VC Confidential

Ignite Chicago Fundraising Presentation

I am talking tonight (Thurs, Dec 6th) at the Ignite Chicago event (click for the site) at the Debonair Social Club (1575 N Milwaukee Ave). I was originally going to do a talk on Venture vs Angel fundraising. However, I have decided to change topics last minute and do it on Nassim Taleb's book, The Black Swan: The Impact of the Highly Improbable. I have written in the past on this topic, The Turtles of Omaha, but was inspired to do another post (coming) and change the presentation after Steve Jurvetson gave a compelling talk on our monthly partners call this morning on the book & topic. For those interested, you can download the original presentation on fundraising, Off to See the Wizard, by clicking. Download 2007_12ignite_talk.ppt.

Wikipedia gives a brief overview in its Black Swan Theory entry.

How VC's Determine % Ownership Thresholds

Jason and Brad at AsktheVC forwarded to me a question sent in by one of their readers. Their site is a great site for answering a broad array of questions regarding VC and entrepreneurship.

Question: What's a completely generic range of equity a VC typically wants for a round 1 or round 2 investment?

Most VC’s will generally say they target 20-30% ownership in a company to “make it worth their time”. This means that if they invest $3m early on, they expect the post-money to be around $10-15m and if, in later rounds, they are investing $10m, they expect to have a $30-$50m post-$.

Often, however, VC’s will use the “percentage” threshold as a means by which to increase money into a round or to get the valuation down. I have seen a given VC say they need 25% ownership for deal (to get valuation down) and do a more competitively sought deal at 15% two weeks later. In the end, two things drive all of this. First, there are legitimate minimum investment amounts a firm needs to have per deal. A $500 million fund will never get its capital deployed by doing $2m and $3m deals. They need to put $7-10m to play early and $20m+ over the life of the investment. Second, the valuation (and hence % ownership) will be driven by attractiveness and competitiveness of the deal. In the end, it is really about valuation (assuming their investment appetite remains in a set range).   

Term Sheet 101: Preference

Nearly all VC’s use convertible preferred stock as their vehicle of choice. Most entrepreneurs know this but many don’t fully understand the different flavors and elements of it.

Preference refers generally to the seniority of a given class of stock versus others. Preferred A stock usually gets paid back before common and follow-on Preferred issuances (B, C, D, etc) usually have seniority over both the A and common. This means that the investors will get their capital out before the entrepreneur and team usually.

There are two primary forms of Preferred stock: straight and participating. Straight convertible preferred stock is an either/or situation. Investors can opt to get their capital back but not participate in further upside (e.g. stay as preferred stock…usually the election in downside scenarios) or they can convert to common and participate alongside management & the entrepreneur. The kick point of this conversion is usually pretty clear. If an investor has put $10m in and has 10% of the company, for any exit that values equity above $100m, they will convert to common. For any exit below, they will stay as preferred.

With participating preferred, investors first get their initial capital out and then participate as common shareholders. So, in the above case, at $100m, the investor would get his/her $10m back and then would get an additional $9m (10% of the remaining $90m). Investors will often use this to hit return targets when having to pay a high initial price.

Some term sheets will include participation multiples where investors get 2x or 3x their capital out before other classes. This usually happens when there is significant preference (invested dollars) in the company and there is gap between when their get their capital back and when they start to participate in the upside.

Dividends also play a role in preference. There are cumulative dividends and “when & as declared by the board” dividends. With cumulative dividends, investors “preference” grows each year at a set rate (say 6%), thereby providing an ongoing discount for the investor. This dividend begins to kick in day one. Other dividends start only “when & as declared by the board”. I have not generally seen many boards vote to trigger a dividend.

New preferred stock can be either senior to previous preferred classes (say the Pref B gets its money before the Pref A) or it can be “pari passu” to them (the Pref B and Pref A have the same seniority and come out pro-rata based on their relative sizes). This term usually does not affect the entrepreneur who is subordinated to both classes but is an investor group matter.

As market conditions tighten, investors look to offset increasingly rockier environments through more aggressive terms. As they get more competitive, terms trend more loosely. Lastly, while earlier investors may lock in strong terms, everything is up for renegotiation when new investors come in. Previous preferred terms can stay in place or, in severe cases, get pushed to common. Participation multiples can be eliminated as can dividends. However, for entrepreneurs looking to use new financings to recut their deals, they should be careful. Earlier investors usually have blocking rights on new capital coming in. Additionally, entrepreneurs that play the sides against the middle (old vs. new investors) will significantly impair their relationship with initial investors if they blatantly play this card.

Preference takes many forms in venture capital. It is critical that entrepreneurs fully understand the implications of the terms they are accepting so that it does not impact future relationships going forward.

How to Divide the Pie

Sam Martin sent in an email asking about determining founder equity. "What amount/percentage of equity is usually reserved for the founder, CEO, and management team.  Is there a rule of thumb for how you determine who should receive equity and who shouldn't?  What is a common vesting schedule--if there is such a thing?"

Great questions and ones that we have to address with every deal. I have a couple of thoughts on the above:
1) Alignment of interests is critical...all the way down to the entry level Java programmer. Equity is the great connector. I am a fan of making certain that all employees have equity, even if only token shares. This means making certain that you have an option program in place and all employees are participants.

2) Setting equity levels is more art than science though there are ranges. At the start-up level, equity allocations will be larger since they will be diluted down with financings. As you start to near break-even, some ranges...CEO 5-10%, VP-Sales or Marketing 1-2%, CFO 1%, next level down .25-.5%.

3) Most of our companies have fairly consistent option plans that a lawyer who is familiar with VC deals can help set up. These usually have a one year cliff vest (e.g. no equity before 12 months) and then monthly vesting for the next 3 years...a four year vesting in total. Strike price is usually a fraction of the preferred and with the new 409A accounting rules, you'll need an appraiser to CYA. The employee has two months to exercise options upon leaving. The company has the right to buy back those shares at fair market value.

4) Dividing the pie up should be split into two parts. The first is to divide the equity amongst the founding team. This is a matter of determining who deserves what and who has what leverage. Some founders go with an equal split mentality (four founders, each with 20% and another 20% set aside for future hires). Others go with a layered approach and different ownership levels. The second is to determine how much capital is coming in and what pre-$ valuation. If $1m is coming in at a $2m valuation, then the new money gets 33% of the business and all existing shareholders are all diluted down by 33% (e.g. the 20% above is now 13.6%).

The trick to all of this is to break these allocations into multiple steps, lock %'s down and then go to the next step. It is also key to have good counsel to make certain the appropriate provisions are in place such as a drag-along provision (if the majority agree to sell, everyone else has to also...avoids small, disgruntled investors from holding the company hostage) and a legal structure.

In short, though, share the wealth as it is a lot easier to row the boat together when incentives are aligned.

Is Your Customer's Money Green?

One of my readers asked me how I viewed companies raising money from customers. The traditional advice is not to take money from customers since it gives them additional leverage. I recently experienced this at a company where our portfolio company was a key supplier to the firm. The business arrangement was worked out but things got more complex when we surfaced the idea of their investing. You generically run into a couple of speed bumps:
1) the customer often wants a special term for investing such as a right of first refusal, best nation pricing, exclusives and such
2) the customer has an incentive to mess with the financing to drive the price down. This is where divergence at the customer hits when the investment arm is focused on ROI (lower price) and the business unit wants a well funded supplier.
3) this potentially complicates your exit if they are a potential acquirer. They are an insider and the only way a third party outbids an insider is by paying too much based on inferior information.
4) having a customer invest potentially messes up future sales with some of their competitors (potential customers for you). They may suspect that their competitor will have privileged information as an insider about them.

On the positive side, you:
1) potentially get affirmation in the market place about your product if a major player (your customer) in the market is willing to invest capital as well as do business with you.
2) can get a higher valuation since they are not investing purely for ROI and they also have a deeper appreciation for what you can do.
3) can get fewer restrictions and likely no board seat requirement.

All of these are broad generalizations and only one or two possibly come into play on any given deal (and often none do). But, you should be careful not to get blinded to these facts because of the higher valuation that you will likely get from them. Overall, I would say that if you can avoid taking money from customers, you should. It adds another dimension and lever point in the relationship.

Those Pesky Common Shareholders

Rick Segal posted a great piece, A Fatal Paper Cut , laying out the importance of incorporating the key voting elements into your early and initial share grants and purchases. When new money comes in, it will usually ask that most, if not all, of the existing investors have signed off and agreed to the terms of the new money. They do not want to take a minority shareholder suit at some future date. Unfortunately, many entrepreneurs begin issuing stock early and often in lieu of cash (programmers, attorneys, etc) as well as to angel investors. It is critical that you also include a Voting Agreement with these shares that layout specifically how future approvals will occur.  In the cleanest situation, you can state that if the majority of a share class (e.g. common in this case) agree with a certain action (financing, merger, etc), that the entire class is "dragged along". You can set up more refined versions of this whereby this applies to investors owning less than x% (say 10%). In any case, you do not want to end up in a situation where you are trying to chase down signatures for a much needed financing and you either a) can't find the shareholders or b) they are holding out.