Summary

Venture financing is a game of economics and control, and the term sheet is where the rules get written. Pre-money valuation, option pools, liquidation preferences, and anti-dilution provisions determine who gets paid and how much — everything else is negotiation theater. The players range from micro VCs with under $15M to late-stage firms managing billions, each with different incentives and timelines. Smart founders come prepared with an option budget, understand the difference between participating and non-participating liquidation preferences, and know that creating competition among 3-6 VCs over months is the primary fundraising strategy. Board composition, protective provisions, and drag-along rights determine control — and control matters more than valuation when things go sideways.

Key Takeaways

Notes

1: The players

• VC roles:
  • MD / GP: actually invest (founding)
  • Partner: junior, blanket term
  • Principal, director: need GP help
  • Associate: works for partner
  • Analysts: due diligence etc.
  • EIR: intros, due diligence, rights
• Nomenclature:
  • Pre-seed, seed, A: early stage
  • B-D (1, 2 etc.): mid-stage
  • E+: late stage
• Types of VC firms:
  • Micro VC: single GP, <$15M
  • Seed fund: 1st board member, <1$50M
  • Early stage: up to B, $100-300M
  • Mid stage / growth: B+, $200M-1B
  • Late stage: also PE, hedge funds, etc.
• Angel investor: individuals
  • Super-angels: micro VC
• Syndicate: collection of investors
  • Also all investors in your company
• Lawyer: experienced, handles finer points
  • Skyrockets if lawyers don’t get along
  • Cap fee before starting negotiations
• Accountant: only for later stage
• Banker: only for late stage ($50M+)
• Mentor: free help

2: Preparing for fundraising

• Choose the right lawyer:
  • Experience, cost, comm style
  • Efficiency > cost
• Delaware LLC
• Be proactive about record keeping
• IP: patents, copyright, trade secrets etc.

3: How to raise money

• Exude confidence
• Determine amount: time to MVP x burn rate
• Fundraising materials:
  • Elevator pitch
  • Prototype or demo
  • Executive summary
  • Pitch deck (10-20 slides)
  • Business plan (30+ pages)
  • PPM, financial models
• Due diligence
• Finding VCs: use reviews from friends
  • Ask for references
  • Lead vs slow VCs
• VCs have different funnels
• Create competition: 3-6 months
  • Never say who you’re talking to

4: Overview of the term sheet

• Term sheet: relationship with VC
• Two factors: economics and control

5: Economic terms of the term sheet

• Pre- and post- money valuation:
• Fully diluted: all outstanding stock vested
• Option pool: incentive for new hires
  • Early stage: usually 10-20%
  • “On issued”: not including already disbursed employee options
  • Come in with an option budget, listing anticipated hires and option grants, to prevent high upfront options pool
• Warrant: option to buy series X stock at agreed upon price for certain period
  • Instead, negotiate lower pre-money valuation
  • Bridge loan: convertible debt investment, waiting for other investors
  • Convertible debt: converts into equity after next round is raised (20% disc.)
• Early investors: help negotiate later rounds
• Don’t take valuations personally
• Liquidation preference: most important when sold for less than cost of assets
  • Eg. 1x preference for series A over common stock
  • No, full, capped participation: also participating in common stock
  • Liquidation preference overhang: price to make it to common stock
  • Stacked preferences: B before A
  • Blended preferences: A, B equivalent
  • Keep it simple in early rounds
  • Kick out: no participation once reasonable return via preferred shares
• Pay to play: must invest pro rata in next round, else converted to common stock
  • Generally good to have
  • Waived during big rounds
• Vesting: shares over period, with cliff
  • Unvested stocks → un-dilutive event
  • Can allow for purchasing invested stock at agreed price if leaving
  • Double vs single-trigger acc. vesting
• Exercise period: can purchase stock outright within period (90 days, 10 years)
  • Good for employee retention
• Anti-dilution: protection from down rounds
  • Ratchet-based: full, half, etc.
  • Weighted average: values of outstanding shares updated
  • Focus on minimizing impact

6: Control terms of the term sheet

• Board of directors: planning department
  • Board observers: be weary
  • 5 person: 2 founders, 2 VC, 1 outside
• Protective provisions: veto rights
  • Founders generally want to limit
  • Generally for monetary interests
  • Fight to vote as a single class
  • Drag-along agreement: common stock consent to series A vote
• Conversion: convert to common stock
  • Automatic conversion: for IPO
  • Want lower threshold: prevent veto

7: Other terms of the term sheet

• Dividends: 5-15%, largely unimportant
  • More important with lower return ratio
• Redemption rights: guaranteed exit path for VCs due to fund lifespan
  • Adverse change redemption: bad
• Conditions precedent to financing:
  • Approval by investors partnerships: VC still hasn’t formally approved deal
  • Rights offering to be completed by company: adds time + expense
  • Understand compensation, what happens if you get fired
• Information rights: need transparency
• Registration rights: don’t worry
• Right of first refusal: pro rata right
  • No worries, but for big investors
• Voting rights: standard
• Restriction of sales: ROFR on common
  • Good thing for companies
• Proprietary info and inventions agreement:
• Co-sale agreement: try to negotiate down
• Founder’s activities: 100% towards startup
• IPO shares purchase: don’t worry about it
• No-shop agreement: monogamy
  • Seek 30-60 day agreement
• Indemnification: insurance policy
• Assignment: VC transfer flexibility

8: Convertible debt

• Convertible debt: loan → equity later round
• Arguments against:
  • Used to be much cheaper, but standard term sheets (SAFE) negate
  • Discount may dissuade VCs
  • Valuation cap draws line in sand
  • Better seed, underpriced series A
• The discount: incentive on top of interest
  • Discounted price on next round equity
  • 10-30%, sometimes non-static (90d)
• Valuation cap: investor-friendly cap on price
  • Defers discussion to next round
  • Don’t disclose unless required by VC
• Interest rate: lowest possible, usually 5-12%
• Conversion mechanics: raise target, period
• Conversion in sale: various methods
• Warrant: option to purchase at certain price
  • Length, merger considerations, OID
  • Add complexity, cost
• Pro rata: future round participation
• Bridge round: with liquidation preference
• CD risk: insolvency
• Synthetic instruments: best of both
  • SAFE, KISS

9: The capitalization table

• Founders, employee options, investors
• PPS for convertible notes: 3 methods
• Pre-money: most common
  • Most dilution for investors
• Percentage-ownership: post-money
  • Most dilution for founder
• Dollars-invested: compromise ↑

10: Crowdfunding

• Product crowdfunding: presale campaign
• Equity crowdfunding: Angel-list, security
  • Limits: accredited, investor, $1m
  • You set the terms
• Token offering: ICO

11: Venture debt

• Debt: short term, narrow, defined objective
  • Equity: long-term, flexible
• Generally up to 25-50% of equity $$
  • Best when growth > profitability
• Loan: beginning of a long-term partnership
• Loan used as:
  • Performance insurance
  • Lower-cost runway extension
  • Funding for capital expenses
  • Short-term bridge to next round
• Commercial loan: type determined by PSOR
  • Term loan: based on cash flow
  • Asset-based loan: collateral → cash
• Venture debt: relies on access to VC
• Growth capital term loan: ↑
  • 3-4 year repayment, 6-12m IO period
  • Interest-only period: ↑
• Recurring revenue loan: based on ARR
• Economic terms:
  • Interest rate: usually variable
  • Loan fees: when exceeding draw
  • Warrant:
    • Class of stock, strike price
    • Duration: push for shorter
  • Final payment, pre-payment terms
• Amortization terms:
  • Draw period: request cash advances
  • Conditional IO extensions:
• Control terms: based on performance
  • Affirmative, negative convenance
  • ↑ basically following the rules
  • Material adverse change: MAC clause
  • ↑ needed due to high risk
• Reputation is critical
• Watch for deal term drift
• Technically defaulting on loan terms is ~ inevitable, so relationship is paramount

12: How VC funds work

• Structure:
  • Management company: franchise
  • LP vehicle: fund containing LPs
  • General partnership: legal entity
• LP agreement: agreement to fund amount
• Capital call: get LP funds for investment
  • LPs have legal requirement to provide
• Management fee: usually 1.5-2.5%
  • AUM generally matches compensation
• Carry: usually 20-30% of fund profits
  • Carried interest, per-partner
• 1-5% GP investment vs LPs
• Clawback: past payment back to LPs
• Commitment period: investing in fund
  • Generally 5 years
  • Zombie: no active fund, only manage
• Investment term: how long can manage
  • Generally 10-12 years
• Secondary sale: transfer of portfolio
• Reserve: money saved for follow-on rounds
  • Can usually raise new round when 70% of previous fund is invested
• Cross-fund investing:
  • Side fund: different structure
• Understand VC’s partner dynamics
  • Is someone about to leave?
• CVC: have a large corporation behind them
  • Typically higher valuations
  • More control: ROFR
  • Beware of conflict of interest
• Strategic investors: one-offs

13: Negotiation tactics

• What matters:
  • A good and fair result
  • Not killing relationship getting there
  • Understand deal you are striking
• Game theory: multi-turn game
• Prepare:
  • Know your price, what to concede
  • Study, know the other people
• Ask for VC’s 3 most important factors:
  • Easier to call them out later
• Be transparent and easygoing
• BATNA: could be second best offer
• Leverage:
  • Multiple offers (never disclose who)
  • Anchor terms: flexibility elsewhere
• Go through terms in thoughtful order to maintain perspective, focus
• Never make the first offer
• Choose a great lawyer:
  • Ask around, always get references
  • Ask VC before and after

14: Raising money the right way

• Pass the “beer test”: be a friend
• Don’t ask for an NDA
• Don’t ask for referrals after a no
  • Ask why the answer is no
• Team > idea, patents / IP

15: Issues at different financing stages

• Seed deal:
  • Establishes precedent
  • Important to have a good lead investor
• Early stage:
  • Pay attention to establishing:
    • Liquidation preference
    • Protective provisions
• Mid and late stages:
  • Board composition: don’t want to be dominated by investors
  • Clean deal > high valuation

16: Letters of intent: the other term sheet

• LOI: first step in acquisition process
• Big difference vs VC: fixed vs growing pie
• Two components: price, structure
• Escrow: for post-acquisition complexities
• Working capital: should be zero
• Earn out: at risk
• Management retention pool:
• Types of acquisition deals:
  • Asset deal: purchasing just assets
  • Stock deal: whole company
• Know what you’re getting:
  • Cash > stock (pay attention to type)
• Assumption of stock options:
  • Vesting of outstanding stock options
  • Cash, private, or public stock
• Reps and warranties: promises by seller
  • Company or shareholder liability
• Escrow: holdbacks - always decreases $$
  • Fraud, taxes, IP issues etc.
  • Buyers “often” try to overreach
• NDA: in case of breakup of deal
  • Should be evenly bidirectional
• Conditions to close: subject to…
  • Hints at attitude of buyer
• No-shop clause:
• Breakup fees: generally only public co’s
  • Reasonable if high risk
• Registration rights: unregistered stock
• Shareholder rep: don’t be one. Painful

17: How to engage an investment banker

• IB: can help with M&A
• Shopping: contact 50+ potential acquirers
• Saves time, don’t have to be the bad guy
• Want connected, experience, culture fit
• Engagement letter:
  • Success fee: % of deal (90% of cost)
  • Retainer: monthly fee, reimbursement
  • Indemnification: ensure reasonable
  • Key person provision:
  • Fairness opinion:

18: Why do term sheets even exist?

• No actual requirement for term sheet
• Generally for LPs, auditing, legal
• Watch out for misalignment
• Transaction costs: lawyers, meetings, due diligence
• Information asymmetry: agency dynamics
  • Eg. sell company at loss vs keep going
  • Think about provisions, eg. board seat

19: Legal things for entrepreneurs

• IP: be very careful
  • Work for hire: ensure no issues
• Patents: 20 year monopoly over use
  • Must file within first 12 months of use
  • Provisional, utility patent application
  • Seek guidance from patent council
• Trademark: protects brand symbols
• Employment issues: “at will”
  • Pre-bake severance terms
• Corporate structure:
  • C corp: when you’re taking VC money
  • S corp: single tax structure
  • LLC: similar to ↑, but no equity
• 409a valuation: fair price for stock
  • Employees are getting less (10 → 30%)
• (83)b elections: tax for stocks vesting
• Founders stock: common stock issued to founders at inception of company
  • Single, trouble trigger vesting
• Consultants vs employees: min liability
• Equity incentive plan:
  • Common stock with vesting