Venture Deals Venture Deals BE SMARTER THAN YOUR LAWYER AND VENTURE CAPITALIST Third Edition Brad Feld Jason Mendelson www.itdf.ir Cover images: Background © Mina De La O/Getty Images, Inc.; Adhesive Note © subjug/Getty Images, Inc. Cover design: Wiley Copyright © 2016 by Brad Feld and Jason Mendelson. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley .com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993, or fax (317) 572-4002. Wiley publishes in a variety of print and electronic formats and by print-on- demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com. 978-1-119-25975-6 (cloth) 978-1-119-25978-7 (epdf) 978-1-119-25980-0 (epub) Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 www.itdf.ir To our wives, Amy and Jennifer, and our partners, Seth, Ryan, and Lindel. www.itdf.ir Contents Foreword xiii Fred Wilson Foreword xv James Park Preface xvii Acknowledgments xxiii Introduction: The Art of the Term Sheet 1 Chapter 1 The Players 5 The Entrepreneur 5 The Venture Capitalist 6 Financing Round Nomenclature 9 Types of Venture Capital Firms 10 The Angel Investor 11 The Syndicate 13 The Lawyer 14 The Mentor 16 Chapter 2 How to Raise Money 19 Do or Do Not—There Is No Try 19 Determine How Much You Are Raising 20 Fundraising Materials 21 Due Diligence Materials 28 Finding the Right VC 28 Finding a Lead VC 30 vii www.itdf.ir viii Contents How VCs Decide to Invest 31 Using Multiple VCs to Create Competition 34 Closing the Deal 35 Chapter 3 Overview of the Term Sheet 37 The Key Concepts: Economics and Control 38 Chapter 4 Economic Terms of the Term Sheet 39 Price 39 Liquidation Preference 45 Pay-to-Play 53 Vesting 56 Exercise Period 60 Employee Pool 61 Antidilution 63 Chapter 5 Control Terms of the Term Sheet 67 Board of Directors 67 Protective Provisions 70 Drag-Along Agreement 74 Conversion 77 Chapter 6 Other Terms of the Term Sheet 81 Dividends 81 Redemption Rights 83 Conditions Precedent to Financing 85 Information Rights 87 Registration Rights 88 Right of First Refusal 91 Voting Rights 92 Restriction on Sales 92 Proprietary Information and Inventions Agreement 93 Co-Sale Agreement 94 Founders’ Activities 95 Initial Public Offering Shares Purchase 96 No-Shop Agreement 97 www.itdf.ir Contents ix Indemnification 100 Assignment 101 Chapter 7 The Capitalization Table 103 Chapter 8 Convertible Debt 107 Arguments For and Against Convertible Debt 108 The Discount 110 Valuation Caps 111 Interest Rate 112 Conversion Mechanics 113 Conversion in a Sale of the Company 115 Warrants 116 Other Terms 118 Early-Stage versus Late-Stage Dynamics 119 Can Convertible Debt Be Dangerous? 120 An Alternative to Convertible Debt 121 Chapter 9 Crowdfunding 123 Product Crowdfunding 123 Equity Crowdfunding 125 How Equity Crowdfunding Differs 127 Chapter 10 How Venture Capital Funds Work 129 Overview of a Typical Structure 129 How Firms Raise Money 131 How Venture Capitalists Make Money 132 How Time Impacts Fund Activity 136 Reserves 138 Cash Flow 140 Cross-Fund Investing 141 Departing Partners 141 Corporate Venture Capital 142 Strategic Investors 144 Fiduciary Duties 145 Implications for the Entrepreneur 146 www.itdf.ir x Contents Chapter 11 Negotiation Tactics 147 What Really Matters? 147 Preparing for the Negotiation 148 A Brief Introduction to Game Theory 150 Negotiating in the Game of Financings 152 Negotiating Styles and Approaches 154 Collaborative Negotiation versus Walk-Away Threats 156 Building Leverage and Getting to Yes 158 Things Not to Do 160 Great Lawyers versus Bad Lawyers versus No Lawyers 162 Can You Make a Bad Deal Better? 163 Chapter 12 Raising Money the Right Way 165 Don’t Be a Machine 165 Don’t Ask for a Nondisclosure Agreement 166 Don’t Email Carpet Bomb VCs 166 No Often Means No 166 Don’t Ask for a Referral If You Get a No 167 Don’t Be a Solo Founder 168 Don’t Overemphasize Patents 168 Chapter 13 Issues at Different Financing Stages 171 Seed Deals 171 Early Stage 172 Mid and Late Stages 173 Chapter 14 Letters of Intent—The Other Term Sheet 175 Structure of a Deal 176 Asset Deal versus Stock Deal 179 Form of Consideration 181 Assumption of Stock Options 182 Representations, Warranties, and Indemnification 186 Escrow 187 Confidentiality/Nondisclosure Agreement 189 Employee Matters 189 Conditions to Close 191 The No-Shop Clause 191 www.itdf.ir Contents xi Fees, Fees, and More Fees 193 Registration Rights 193 Shareholder Representatives 194 Chapter 15 Why Do Term Sheets Even Exist? 197 Constraining Behavior and the Alignment of Incentives 198 Transaction Costs 199 Agency Costs and Information Asymmetry 200 Reputation Constraints 201 Chapter 16 Legal Things Every Entrepreneur Should Know 203 Intellectual Property 203 Employment Issues 205 State of Incorporation 206 Type of Corporate Structure 207 Accredited Investors 207 Filing an 83(b) Election 208 Section 409A Valuations 209 Authors’ Note 211 Appendix A: Sample Term Sheet 213 Appendix B: Sample Letter of Intent 223 Appendix C: Additional Resources 231 Foreword to the First and Second Editions 235 Glossary 237 About the Authors 247 Index 249 Excerpt from Startup Communities 261 www.itdf.ir Foreword I remember the first week of my career as a VC. I was 25 years old, it was 1986, and I had just landed a summer job in a venture capital firm. I was working for three experienced venture capitalists in a small firm called Euclid Partners, where I ended up spending the first 10 years of my VC career. One of those three partners, Bliss McCrum, peeked his head into my office (I had an office in Rockefeller Center at age 25) and said to me, “Can you model out a financing for XYZ Company at a $9 million pre-money, raising $3 million, with an unissued option pool of 10%?” and then went back to the big office in the rear he shared with the other founding partner, Milton Pappas. I sat at my desk and started thinking about the request. I understood the “raising $3 million” bit. I thought I could figure out the “unissued option pool of 10%” bit. But what the hell was “pre-money”? I had never heard that term. This was almost a decade before Netscape and Internet search so searching online for it wasn’t an option. After spending ten minutes getting up the courage, I walked back to that big office, peeked my head in, and said to Bliss, “Can you explain pre-money to me?” Thus began my 31-year education in venture capital that is still going on as I write this. The venture capital business was a cottage industry back in 1985, with club deals and a language all of its own. A cynic would say it was designed this way to be opaque to everyone other than the VCs so that they would have all the leverage in negotiations with entrepreneurs. I don’t entirely buy that narrative. I think the VC business grew up in a few small offices in Boston, New York, and San Francisco, and the dozens—maybe as many as a hundred—of main participants, along xiii www.itdf.ir xiv Foreword with their lawyers, came up with structures that made sense to them. They then developed a shorthand so that they could communicate among themselves. But whatever the origin story was, the language of venture deals is foreign to many and remains opaque and confusing to this day. This works to the advantage of industry insiders and to the disadvan- tage of those who are new to startups and venture capital.