I’m still running into “inside baseball” stuff that doesn’t get talked about widely.
I remember the salad days of working as an associate in VC. The money was good, the views from our office were unbelievable, and I learned all sorts of things on the job that I never learned from the blogs or in the lecture hall. Years later, I’m still running into “inside baseball” stuff that doesn’t get talked about widely. Below I’ve laid out 6 of those things. Whether you’re an investor, aspiring investor, or an operator, you’ll pick up something you can use in this — or any — venture market.
1. People Who Invest In The Same Company In The Same Round Can Get Different Deals (Yes, even when they sign the same term sheet.)
How can that happen? Here’s an example. When I raised money for a previous startup, I wasn’t planning to give information rights to the investors. But one of them wouldn’t invest unless I did. How I solved that issue is through a side letter, which can be used to offer different terms to different investors in the same financing.
Here’s another example. If you’re a small fund or an angel participating in a round that’s led by an institutional VC, your check size might not hit the threshold for pro rata rights to kick in. Depending on the strength of your relationship with the founders and major investors, you might be able to successfully ask for a side letter that would grant you or your fund pro rata rights even though your check size didn’t warrant it.
But even if you have a side letter in place, it’s no guarantee that those terms will stand the test of time. Here’s why…
2. Investor Protections Can Get Vaporized in the Blink of an Eye
I had no idea this was a thing, until it happened at my firm.
If you remember 2009 you’ll recall that the venture market and the economy as a whole was in the toilet. Walking dead VC firms everywhere. The VC firm where I worked had multiple companies that needed to raise more money. I remember one company in particular that had interest from one of the few VC firms out there that was still flush with cash.
When I saw their term sheet, my jaw dropped.
I expected that we’d be facing a down round. What I didn’t expect was that we’d need to waive our anti-dilution protections AND take a haircut on our existing liquidation preference to get the deal done.
3. The First Round Sets the Stage for the Future Rounds
In later stage deals in a down market, you’re likely to see multiple liquidation preferences (e.g. 2X instead of the typical 1X) on new money coming in. You want to avoid that situation like the plague in early stage deals, because future investors will ask for the same treatment. Soon, you’ll have a stack of preferences that will demotivate the founding team and discourage future investors from coming in. Fortunately, most professional early stage investors won’t ask for multiple liquidation preferences on early rounds, because they know it can really hose the cap table — and the company — further down the line.
4. Convertible Debt Can Get Weird
If you’re going to do multiple rounds of convertible debt, you need to make sure that the terms are very clear and there’s no ambiguity about what happens when the company gets acquired. Otherwise, you’ll have a bunch of soon-to-be-angry investors who are expecting higher returns than they’ll actually realize once the transaction closes. That’s just one wrinkle with convertible debt. Click here to read about several more of them.
5. Option Pool Shuffle
Should the employee option pool be 10%? 15%? 20%? The size of the pool is a determinant of the effective valuation, and investors often want to bake the pool into the pre-money valuation (to their sole benefit). Read ‘Option Pool Shuffle’ to see the numbers in action, so that you can negotiate this aspect of a deal more effectively.
6. Option Math that Breaks Excel (And How to Deal With it)
There’s another problem with options that we need to discuss. A term sheet will usually specify that an investment’s price per share is inclusive of a certain percentage of unissued options. This means that the price per share is now self-referential. And that will cause fits for you if you’re an Excel newbie or haven’t come across this issue before. VC Andrew Parker does a great job in this post describing this common problem, and how to solve it.
