it is the least favorable provision to common shareholders, since it leads to the greatest number shares outstanding, and therefore the greatest degree of dilution of the common.

 

Weighted Average

Weighted average anti-dilution is less extreme than full ratchet, in that it reduces the conversion price of previous rounds, but does not set the conversion price equal to the price of the current down round. Thus it reduces the dilution experienced by protected investors in previous rounds, but does not eliminate the dilutive effect of a down round. The idea behind the weighted average is that the reduction in conversion price is computed as a function of the percent of the total shares outstanding that are owned by each investor. In this way, investors that own a larger percentage of the company receive greater protection from weighted average of provisions.

There are two sub-types of weighted average protection. Broad based weighted average calculates the total shares outstanding by including all preferred stock, common stock, as well as unexercised securities such as employee stock options. Narrow based weighted average includes only those shares which are currently outstanding, and excludes unexercised options. Thus, the narrow-based calculation is a little more favorable to VCs since it assumes a larger percent ownership, and thus a larger adjustment of the conversion price, for each investor.

 

Summary

  • Anti-dilution protection protects VCs by re-pricing their original purchase of shares at a down round.
  • Full ratchet protection effectively eliminates dilution of protected VCs at a down round by setting their conversion price to the share price of the down round.
  • Weighted average protection is less favorable to VCs than full ratchet, since it reduces the conversion price, but does not set it equal to the current valuation.
  • Anti-dilution provisions are most favorable to VCs lead to the greatest dilution of common stockholders if a down round occurs.

Venture Capital Terms: Anti Dilution Protection

Anti-dilution: planning for a rainy dayNegotiating a venture capital financing is often difficult for those not familiar with the meaning of some common VC deal terms. Share price and liquidation preference are among the most sensitive terms when determining the value of equity held by VCs and company founders. In comparison, the inclusion of anti-dilution protection in a deal has the potential to exert nearly as large an effect on returns, but is generally much less well understood, particularly by first-time entrepreneurs seeking funding.

I therefore thought I’d use this post as an opportunity to introduce the basics of anti-dilution provisions and what they mean to VCs and common stockholders. I will discuss some common types of anti-dilution protections in a follow-up post next week.

 

What is dilution?

Broadly speaking, dilution occurs anytime new shares are issued in a company. For example, if a particular stockholder owns 100 shares in a company that has 1,000 total shares outstanding, he owns 10% of the company. If an additional 1,000 shares are later issued, the stockholder is diluted since he now owns 100 out of 2000 shares, or 5% of the company.

By the above definition, dilution occurs every time a new financing occurs. When VCs make an investment, they purchase shares which are issued at the time of the financing. This dilutes the percent ownership of all existing stockholders, since new shares are issued. However, if all goes well and each round of financing is accompanied by an increased share valuation, the reduction in the actual percent ownership for each stockholder is more than offset by the increased value of each share.

If, on the other hand, the company experiences a “down round”, i.e. a round of financing that comes with a reduced valuation compared with the previous finance round, the dilution causes a reduction in the actual monetary value of each shareholder’s equity. To protect themselves from this eventuality, VCs often include anti-dilution protections in term sheets.

 

Who is protected and how?

The first thing to realize about anti-dilution protections is that they protect the preferred stockholders from previous rounds in the event of a down round, but do not protect company founders and other common stockholders. In fact, when a VC exercises his anti-dilution rights, it actually causes additional dilution to common stockholders.

The basic mechanism by which VCs are protected by anti-dilution provisions is that the conversion price (the price at which their original investment is converted to shares) is reduced. The actual amount by which the conversion price is reduced is determined by the type of anti-dilution protection in the term sheet, but the basic effect is that the VC gets to purchase shares at a lower price than the original purchase price. So although this helps offset the dilutive effect on the protected VCs, it leads to additional shares outstanding, and therefore magnifies the dilutive effect of the down round for all non-protected shareholders such as company founders and management.

Anti-dilution protections become an even more important factor in a down-economy. Anyone negotiating a term sheet in the current economic climate must carefully consider the anti-dilution protections included. Down rounds have become increasingly common as companies struggle in a more difficult market, so anti-dilution protections are more relevant than ever.

 

Summary

  • All shareholders are diluted whenever new shares are issued, but as long as share valuation increases with each finance round, the dollar value of everyone’s equity stake still increases.
  • In the event of a down round, VCs can exercise their anti-dilution protections which help offset the dilutive effect for the VC.
  • Anti-dilution protections only protect preferred stockholders, and actually lead to additional dilution of common stockholders at a down round.

Venture Capital Fundraising Made Easy

For a first time entrepreneur or even a veteran of several startups, raising venture capital is one of the hardest tasks to do properly.  It is enormously time consuming and can be a major distraction from the execution of your business objectives.  It is often a necessary step in a company’s life cycle to accelerate development, improve sales, and realize a successful exit. Venture Capital Fundraising Made Easy Much has been written on this subject but there are few guides that work through the process, step-by-step from the perspective of a recovered investment banker.  So what are some things that can be done to improve this process and get the best deal possible?

This venture fundraising blog series will discuss the financing process, which if done properly, will ensure a well-run process and hopefully competitive term sheets for your company.

The process can easily be broken down into the following 10 steps:

  1. Kickoff Meeting and Division of Responsibilities
  2. Business Plan/Private Placement Memorandum and Management Presentation Preparation
  3. Due Diligence Preparation
  4. Initial Outreach
  5. Management Presentation
  6. Investor Follow-up and Due Diligence
  7. Receipt of Term Sheets
  8. Negotiation of Term Sheets and Build Syndicate
  9. Draft and Negotiate Legal Documents
  10. Deal Close

These steps are not discrete and are often represented differently or in a different order depending on someone’s perspective.  That said, all of these must be followed via a structured process to be successful.  We will go into greater depth on each of these in subsequent posts.  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: The Importance of Liquidation Preference

Liquidation Preference: Who gets paid what?As many entrepreneurs discover when they first begin to seek venture capital funding, VC term sheets can be very complex. Naturally, each term in a proposed deal is subject to negotiation, but it is not always clear which terms have the greatest impact on the company’s shareholders.  I therefore thought I’d highlight one extremely important but often misunderstood deal term: liquidation preference.

Although liquidation preference is nearly as important as share price in determining the value of equity held by a company’s founders, management, and VCs, it is often overlooked by entrepreneurs during negotiation because it is unfamiliar to those who have limited experience with venture capital.

 

What is liquidation preference?

So what is liquidation preference, anyway? Liquidation preference determines the order in which the various shareholders of a company get paid upon the liquidation of the company. When venture firms invest in a company, they generally purchase preferred stock, which means they get to redeem their shares before common stockholders like founders and company management.

The exact amount VCs get to collect as part of this preferred payout is determined by the preference multiple, which is a multiple of the original purchase price. For example, if a VC firm purchases preferred stock with a 2X liquidation preference, then they have the right to get paid double their original investment before the common stockholders get paid anything. It is not difficult to imagine that this preference might be extremely important under the right circumstances. For instance, if a VC has invested $10M with a 2X liquidation preference, and the company sells for anything less than $20M, then the common stock held by founders and management becomes worthless – the VC collects the entire exit proceeds.

 

Participation

Another important aspect of liquidation preference is participation. Many term sheets grant VCs the right to participate with common shareholders pro rata (i.e. proportional to the percent of the company they own) even after they have been paid their preference multiple.

To illustrate what this means, let’s continue the example above. Suppose a VC has invested $10M in a company, with a 2X liquidation preference. Let’s imagine that the VC owns 80% of the company’s shares, the remaining 20% are retained by common stockholders at the company, and the company sells for $25M.

Without participation, the VC gets paid $20M (its 2X liquidation preference), and the remaining $5M is paid out to the common stockholders. In that case, the common receives 20% of the exit proceeds, as might be expected from their percent ownership. If the VC’s preferred stock has participation rights, however, then the leftover $5M is split 80/20 ($4M / $1M) between the VC and the common. So even though the common stockholders own 20% of the company’s shares, they will actually receive only $1M of the $25M sale!

To limit the benefit received by VCs from participation, some term sheets contain a “cap”, a multiple of the original investment at which VCs no longer get to participate until they let the common “catch up” to their ownership percentage. Such caps benefit the common by allowing them to be paid their full ownership percentage, but this requires the company to sell for an amount higher than the cap in order to be effective.

 

Summary

  • Liquidation preference has a potentially huge impact on the payout to common stockholders, and should not be overlooked during negotiation.
  • Term sheets with higher preference multiples and participation rights favor VCs.
  • Those with lower multiples and no participation (or capped participation) are more favorable to the company.