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There are a few legal issues that we’ve seen consistently become hurdles for entrepreneurs and their lawyers. While in some cases they will simply be a hassle to clean up in a financing or an exit, they often have meaningful financial implications for the company and, in the worst case, can seriously damage the value of your business. We aren’t your lawyers or giving you legal advice here (our lawyers made us write that), but we encourage you to understand these issues rather than just assume that your lawyer got them right.
In this final chapter of the book, we will briefly cover Intellectual Property, Employment Issues, State of Incorporation, Accredited Investors, Filing an 83(b) Election, and Section 409A Valuations.
We hope you’ve enjoyed the overview of Venture Deals: Be Smarter Than Your Lawyer And Venture Capitalist. If you have, grab a copy of the book. We are open to any and all feedback, including topics you wished we had covered, things that aren’t clear, and things you disagree with. Regardless, we hope we’ve helped you be smarter than your lawyer and venture capitalist.
There is another type of term sheet that is important in an entrepreneur’s life—the letter of intent (LOI). Hopefully, one day you’ll receive one from a potential acquirer that will lead to fame, riches, and happiness. Or at least you’ll get a new business card on heavier card stock.
Typically the first formal step by a company that wants to acquire yours is for it to issue a letter of intent. This sometimes delightful and usually nonbinding document (except for things like a no-shop agreement) is also known as an indication of interest (IOI), memorandum of understanding (MOU), and even occasionally a term sheet.
As with our friend the term sheet, there are some terms that matter a lot and others that don’t. Once again there are plenty of mysterious words that experienced deal makers always know how and where to sprinkle so that they can later say, “But X implies Y,” often resulting in much arguing between lawyers. We’ve had LOIs get done in a couple of hours and had others take several months to get signed. As with any negotiation, experience, knowledge, and understanding matter. The LOI negotiation is usually a first taste of the actual negotiating style you will experience from the other party.
To keep things straightforward, we are going to focus on explaining the typical case of a two-party transaction between a buyer and a seller, which we’ll refer to as an acquisition. As with many things in life, there are often more complex transactions, including three or more parties, but we’ll save that for a different book.
As we enter the home stretch of the book, we spend some time talking about financings at different stages of the life of a company.
Not all financings are created equal. This is especially true when you factor in the different stages that your company will evolve through over its lifetime. Each financing stage—seed, early, mid, and later stage—has different key issues to focus on.
Every book we’ve ever read has mistakes in it. Ours is no exception. We tried hard to get everything right, and say it clearly, but we know some errors snuck in.
We’ve created an Errata page on this site. Whenever we find an error, or someone reports a mistake, we’ll put it up on the page. If there’s another edition of the book, we’ll make the changes.
If you find an error, just email us. If you are the first person to report the error, we’ll send you a free signed copy of the Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist.
While most people ask themselves “What should I do?” when seeking VC financing, there are also some things that a person should not do. Doing any of the following at best makes you look like a rookie (which is okay, we all were rookies once) and at worst kills any chance that you have of getting funded by the VC you just contacted. We encourage you to avoid doing the following when you are raising money from VCs.
- Don’t Ask for a Nondisclosure Agreement
- Don’t E-Mail Carpet Bomb VCs
- No Often Means No
- Don’t Ask for a Referral If You Get a No
- Don’t Be a Solo Founder
- Don’t Overemphasize Patents
Regardless of how much you know about term sheets, you still need to be able to negotiate a good deal. We’ve found that most people, including many lawyers, are weak negotiators. Fortunately for our portfolio company executives, they can read about everything we know online and in this book, so hopefully in addition to being better negotiators, they now know all of our moves and can negotiate more effectively against us.
There are plenty of treatises on negotiations; however, this chapter walks through some negotiation tactics that have worked well for us over the years. Although this book is primarily about financings, we’ll talk about a range of negotiation tactics that you can use in your life, and we illustrate some of the different types of characters you’ll probably meet along the way.
Before we talk about the dynamics of the negotiation of the deal, it’s useful to understand the motivation of the person you’ll be negotiating against, namely the venture capitalist (VC). We’ve been asked many times to divulge the deep, dark secrets of what makes VCs tick. One night over dinner we talked through much of this with a very experienced entrepreneur who was in the middle of a negotiation for a late stage round for his company. At the end of the discussion, he implored us to put pen to paper since even though he was extremely experienced and had been involved in several VC-backed companies, our conversation helped him understand the nuances of what he was dealing with, which, until our explanation, had been confusing him.
In general, it’s important to understand what drives your current and future business partners, namely your VCs, as their motivations will impact your business. While the basics of how a venture fund works may be known, in this chapter we try to also cover all the nonobvious issues that play into how VCs think and behave. To do that, we’ll dive into how funds are set up and managed as well as the pressures (both internally and externally) that VCs face.
Now is your chance to show off their proficiency with a spreadsheet. Even if you know what a cap table is, we’ll give you a simple way to calculate the summary level ownership categories with a calculator (or a simple spreadsheet model).
Now that we’ve worked through all of the specific clauses in the term sheet, let’s go through how a typical capitalization table (cap table) works. A term sheet will almost always contain a summary cap table, which we describe in this chapter. You, your prospective investors, or occasionally your lawyers will generate a more detailed cap table.
The cap table summarizes who owns what part of the company before and after the financing. This is one area that some founders, especially those who have not been exposed in the past to cap table math, are often uncomfortable with. It’s extremely important for founders to understand exactly who owns what part of a company and what the implications are in a potential funding round.
If you get confused about how much you might own after the pre-money, post-money math and option pool (issued and unissued) calculation runs through the cap table, along with being perplexed on how to actually calculate price per share in a complicated financing, this is the chapter for you.
In this chapter we cover the non-economic and non-control terms in the term sheet. Some matter, some don’t, and context matters a lot. Hopefully we’ll give you plenty of it to use in your negotiation with your venture capitalist.
Up to this point we’ve been exploring terms that matter a lot and fall under the category of economics or control. As we get further into the term sheet, we start to encounter some terms that don’t matter as much, are only impactful in a downside scenario, or don’t matter at all.
This chapter covers those terms, which include dividends, redemption rights, conditions precedent to financing, information rights, registration rights, right of first refusal, voting rights, restriction on sales, proprietary information and inventions agreement, co-sale agreement, founders’ activities, initial public offering shares purchase, no-shop agreement, indemnification, and assignment.
If we’ve worn you down by now and you’ve bought Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist, thank you. If not, what are you waiting for?
Yup – many VCs are control freaks. And they love control terms. In this chapter we tell you which ones matter, why they matter, and what you should pay attention to. We also give you some advice on what is worth negotiating hard for, as well as what you shouldn’t worry about too much.
The terms we discussed in the preceding chapter define the economics of a deal; the next batch of terms define the control parameters of a deal. VCs care about control provisions in order to keep an eye on their investment as well as comply with certain federal tax statutes that are a result of the types of investors that invest in VC funds. While VCs often have less than 50 percent ownership of a company, they usually have a variety of control terms that effectively give them control of many activities of the company.
In this chapter we discuss the following terms: board of directors, protective provisions, drag-along rights, and conversion.
Once again, our friend Matt Blumberg from Return Path has a bunch of important sidebars where he talks about the terms from “The Entrepreneur’s Perspective.”