The authors, Brad Feld and Jason A. Mendelson, starts out by mentioning that bringing one’s company to the next level requires an influx of cash. Founders turn to venture capitalists who provide the perfect form of financing to ventures. The author suggests that they focus on investors and understand how they work in terms of decision-making process, capital sourcing, timing, industry focus and negotiation style. The author also looks at term sheets and how to get the best deal in terms of valuation, governance and board seat composition. He recommends that founders put a lot of effort in preparing meetings with venture capitalists and seek advice from a competent lawyer especially when negotiating term sheets.
VCs offers the perfect form of financing
Unlike bankers who provide loans and look at existing cash, venture capitalists are well versed in helping companies that generate little or no cash flow whatsoever. They know the value of a startup comes not from its existing operations but rather its future cash flows. That’s why entrepreneurs are well advised to seek venture capital funding. In doing so they should focus on managing directors and General Partners, as they ultimately have the decision-making authority, unlike more junior positions such as analysts who sift through hundreds of business plans.
Entrepreneurs must understand how the VC industry operates
Before even approaching investors, the authors suggest that entrepreneurs understand how the industry works. Much like entrepreneurs, venture capitalists are also on a quest to securing funds. They get their money from limited partners which maybe University endowments, retirement funds or government funds. Venture capitalist earn a small management fee and get an additional performance-based fee when their investments provide handsome returns. As a consequence, VC minimize their risks by spreading investments across many different startups. But this comes at a cost: it doesn’t give entrepreneurs the kind of focus they need. Entrepreneurs seeking solid long-standing advice should probably look for or investors that aren’t spreading their investments so widely.
Plus, much like entrepreneurs, venture capitalist manage their money based on strict time periods. They usually get their capital from Limited Partners every three to five years and continue investing in their startups portfolio for a longer period of time. Therefore, if entrepreneurs are engaging with venture capitalists as their fund is nearly expired, they’re taking the risks of working with investors lacking funds.
Negotiating the best, “Term Sheet”
The author also talks about term sheets. These are made up of two distinct elements: valuation and governance.
There are two ways to look at valuations:
- Venture capitalists tend to look at “post-money valuation”. In other words, assume a company is valued at 20 million dollars. They consider investing $5 million and are looking to secure 25% at the startup’s shares.
- Entrepreneurs tend to look at valuation before the investment; this is also called “pre-money valuation”. Assume a company is valued at $20 million. If investors were to invest 5 million then the company’s total valuation would be 25 million. As a consequence, VCs, in the eyes of the entrepreneur, should get 20% startup shares.
In the end, entrepreneurs and venture capitalist get to an agreement based on negotiation and consensus building.
The author talks about governance. A well-balanced board is made up of five positions:
- The first two go to the Startup founders
- Another two go to investors and, they must not secure veto rights.
- Finally, another seat goes to an independent board advisor.
Approaching requires focus and preparation
Then, the author looks at how to approach VCs.
He mentions that entrepreneurs should write a one to three-page description of their company in addition to drafting a business plan. He suggested that founders target specific venture capitalists based on their blogs, social media and website. Then, he should ask for recommendations and introductions in the entrepreneurial and VC community.
Once negotiations begin, the author recommends that CEOs get a competent lawyer simply because VCs, well versed in terms sheet negotiation, typically outclass entrepreneurs who are less experienced in this specific matter. A competent lawyer will guide the conversation on what really matters : valuation and governance. Founders may find a lawyer by asking for recommendations from friends and other CEOs.
In preparing for negotiation, the authors suggest that entrepreneurs know what they really want in terms of evaluation and governance. Plus, he suggests that entrepreneurs know what VCs are looking for in terms of evaluation and control. He mentioned that some VCs have developed a certain kind of governance and valuation philosophy. If this doesn’t meet up with the founder’s expectations then he should pass.
The author finishes his book by mentioning the kind of attitude that founders should follow during negotiations: listen rather than talk. Silence is often the best answer to any kind of objection.
To sum up
The author starts out by mentioning that bringing one’s company to the next level requires an influx of cash. Founders turn to venture capitalists who provide the perfect form of financing to new ventures. The author suggests that they focus on investors and understand how they work in terms of decision-making process, capital sourcing, timing, industry focus and negotiation style. The author also looks at term sheets and how to get the best deal in terms of valuation, governance and board seat composition. He recommends that founders put a lot of effort in preparing meetings with venture capitalists and seek advice from a competent lawyer especially when negotiating term sheets.