Venture Deals - Spring 2023 Course

Levelling the information playing field between founders and venture capitalists

1. Capital Ecosystem

Recently, I've been learning about venture capital financing. I wanted to understand how founders can be better prepared when fundraising. The Venture Deals course was designed to level the information playing field between founders and venture capitalists, making it an optimal starting point for my studies.

Brad Feld, the cofounder of Foundry, Techstars, and Venture Deals, and Jeff Harbach, CEO of Kauffman Fellows, created this course, and the following venture capitalists contributed their insights and opinions:

• Elliott Robinson, Partner, Growth Equity at Bessemer Venture Partners

• Miriam Rivera, CEO and co-founder at Ulu Ventures

• Nicole Glaros, Venture Capitalist, Entrepreneur, and Board Director

• Jaclyn Hester, Partner at Foundry

Brad originally wrote a book called Venture Deals with Jason Mendelson.

Course Structure

The course consists of 5 parts:

• Lesson 1: The Capital Ecosystem, Investor Engagement, and Best Practices

• Lesson 2: Preparing to Fundraise, How a VC Works, Valuation, and Cap Tables

• Lesson 3: Term Sheets and Negotiations

• Lesson 4: Diversity, Equity and Inclusion in Venture Capital

• Lesson 5: Mental Wellness

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The Capital Ecosystem, Investor Engagement, and Best Practices – 8 takeaway points

The key players in the capital ecosystem

• Institutional Investors. They are known as Limited Partners (LPs) and act as the source of funds.

• Venture Capitalists. They are known as General Partners (GPs), and they raise funds to invest in companies.

• Corporate Venture Capitalists. Typically, large companies earmark capital for venture deals.

• Accelerators/Incubators/Studios. As their names suggest, they nurse startups and get them up and running. They provide introductions to investors and are often the source of early financing.

• Angel Investors. Angels are typically high-net-worth individuals and sometimes were even founders themselves. They most often invest at the earliest stages.

• Entrepreneurs/Family/Friends. Many companies get off the ground with the help of family and friends.

VCs make money when...

A portfolio company has a liquidity event. A liquidity event could be a sale, merger, or initial public offering (IPO). The fund will return that capital to investors, and the VC will keep their share. This description is intentionally simplified. To explore this further, see The Basics of Venture Capital Fund Distributions.

VC is a high-risk form of financing, and not all portfolio companies return capital to the VC. This fact means that VCs must seek out companies with tremendous growth and disruptive potential because those investments generate massive returns for the VC fund. It pays to be bold in your vision when pitching VCs.

Building human relationships with VCs is important (surprise!)

Most founders would say this is obvious, but I've seen startups violate this repeatedly. This usually occurs because of the startup being in a rush for cash, or the founders lacking prior relationships with VCs, or inexperienced founders not knowing how to raise funds.

Investors "invest in lines, not dots." To summarise this principle, speak to your potential investors early. Imagine the investor wants to plot you on a graph. If you reach out only when you're ready for investment, they can only assess you based on that one data point. Conversely, if you forge a relationship earlier, the investor can plot your progress on a graph. This approach will give the investor several data points to assess your growth and delivery ability.

When your company draws up a prospective investor list, target individual VCs at firms and consider creative ways your founding team can form bonds with them, like common schools attended, similar hobbies, or both belonging to an underrepresented group. Find a piece of content they've published that you can reference when you do connect with them. Work your own network to find people who know the VC. Don't know someone who knows them? Form a relationship with someone who knows them. Aim to find at least two people per VC, one who can make an introduction and another who can follow up for you later.

Engaging with investors is like dating, emphasising a human relationship, authenticity, honesty, and delivering on commitments. Handling rejection well can still lead to future opportunities.

When fundraising, your objective is to achieve a yes or a no quickly from an investor

Watch out for the 'maybe' investors. Many investors will say maybe because they don't gain anything from rejecting you early on. They might want to see if there is interest from other investors before they decide (FOMO runs strong in the world of VC!), which can slow down your process. Once you have established a relationship with the VC, get to a yes or no quickly.

Choose a lawyer who has experience with venture capital deals.

This approach will save you time, cost, and headaches, and your investors will also thank you! When an inexperienced lawyer raises objections or clarifications about perfectly standard clauses in financing documents, it can frustrate all parties. The VC-experienced lawyer will also know how to protect your interests during the deal.

65% of startups fail due to team issues

Research by Dr Noam Wasserman, formerly of Harvard Business School, indicates that 65% of startups fail due to team issues. VCs will naturally want to explore your team and its dynamics. How do you work together? Where are your strengths? What about weaknesses? How aware are you of these issues?

Spend some time researching common reasons why teams fail. In particular, why cofounders fall out. You will spend a lot of time with your co-founder and endure periods of high stress and tension, and it's a relationship which needs to be nurtured and maintained.

Preparing to fundraise requires good planning

The company's story is essential. What's your pitch? VCs are thinking about the growth potential of your company. Would you be a good steward of their capital? What are the risks within your business? Who are your competitors? Is your market growing or shrinking? What does your team look like?

Keep the above questions in mind when assembling your pitch deck. If you think about risks and opportunities within your business, your pitch deck will address the most pertinent investor questions.

Use a spreadsheet, CRM, or pipeline software to track your fundraising process. I've created a template prospective investor spreadsheet based on the one shown in the course.

Divide the investors into three groups: A, B, and C.

• Group A contains your dream investors, offering capital and deep expertise. These investors can massively influence your chance of success.

• Group B includes investors who can only offer you a little beyond their money.

• Group C is the 'we are desperate and will take anything' group.

Pitch to your group B investors first. Start at the very bottom of your group B list. The benefit of pitching to group B investors first is that you'll learn as you go. You'll understand common questions and how best to respond to them. You can use this information to refine your pitch and your conversational style.

Once your group B is exhausted, go to your group A list.

If groups A and B get you nowhere, go to group C, but if you reach this stage, there may be an issue with your company that needs to be addressed. Check the feedback you've received to date and look for themes. You'll probably need to address recurring issues before completing a successful fundraise.

If you follow a structured process when identifying and contacting VCs, you'll end up with the right investors and waste less time.

Do what you say you're going to do

Nicole Glaros placed a massive emphasis on this point. She explained that often, founders say they will do something by a specific date and then don't deliver on that date. It could be as simple as replying with some data. Even if you don't have the information you thought you would have by that date, send an update and offer a revised timeline.

Take no well

There's a range of reasons why your particular company might not suit a venture capitalist right now. Many of those reasons are not in your control. Maintain good relationships and take a ‘no’ well; that venture capitalist might invest in you at a future point.

2. Preparing to Fundraise

Preparing to Fundraise, How a VC Works, Valuation, and Cap Tables - 7 takeaway points

Think seriously before raising venture capital.

7/10 venture-backed companies fail. The odds are not in your favour! Discuss with your cofounders to decide if venture capital is the correct financing for your company. Raising venture capital can distract you from building a profitable company and introduce new external pressures on your team.

If you decide to fundraise, understand what venture capitalists will consider about your company. VC funds typically want to return 3-5x on the money they borrow from their investors. If 7/10 of their investments never return capital, then the math is such that a minority of companies within the fund need to produce exceedingly large multiples. Ask yourself:

• Could we generate a 10x+ return for investors?

• What's our exit strategy?

• How long will we be in this company?

VCs must see tremendous growth potential, an exit strategy, and a realistic liquidity timeline.

Think like an investor

When an investor reviews your company, they are looking at several things:

• What are the risks and opportunities associated with your company?

• Investors "invest in lines, not dots."

• Does this investment opportunity suit me/my fund right now? Experienced fundraisers will speak with venture capitalists about their fund's lifecycle. It's okay to be direct about this. For example, a typical VC fund lifecycle is ten years. There will be a specific investment period, usually five years, followed by a support period in which they help the portfolio companies to flourish. I've left out some of the nuances here for brevity. The key takeaway point is to ask the fund about its lifecycle.

• Will this team be good stewards of the capital we provide?

Understand how a VC firm makes money

Typically, a VC firm makes money in two main ways:

1. Management fee - The annual fee charged by the VC. Usually, it's around 2% of the capital committed within the fund.

2. Carried interest (carry) - The percentage of profits the VC keeps, usually 20%.

Carry is the main thing a VC is interested in.

10-20% of investments will generate 80-90% of the fund's returns.

Understand the typical VC fund lifecycle

Some key definitions:

• Fund life - The duration of the fund. Typically, ten years with a two-year extension (at the discretion of the VC).

• Investment period - when the funds get deployed. Typically 2-5 years.

• Therefore, if a fund is in its fifth year or later, it might not have funds to invest in new companies.

• Vintage year - The year the fund first deployed capital.

• Dry powder - The remaining money in a fund.

Experienced entrepreneurs will ask a VC about the vintage year and how much dry powder remains. This information helps the entrepreneur to understand if this fund could commit additional capital when the company needs to raise capital next.

On the topic of valuation...

Many early-stage companies delay the valuation conversation by issuing convertible notes, often with a cap. You can learn more about this over at YCombinator's Documents page.

Before going out to market, look at similar companies to gauge their valuations. Your valuation will likely be a product of how much you want to raise, how much dilution you will tolerate, and how much your investor needs to own.

Brad Feld says that a Series A investor typically looks for 15-20% of the company. He recommends having valuation conversations early on with your handful of suitable investors. Explain to them that you want to raise X for Y% of the business and ask if that fits with them. Brad also recommends asking whether the valuation you're receiving is pre- or post-money. Not asking the investor and misunderstanding this concept can trip up founders.

Don't lie to VCs about offers you've received because it's an interconnected industry, and information flows between different venture capital firms when they want to test your claims.

If you are lucky to obtain multiple term sheets, sit down with your other founders and consider the pros and cons of each investor. Measure their values and decide what fits best with your company.

Know thy cap table

A cap table lists which entities own what of the company. You could make it in Excel or use software tools provided by companies like SeedLegals.

Investors want to see your cap table to ascertain how much of the company you own and whether you have an employee options pool to incentivise and attract staff.

Founders commonly make mistakes about whether a valuation is pre- or post-money. Consider the following example:

• $10m valuation

• $5m investment

• If this is a post-money valuation, the $5m bought the investor 50% of the company.

• If this is a pre-money valuation, the $10 + $5m = $15m and the $5m bought the investor 33% of the company.

• Always ask if a valuation is pre- or post-money!

Modelling your future cap table can also help to avoid simple misunderstandings.

Keep your cap table clean.

When you're fundraising, investors will want to see your cap table because it gives them an idea of your company's ownership structure. The investors will look for many key things; having a clean cap table is ideal.

A clean cap table refers to the following:

• The number of investors. Sometimes, a startup could have many angel or crowdfunding investors. Lots of investors can create a headache and a time overhead.

• No bad debts.

• No toxic convertible notes, defined as one in which an early-stage investor ends up with a disproportionately large amount of your company.

• No investors holding shares with much better rights than others (e.g. liquidation preferences)

• Preferably no ex-founders who left and still own a sizeable amount of the company

3. Term Sheets and Negotiations

Term Sheets and Negotiations

Term sheets include three main types of terms, which relate to:

1. Economics

2. Control

3. Other

Economic Terms

Founders tend to focus on the headline price/valuation, but several other terms adjust the valuation. Let's consider each:

Employee option pools

Many investors will insist that you have an unissued employee option pool in the deal. Consider two scenarios:

£10m pre-money valuation - 20% option pool = £8m pre-money

Compare this to asking for the 20% option pool post-money; your valuation would now be £12m.

£10m pre-money valuation + 20% option pool = £12m post-money.

Always determine if a valuation is pre- or post-money. Similarly, if you have already issued some options, ask the VC if the 20% option pool will include the already issued options.

Warrants

If your company has issued an investor a warrant, ensure this is accurately recorded on your cap table. Warrant issues often arise when lawyers go through the fundraising details. If you didn't disclose the warrant to the investor, you, not the investor, will likely suffer the additional dilution.

Liquidation Preferences

When you issue a liquidation preference, you give an investor preferred stock with particular characteristics. This will alter the eventual payouts received during an exit. It's vital to understand the implications of liquidation preferences. To learn more about the different types of liquidation preferences, see: What is a Liquidation Preference? and Beware of the Trappings of Liquidation Preference.

Vesting

Getting founder-to-founder vesting right from the start is critical. Don't avoid difficult cofounder conversations at the beginning of your company because those conversations will only become more complex with time. A vesting agreement gives each founder some level of protection if another founder does something unexpected. A standard vesting schedule is 4 years, either annually, quarterly, or monthly.

Brad Feld gives an example of 3 founders he invested in who said they were committed to working together forever. He tried to argue why they should sign a vesting agreement, and they were suspicious that he wanted it to ease one of them out. Brad liked them and said, “don't worry about the vesting.” Within one year, one founder fired another; within two years, another founder was no longer active in the business. All three founders had the same stock, and one of the founders working on the company was frustrated by the value increases that the other founders were receiving.

Key lesson: Founders should protect each other from themselves by having vesting.

Redemption Rights

An investor with redemption rights can insist that the company pay them a certain amount for their shares after a particular time. This is to protect the investor when a company isn't moving towards an exit.

Anti-dilution protection

Whenever a company issues new shares, the existing shareholders are diluted. This is fine when the company's valuation is increasing, but if the company has to raise funding at a lower valuation, then existing investors will want protection. This is where anti-dilution comes into effect.

This impacts your valuation because you'll need to give existing shareholders with anti-dilution protection more shares, which changes the economics of the valuation you received from the new investors.

Ask your lawyer about anti-dilution protection clauses in your term sheet and look out for and avoid at all costs full-ratchet anti-dilution, which is hugely dilutive because it, in effect, reprices your new round at your old round's price.

Remember that you never know when the market conditions will change. Even if your company is growing well, a future fundraise could be at a lower valuation for reasons beyond your control. Protect your interests!

Control Terms

Founders often mistakenly believe that they control the company if they own 50% or more. In reality, the control terms can dramatically change who has the power within the company.

Here are some key ways that control within a company can be altered:

Board of Directors

The board is ultimately responsible for the company's management. Aim to have other non-financial directors on your board, even at an early stage.

Broadly speaking, there are three main types of directors:

1. Common stock directors (including founders and the CEO)

2. Investor seats (one or many)

3. Independent directors

Investors will tend to add a financially-minded director per investment round. Brad Feld coauthored another book entitled Startup Boards: A Field Guide to Building and Leading an Effective Board of Directors, which addresses board composition. One noteworthy point is to add an independent director for every investor director who joins your board in a new round.

Configuring your board of directors to be diverse and have the right people on it will be good for business, especially if your board represents the same diversity as your customer base.

Protective Provisions

If these provisions exist, you have to get consent from your investors to do certain things. This changes the control dynamic within the business, so pay careful attention to protective provisions. You want to avoid overly burdensome ones. For example, some standard protective provisions include:

1. Preventing the company from changing the stock without the investors' consent

2. Preventing the company from selling without the investors' consent

3. Prevent the company from taking on debt that would have seniority over equity investments

Some bad protective provisions which could slow down your company and lead to strange power dynamics might be:

1. An investor needs to approve all commercial transactions.

2. An investor can veto the decisions of the majority.

Drag Along Rights

A term to describe a situation where you would vote your stock in alignment with the majority. It allows a class of investors to 'drag along' other investors.

Like founder-to-founder vesting, drag-along rights seem undesirable to founders initially, but make a lot of sense. For example, imagine a founder leaving a business on bad terms and having considerable company equity, and they could hold up decisions due to the size of their shareholding. Drag-along rights would prevent such a situation.

Conversion Rights

This allows investors to convert preferred stock into common stock. You can have optional and mandatory conversion rights. A mandatory conversion right would be a situation like an IPO, when all preferred stock converts into common stock. An optional conversion right might arise when it's more advantageous for an investor to own common stock than preferred stock, for example, when there is a low liquidation preference multiple, and the company sells for a high valuation.

Other Terms

Focus mainly on the economic and control terms. There are some other terms on a term sheet which are noteworthy:

Dividends - Aim for non-cumulative rather than cumulative. Cumulative is more common in PE deals, whereas non-cumulative is in VC deals.

Information Rights - Often, there's a threshold to determine access to company information. If you have a lot of smaller investors, you might want to grant them a different level of information access than your leading investors.

Rights of First Refusal - Grants existing investors the right to invest in the next round. A simple pro-rata right is perfectly reasonable.

Voting Rights - Check with your lawyer that these are boilerplate to avoid situations where an investor can have an unfairly disproportionate voting voice.

No-shop Agreement - This exists to prevent the founders from taking that term sheet elsewhere to try and get a better deal. It gives the investor confidence that you're acting in good faith and willing to do all you can to make this deal happen with them.

Remember, working with VC-experienced legal counsel will save you time and hassle. They will help you to identify and push back against abnormal terms. It will also show your investors that you take negotiations seriously.

Negotiations

There's an asymmetry for founders going into a venture capital financing negotiation. The VC has likely done this many more times than the founder!

Three key things to remember:

1. Make sure the VC feels heard and understood. Use basic mirroring or rephrasing to achieve this.

2. Listen more than you talk.

3. Always have a next step.

Be Prepared with your Best Alternative To a Negotiated Agreement (BATNA)

Establish with your cofounders what your BATNA is, and be clear about the terms that matter to you. Your BATNA represents the most advantageous alternative you can take if negotiations fail. If you negotiate without knowing your BATNA, you'll likely get pushed in a direction that makes you unhappy later.

Understand who you are negotiating with

This conversation is ultimately about people. People have different motivations and self-interests. What motivates and excites the people you're negotiating with? What personality type do they have, and how does this impact their negotiation style? Try and figure this out during the fundraising journey with them.

4. Diversity, Equity and Inclusion

During this lesson, six different VCs offered their perspectives on DE&I and how it influences their investing decisions:

Brad Feld

Brad's key point is that during the process of learning more about diversity, equity and inclusion, he often made mistakes about how he referred to certain things. He used to feel guilty about this, but realised that these moments are necessary if you really care about building a diverse, equitable and inclusive company. Reframing those moments as valuable learning steps on a work-in-progress pathway can be helpful.

Elliott Robinson

Elliot's key point is to remove this outdated idea of cultural fit and replace it with values fit. When hiring new team members, think about their cultural add. You want to expand your company's access to novel ideas and opinions. If you start with diversity from the beginning, those roots and foundations will expand. DE&I isn't just marketing; it's superior business practice.

Miriam Rivera

Diverse teams perform better because they draw on different life experiences. When you systematically overlook communities, you miss out on markets and opportunities. The same is true for a company. A diverse team will understand the needs of a broader range of customers.

Nicole Glaros

When we can lean into our differences as competitive advantages rather than weaknesses, we bring a diversity of thinking to the table. We can build better businesses that way and a more equitable society for everyone. Use your diversity strengths to strengthen the room.

Jaclyn Hester

Diverse perspectives lead to more informed decision-making.

Jeff Harbach

The entrepreneurs who will solve the world's greatest problems in the 21st century will likely be the same people who have experienced those problems.

5. Mental Wellness

Mental Wellness - Guidance from the Teachers

• Do your part to reduce the stigma around mental health.

• Being a founder is challenging; don't suffer in silence.

• Stress and anxiety with no end in sight are not good things. Some stress can be good, for example, if you are working to push your limits slightly and then following that up with some time to rest and recover.

• Being a CEO can be lonely because you have to choose what you share with different people at the company. Your positivity and mental well-being also set a tone for others. Miriam tries to be vulnerable at work to make it safer for others to do the same.

• Success is hard. Build tools and systems of support for your mental well-being during difficult journeys.

• Sometimes it can be helpful to join communities where you can connect with others and share stories.

• If you are working remotely, getting together occasionally with your team can help build empathy.

And finally...

Think of your uniqueness as your competitive advantage. Shed yourself of the individuals who don't allow you to do that.