First-time Entrepreneur’s Guide to the Series A Term Sheet–Part 1

June 11, 2011

Getting your first term sheet from an investor can be exhilarating. It is the first tangible step that says someone is really interested in funding your business. Of course many term sheets never lead to a completed deal but most do.

But that first term sheet can also be daunting. The standard “NVCA Term Sheet” that many venture firms use these days can include as many as 40 different terms.

The best advice I can give is to make sure you have an attorney representing you with lots of experience negotiating venture deals. This is a very specialized area so don’t leave it to your family lawyer. And if you can’t find someone in your part of the country (or world) there are hundreds in the active investing areas of the US coasts and most deals are done by phone and email anyway.

This discussion assumes a “priced round” of preferred stock. I wrote about convertible notes in an earlier post. And “Series A” generally refers to the first of what is often several rounds of financing. Some angel financings will be referred to as “Series Seed” to retain the “A” designation for the first venture round.

The first thing to understand about preferred stock is that it includes “preferences” that grant holders rights not available to holders of common shares. The most important among these rights, from an economic standpoint, is the liquidation preference. This means the holder of a preferred share gets her money back before the holder of common shares. If, on liquidation of the company, there is not enough money to pay all preferred shareholders, the common holders get zip.

There are two principal types of preferred stock used in early-stage financings: “non-participating” (also known as “convertible”) and “participating”. With the former, a preferred shareholder can either get their liquidation preference—typically the money they invested—or convert to common and get their pro rata share of the liquidation proceeds but not both. This is virtually always done in connection with a “liquidation event”, typically a sale or IPO (which requires conversion of preferred shares) so the lawyers will normally do the math and suggest the proper choice.

With participating preferred, the holder receives the liquidation preference and then shares pro rata in the remainder with the holders of common shares. In earlier days, some of us called this “piggy preferred.” This structure is a better deal for the investor because it provides a return of the initial investment plus a share of the upside.

That’s probably enough for this first post. I’ll discuss valuation and dilution in Part 2.

Advertisements

First-time Entrepreneur’s Guide to a Convertible Note

April 25, 2011

My friend Tim from Cleveland called me to day and wanted a quick overview of how convertible notes work.  They’re pretty simple if you understand a few basic points.

First, use of this security is a way to avoid having to agree on a value for your business today.  What the investor/lender is really saying is “I’ll give you the money now and we agree that it will buy shares later when someone else comes in and establishes the price.”

Second, by giving you some money now, as opposed to waiting until everyone else ponies up, they’re taking more risk and are generally rewarded with a lower price per share, either via a straight discount or warrants to purchase more shares, plus interest at a reasonable rate.

Third, these notes generally include a mandatory conversion feature that says “if you raise a minimum of x dollars, I agree to convert my loan into shares of the round.”  If the note didn’t include such a feature, the lender could demand repayment which might enable her to take control of the company or at least its assets.

Most frequently, the term is one year but shorter or longer terms may be used depending on the circumstances.  Investors rarely want to own the companies they lend to so extensions are not uncommon.

But own them they can, potentially including valuable intellectual property so caveat borrower.  And get a good lawyer.


When are you ready to raise money?

April 11, 2011

You’ve got a great idea for the next social couponing service or massively customized hair braider and you need to raise some money to get it off the ground.  When are you ready?

I’m going to go with the copout answer here and say “it depends”.  It depends on a bunch of things: your track record, how much you are raising, how fast you will spend it, who you plan to raise it from, the background of you and your team, how good your network is, how good the general fundraising environment is and other factors.

Track record – If you have a successful exit (or several)  under your belt and your idea is solid, you may be able to raise money with a few phone calls and a PowerPoint.  If not, keep reading.

Amount – raising many hundreds of thousands of dollars from angel investors or millions from venture capitalists is hard and takes months.  Most angel investments are made in $25,000 to $50,000 chunks so you need a lot of those for a large angel round and you must be well prepared.  Raising $250,000 or less is easier and raising $50,000 from friends and family is easier still.  And of course how much you are raising depends on how fast you are spending it.  As a general rule, you should raise enough money to get you to some sort of “milestone” and then have a bit left over to give you time to raise some more.  The longer you can make a small amount last, the better.

Team – if you are a single technical founder (or team) or have deep experience in the business you are building, raising money is easier, not to say easy.  It also helps if you can live on a small salary.

Network – If you have a strong group of investors who know you well and trust you, raising money can be relatively easy.

Fundraising environment – As I write this in the Spring of 2011, it is a great time to raise money.  Many are calling it a bubble but I disagree.  One of the smartest bloggers I read, Ben Horowitz, had this to say.

Other factors – There are many but one I will mention is buzz.  Some people and teams are just good at creating buzz around a concept.  If you’re one of them, great!

So if you think you’re ready, it pays to be prepared and the more of the following (in no particular order) you have, the easier raising money will be:

  1. Analysis of the market: how big? how fragmented? who are the competitors? barriers to entry? who are the users? propensity to adopt new solutions? etc. etc. etc.
  2. Product: at least a prototype to demo, ideally, something in the market with evidence of market traction.
  3. Financial model: it doesn’t need to be complex but should reflect in detail the revenue model and costs to support it.  How will you sell and market this?  What are those costs?  How much will buyers pay and how will that change over time?
  4. Executive summary: can be as short as a page or two but must have enough information to pique the interest of investors.  The only goal of this is to get a meeting.
  5. Presentation: a short PowerPoint or equivalent to use when sitting down with your potential investors.  Keep it short and sweet.  Fred Wilson has a great post on this.
  6. Attorney: you will need a good one experienced in early-stage financing to help with the close so it’s rarely too early to get one involved.  If they like your idea, they’ll generally defer billing until you raise the money.

So get going!


Back to Blogging

February 16, 2011

Forgive me readers for I have sinned. It’s been many months since my last blog and I’m giving it another go.

First up, a shout out to Fred Wilson, my favorite blogger.  Today he describes a talk he gave yesterday (2/15/11) at HBS regarding startups.  You can read the entire post here but below are some of his points that resonated.  In particular, they reminded me of things my friends at FitnessKeeper (aka RunKeeper) are doing right.

  • There is a very high correlation between lean startup approach and the top performing companies in our two funds.
  • Lean startup methodology is great, but it is really a lean startup culture you want.
  • Early in a startup, product decisions should be hunch driven. Later on, product decisions should be data driven.
  • Hunches come from being a power user of the products in your category and from having a long standing obsession about the problem you are solving.
  • Domain expertise to the point of obsession is highly correlated with the most successful entrepreneurs in our portfolio.
  • Ideas that most people derided as ridiculous have produced the best outcomes. Don’t do the obvious thing.
  • Monetization should be native and improve the experience for users.
  • If you have an idea that you can’t get out of your head, do a startup. Otherwise join a startup.
  • If you are not technical, get product experience. Get your hands dirty and work with engineers.

Jason and the gang are really kicking it right now, this explains some of the “why”.


Financing a Startup

July 8, 2009

One of my favorite bloggers is Bill Gurley of Benchmark Capital.  He used to write a great column in Fortune Magazine which I miss.  Today he writes about how stupid it is to be funding startups with debt capital.  He is exactly right.

Anyone who has been involved in early-stage companies knows that it is hard enough to get to cash flow breakeven with no debt.  Our government has decided the normal rules don’t apply and have loaned two money-losing companies almost half a billion dollars of our money.  Could someone please explain why?


Less is More

July 6, 2009

My partner John from back when I was in venture capital used this phrase often.  As far as he was concerned it could be applied to most any circumstance.  And he was right.

In the venture world, we heard a lot of pitches and without exception, less is more when it comes to pitching your business.  The other day I was listening to a senior exec for one of my clients work through the “market” section of his deck—seven slides.  It took him half an hour!  Not that he wasn’t knowledgeable or articulate but he just felt he needed to communicate much more detail than was necessary.

So if you are a natural born talker, either find someone else to give the pitch or discipline yourself to be concise.  Less is more indeed.


Men are from Mars

June 24, 2009

About the only thing I remember from reading this book way back when is explained by this “Man Rule” sent to me recently by my friend David.

1. Come to us with a problem only if you want help solving it. That’s what we do. Sympathy is what your girlfriends are for.

It’s true.  Solving problems is what men do.

I like to solve startup problems and this is a recent example: The founder of one of my clients wanted to take on a co-founder.  The company was bootstrapping so there was no money to pay salary but #2 was willing to take equity instead of cash.

#1 correctly noted that if the co-founder had been involved from day one, they probably would split ownership 50/50.  But the company had made quite a bit of progress before #2 was ready to join, how to determine a fair split?

My solution: deconstruct.

Start with an estimate of the value of the business, call it $2 million.  Divide that by the number of shares, we’ll say 2 million to keep the math simple, $1.00 per share.

Next, determine the elements of compensation: salary that would have been paid, over the number of months until capital is raised and the company can start paying, plus a number of shares that would have been offered as incentive compensation if #2 had joined as a paid employee.

So if #2 would have been paid $100,000 per year and we expect him to work without pay for six months, we’ll give him 50,000 shares of stock that vest over six months.  In addition, someone at his level wound normally receive options for 2% of the company, we’d grant him one for 40,000 shares vesting over three years.

This may not be where the numbers end up but by deconstructing, we’ve established a framework for a constructive conversation that is based on more than just “I think you’re/I’m worth x%.”