The kind folks over at The Funded have created a template early stage term sheet that they believe will help make it easier for VCs and entrepreneurs to close Series A rounds with lower legal fees. This is very much a noble cause and I support the idea. Reducing friction and costs associated with a fund raise = great idea.
I’m not a lawyer (and as always I advise you to get a good one if you are negotiating with VCs), but if you can get a VC to agree to this term sheet at a valuation and $’s raised that you like I think you ought to accept it! This is a pretty darn entrepreneur friendly term sheet and you’d be feeling pretty good if you got a VC to sign it.
However, I’m pretty sure most VCs will push back on at least a few things, such as their preferred stock voting as converted instead of as a single class, the single trigger vesting upon acquisition (meaning the entrepreneur gets all their stock 100% vested if the company is sold), no redemption rights, some VCs will want full participation and finally I don’t see an exclusivity period in this term sheet. I’m not sure any VC that signs a term sheet without an exclusivity period really knows what he or she is doing. And they are probably going to have to ask you to pay for their legal fees (oh – you thought the term sheet was the expensive legal part of a venture capital round? It actually gets expensive when you are drafting the stock purchase agreement, the investor’s rights agreement, etc.)
Of course, if you need to raise a Series B round THAT investor may try to get different terms. And, if you use this term sheet and have issues further down the line remember that I warned you to get a lawyer to help you…
A guess the real question is, will there ever be a fund raise where the entrepreneur is going to be able to risk not having good (read: expensive) legal advice? Will it ever actually be possible to reduce the importance of sound legal advice when negotiating with VCs? A few years ago the NVCA published standard legal documents for venture capital investments. So far as I know, all decent venture capital firms base their investment documents off of these standard templates. But did this actually reduce the cost of legal advice on the typical venture capital investment? Has anyone actually looked at the average cost of company counsel pre-NVCA standard docs being published and post? I have not been playing this game long enough to know if this initiative actually saved anyone legal fees. My bet (and I have absolutely no data to back this up) is that entrepreneurs are paying about the same in legal fees today on a Series A deal as they did a year before the NVCA published their docs. So, even if The Funded or some other more standardized term sheet takes off I’m willing to be it will ALWAYS be a competitive advantage to pay up and get good legal advice on a VC transaction. You just don’t want to mess anything up when you first establish your capital structure…
One more thing: expect to pay around $25k to your company counsel and $25k to the investor’s on your Series A round.
Two quick items today:
1) Mass High Tech just announced their “2009 All-Stars of New England Innovation” Congratulations to Dharmesh Shah of Hubspot and David Beisel of Venrock for making the list! Also, congrats to Scott Kirsner, the founder of the New England Innovation Month and one of New England’s major technology journalists, and Gail Goodman, who doesn’t know me but whom I’ve seen speak at an entrepreneurship forum and who I greatly admire. Also, congrats to all the other innovators on the list, who I don’t know at all but who sound like they are doing some really forward-thinking things here in NE.
2) Growthology has a sobering post on the White House’s proposal to lump venture capital firms in with PE funds and hedge funds for new proposed financial regulation. VCs over a certain size would be required to report “information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability.”
I guess I understand what is going on here. It is probably too hard to distinguish between some hedge funds and VCs. Except for the fact that VCs use almost no complex derivatives and very modest leverage. Now, I’ll admit that there are sometimes some pretty serious repercussions when a VC funded company fails, like if a major corporation relys on a VC portfolio company for important ERP software and it one day goes under, or if Kozmo.com goes out of business and you can no longer have DVDs and Starburst hand couriered to your house at 3:30 in the morning (yeah, that was a tough one to see go bye-bye.) But a “threat to financial stability?” That seems a little far fetched.
If you believe that VCs a) create high paying jobs by funding companies and b) foster home-grown innovation by taking risks with pre-development technologies, then you should probably be against this sort of regulation as it will slow mid and small-sized VCs ability to make investments. I left the following comment at the bottom of the Growthology post:
The main cost of complying with these types of regulation is the time involved for the managing partner(s). While larger funds can afford to hire non-deal COO/CFO partners, financial administration at smaller funds falls onto the active deal partners. Since the limiting factor at most VCs is the investing professionals’ time, anything that keeps them from investing or working with portfolio companies could be a real burden. Having been a junior VC at a larger firm & having helped with the silly exercise of annual portfolio valuations for the auditors, I can tell you that these sorts of low-value added administration are major time sucks – and did I mention that they don’t really add much value?
Vikram Kumar, the CTO of Pixily, recently took a couple of days off and went to the Cape with his wife and two four year olds. Vik is a new buff, always reading news articles and commenting on happening all over the world. But he realized a funny thing on this vacation when he went to buy a newspaper out of a vending machine with his kids on this trip – he never reads physical newspapers anymore. His kids had never seen a real-life newspaper and were totally enthralled by the “big book.” They loved the fact that dad disappeared behind it when he read it over his morning coffee. In fact, they kept requesting over and over that they go buy another one to play with!
How funny is it that someone who reads more news articles than anyone I know never actually reads paper? Newspapers were definitely part of my childhood, but I guess that’s not true for kids anymore!
When I was a venture capitalist, I saw a recurring, common mistake made by startup founders who were trying to project their company’s revenue for the coming years. Of course, now that I am actually trying to help a startup create their financial projections from the other side of the table I almost made the same mistake! This issue is particularly important when the startup has a SaaS or viral revenue model.
How to NOT project SaaS revenues
Probably the number two or three mistake startup founders (and me, almost) make when estimating their revenues is to assume they acquire their customers in a linear fashion during the year. Many, many CEOs project revenue by the following formula:
(Number of expected customers at year end) X (monthly subscription revenue) X (12 months) X 50% = Anticipated Yearly Revenue
The 50% discount attempts to take into account that you haven’t acquired all of the customers on January 1*, but instead get some of them month 1, some month 2, some month 3, etc. However, this creates a major assumption – the assumption is that you get the same number of customers in month 1 as month 12. Usually this is not the case if you are a startup ramping up your marketing and sales programs. Typically you get more of your customers in the final months, and many, many fewer in the first couple. This effect is more pronounced the greater number of marketing programs you are layering on during the year.
To illustrate how this 50% discount will over-estimate your revenues, consider the following example. I am over-simplifying everything to make a point, so please don’t make too much fun of this. Although it is so simplified as to be comical.
Assume a startup has 12 different marketing programs that will run for at least 12 months each. The CEO anticipates that these will result in one new customer per month that they are running. The team will have bandwidth to launch one new program per month, so one new program will be launched each month. The company’s service is so amazing that no customers will churn; assume the service costs $100 per month. Customer acquisition will be as follows:
1st Month: 1 new marketing program. 1 new customer
2nd Month: 1 new program, one old program. 2 new customers, plus 1 existing customer = 3 total paying customers.
3rd Month: 1 new program, two old programs. 3 new customers, plus 3 existing customer = 6 total paying customers.
I think you get the picture. By the end of the year the company will have 78 paying customers.
Running the formula above for expected revenues, we get $46,800.
The problem is that the company won’t actually have that high of revenue. Revenues will really be only $36,400. 77.8% of the amount projected. So, even if the company hits their customer acquisition plan they will miss their revenue target. Obviously this could have serious implications to their cash flow, etc. The level of your revenue miss will be even greater if you have a viral product, since your growth will be even more exponential.
It’s a much better idea to identify the specific marketing programs that you will be implementing, the months that you’ll be rolling them out and the anticipated customer acquisition by month from them. I realize this takes a long time, and you are probably pretty busy trying to actually get your company going. But projecting your cash flow is such an important part of the success in the early life of your startup that I’d suggest you do it and don’t fall into the trap of making such simple revenue forecasts that you misjudge your cash needs.
*Or whatever your fiscal year day one is
Mark MacLeod pointed me to a recent publication by Fenwick & West (a well known tech law firm) on the increasing number of down rounds for venture funded companies. According to Fenwick, for the past two quarters, “down rounds” have exceeded “up rounds” when venture backed companies are raising follow on financing. To go into a little more depth here, a down round is when a company that has already raised venture capital raises additional capital (another “round”) at a valuation that is lower than the valuation from the previous round. In other words, the company is worth LESS than it was after the completion of its last fund raise. So, for the past couple of quarters, many previously venture backed companies are falling in value.
Why 2009 Q2 valuations are falling
The decrease in valuation for these companies has averaged about -50% for the past three quarters – a pretty hefty drop. This is probably caused by a few horrible issues converging all at once: 1) the NASDAQ is off by 30%ish from its two year high, and was at one point 50%ish off its high – obviously valuations for private technology companies are going to be impacted; 2) the difficult market conditions have made it harder for venture backed companies to achieve their goals and hit their value creation milestones, therefore many of them have probably failed to really move the needle on their valuation in the positive direction; and 3) there is less venture capital floating around, so as supply of follow on financing drops valuations should follow downwards.
The hidden cost of a down round for a venture funded company – anti-dilution provisions
The problem with a decreased valuation, from the startup founder’s perspective, is that the venture capitalists are going to significantly increase their ownership in the business at the expense of the company’s management team. Not only is the price per share that the VCs are investing in down (thus they buy more of the company) but they also will benefit from a standard term in venture capital fund raising – the anti-dilution provision.
The anti-dilution provision is intended to protect the investor in the event of a down round by resetting the conversion price from the VC’s previous investment(s) in the company. This provision resets (much like a “do over”) the price paid per share from a previous investment to the new price per share, or to a calculated price per share in between the previously paid price per share and the new, lower share price paid by the investors in the current round.
I’ll run through a quick mathematical exercise so you can see the impact of a down round on a company with a “weighted average” anti-dilution provision. This is the standard anti dilution provision, and is much more founder friendly than its less standard cousin, the “full ratchet” antidilution provision.
For this example, let’s assume your startup has raised a Series A with the following terms:
$5 million from VCs at a $5 million pre-money valuation. This means the investors own half the company, and management owns the other half. Also, let’s assume that there are 10 million shares outstanding, so the investors own 5,000,000 and management owns the same. Thus, the price per share is $1.00. Post money, after the Series A, is $10 million.
The company needs another $5 million.
Up round – Say that everything is great, and the company is able to raise capital at $2.00 a share. Ownership post financing will be: