I’ve been hearing these stories, several times in the last month, from both here in Vancouver and down in the States, of entrepreneurs having drop-kicked a VC termsheet and walked away, on the basis of terms and/or valuation. If you don’t know what this jargon means, a crash lesson on how the VC process works. For those who do know, a few remarks on VC trends.

Introduction to the VC Process · I’ve been involved in five rounds of Venture Capital (VC) financing in my career, and have consulted for VCs about their investments a few times; I’m not a big expert but I know the basics. Here’s how it works: suppose you’re an entrepreneur with a hot idea that you think can change the world, given some investment capital. Usually, you have to get introduced to the VC by someone who knows you both and thinks you’re worth taking seriously; very few VCs have time to look at input from a stranger.

The first step is that you pitch the VC on your idea, trying to keep it short and tight and punchy and hit the key points; in this essay I’m not going deep on what VCs want to hear and what they’re likely to invest in, lots of people have written books about that.

Suppose the VC likes the pitch and reads your business plan and likes that too, and you have a couple more talks and it all goes well. The next step would be what’s called a Term Sheet; this is an outline, in fairly human-readable terms, of the deal they propose. I’ve seen them as short as two pages and as long as fifteen. The key points in the term sheet are the amount they propose to invest, the Valuation, i.e. how much of the company they get for their money, and the Terms, what else they get beyond some shares.

Here is where the bargaining happens; you argue with the VCs about how much the company’s worth and the terms and so on, and eventually you come to a deal or you don’t. Most times, getting the term sheet feels (to the entrepreneur) like a huge breakthrough; you’re probably going to get funded! Assuming the negotiations don’t break down and you sign the term sheet, you usually end up doing the deal. The VC will do a huge amount more “due diligence” on you post-termsheet, and if skeletons turn up in the closets they’ll back out, and in fact they can back out at any point up until a microsecond before they sign the papers and give you the money. Deals do go south post-termsheet, but it’s the exception rather than the rule.

Terms · If you haven’t been through this process, you might think that the deal would be simple. You agree with the VC that the company’s worth say ten million, and they’re going to give you three million for 30% of the company. It’s not like that. Among other things, most deals are bigger than this, and there’s the issue of “pre-money” vs. “post-money” valuation, but what’s really material is the Terms that the VCs ask for; these are many and various and worth going into.

Preferred Shares · This is the Term from which all the others follow. You, the founders of the company, own common shares. The VCs, in exchange for their investment, get Preferred Shares which have a bunch of extra rights attached.

Board Seats · The investor group (and it’s nearly always a group, not just a single VC) get one or more seats on the Board. Typically, they don’t want or ask for a majority position. You don’t hear too many gripes about this one; the VCs are often in a position to help out with introductions and they’re likely to have seen a lot of the problems you’re going to have, so VCs on the board isn’t an onerous term, especially if you get one of their senior people.

Reporting · The deal will include a bunch of requirements for you to give your investors regular reports on how the company’s doing. If one of your investors is “institutional” (say a bank or a pension fund) you will regularly get requests down the road for more and more detailed and frequent reports as the institutional management tightens the screws on their internal people, but you don’t really have to do anything more than the Investment Agreement calls for.

Ratchet · This is one of the ugly ones. Suppose the VCs have put in their three million. Suppose you don’t do very well and you’re running out of money and you go out to raise some more and the new investors think the company’s only worth five million. A ratchet says that the dollar value of the VCs’ shares isn’t allowed to decrease. So if the company is now deemed to be worth $5M, their $3M investment is now worth 60% of the company, and you’re required to issue them enough new shares to get them there. Of course, this can lead to ridiculous situations when the valuation of the company drops down near or even below the original investment (happened to a lot of companies post-bubble) and the investors end up owning more than 100% of the company.

Entrepreneurs who’ve been around the track shudder at the sound of the word “Ratchet.”

Liquidation Preference · Let’s go back to that three million dollar investment. The VCs will ask for at least a “1x” liquidation preference; that means that if the company is sold or goes public or something, i.e. the shares actually are worth something, then they are guaranteed to get their money back first. That is to say, if you were doing badly and sold it for $5M, they’d get their $3M and the rest of the shareholders split up the remaining $2M.

This is innocuous enough; but in recent times some VCs have been demanding “2x” or higher liquidation preferences, I’ve direct knowledge of at least one “4x” and heard horror stories of even higher numbers.

This kind of thing puts the entrepreneurs in a position where they have to totally swing for the fences and take insane risks if they’re ever going to see a penny; the notion of building a nice stable growing business and cashing out a few years later for a solid profit is just not on, because you won’t see any of it.

Tranches · Suppose, once again, you do that $3M deal. The idea of tranches is that instead of giving you all the money up front you get $750K today, then in six months if you’ve hit certain milestones (usually revenue-related) you get another $750K, and then the remaining $1.5M after another six months, once again depending on you meeting your revenue targets.

Entrepreneurs hate tranches with a passion, because they know that most successful companies have had changes in direction, which tend to make former milestones irrelevant, and if you miss a target you’ve probably been spending money to get there, so if the tranche ain’t there your back is to the wall and you’re going to have to re-cut the deal to keep the doors open, probably at a lower valuation; and then the ratchet gets you.

Nickels and Dimes · When a VC invests in you, they spend some real money on getting all the contracts and other legal work drawn up and drafted. They don’t pay for this, you do, out of the money they give you. While this doesn’t have the potentially lethal consequences that ratchets and liquidation preferences do, every entrepreneur I’ve ever talked to finds it violently irritating; I thought the idea was that we were supposed to use the money to build a business and succeed, not to pay legal bills.

Terms in Recent History · What happened was, there was a fairly standard set of terms stretching over the years, but then in the late Nineties the entrepreneurs and the VCs both had a case of bad bubble craziness (me too). The VCs and entrepreneurs co-operated in enthusiastically throwing a lot of other people’s money away on stupid ideas. The other people—the banks, pension funds, and other flavors of money that fund the VCs—got seriously irritated and beat up those VCs that didn’t just shut down.

So the VCs reacted by trying to reduce their risk and improve their positions, in two ways: lower valuations and tougher terms. In a lot of cases, entrepreneurs signed up anyhow, because they bought into the bubble hype, because they thought that down rounds only happened to other people, because they were sure that unlike all those other troubled companies, if they could just get their hands on the money the future would be golden.

I can’t tell you how many horror stories I’ve heard over the last three years, from VCs, entrepreneurs, Investment Bankers, and Company-Rescue specialists, about meltdowns in the boardroom, companies collapsing that might have been saved, and entrepreneurs walking away from decent results with empty pockets, and VC fund portfolios imploding.

The New Thing · There have always been lots of entrepreneurs who’ve pitched and failed. But until recently, it was really rare to hear about someone getting a term sheet and walking away from it. Now I’m hearing that. I think it’s simple; a lot of entrepreneurs have been around the track and understand the rules of the game and just don’t like the odds they’re facing.

My personal opinion is that the good VCs are going to make money by picking the companies that are going to go over the top, not by imposing onerous terms that demotivate the entrepreneurs. But we’ll see.

A Thought Experiment · I don’t know if I’ll ever go after VC funding again; I’ve nothing against the idea in principle, although the practice is often unpleasant. But if I do, and if I get a term sheet, and if we manage to negotiate away the differences, I’ll say something like this: “OK, it says here that you give us the money and you get this many points in the company plus your terms. How’s this: I’ll give you ten more points for the same money, but you take common shares and we’ll really be partners. Deal?” Then you’d find out if they were really entrepreneurial.

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January 29, 2004
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