4.3 Negotiation and structuring of venture capital deals
4 min read•august 9, 2024
Negotiating venture capital deals is a delicate dance between founders and investors. Term sheets outline key agreements, including valuation, equity stakes, and protective provisions. Founders aim for higher valuations, while investors seek lower ones to maximize returns.
The deal-making process involves more than just money. Board composition, vesting schedules, and shareholder rights are crucial elements. Alternative funding structures like convertible notes and SAFEs offer flexibility. Thorough due diligence ensures all parties understand the risks and potential rewards.
Deal Terms
Key Components of Term Sheets
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- Term sheets outline preliminary agreements between investors and startups
- Valuation determines company's worth before investment ()
- Equity stake represents percentage of ownership investors receive in exchange for funding
- grants investors priority in receiving returns during liquidation events
- Anti-dilution provisions protect investors' ownership percentage from dilution in future funding rounds
- Full ratchet anti-dilution adjusts conversion price to lowest price of new shares issued
- Weighted average anti-dilution considers both price and number of new shares issued
Negotiating Valuation and Equity
- Founders aim for higher valuations to retain larger ownership stakes
- Investors seek lower valuations to maximize potential returns
- Negotiation process involves analyzing comparable companies, market trends, and growth projections
- calculated by adding investment amount to pre-money valuation
- Equity stake percentage determined by dividing investment amount by post-money valuation
Protective Provisions and Investor Rights
- Liquidation preference specifies order and amount investors receive in case of company sale or liquidation
- 1x preference returns original investment amount before other shareholders
- Participating preferred allows investors to receive preference plus pro-rata share of remaining proceeds
- Anti-dilution provisions protect investors from value loss in down rounds
- Broad-based weighted average formula considers all outstanding shares
- Narrow-based weighted average only includes preferred shares in calculation
- grant investors access to financial statements and operational updates
- allow investors to maintain ownership percentage in future funding rounds
Governance and Control
Board Composition and Decision-Making
- Board seats allocated to represent interests of founders, investors, and independent directors
- Typical early-stage startup board composition includes 2 founders, 1 investor, and 1 independent director
- Vesting schedules determine rate at which founders and employees earn their equity over time
- Standard : 4-year vesting with 1-year cliff
- Accelerated vesting triggered by specific events (, IPO)
- Board voting rights and decision-making processes outlined in company bylaws
- Supermajority provisions require higher voting thresholds for critical decisions
Shareholder Rights and Protections
- allow majority shareholders to force minority shareholders to join in company sale
- Ensures all shareholders participate in exit opportunities
- Typically requires approval from board and specified percentage of preferred shareholders
- (co-sale rights) allow minority shareholders to join in sale transactions
- Protects minority shareholders from being left out of favorable exit opportunities
- Minority shareholders can sell their shares on same terms as majority shareholders
- Protective provisions require investor approval for specific actions (issuing new shares, selling company)
- gives company or existing shareholders priority to purchase shares before outside sale
Founder and Employee Equity Management
- Vesting schedules incentivize long-term commitment and align interests
- Cliff period (typically 1 year) before any shares vest
- Monthly or quarterly vesting after cliff period
- Stock option pools set aside equity for future employee compensation
- Typically 10-20% of company's equity reserved for employee options
- Option pool creation impacts overall company valuation
- Restricted stock units (RSUs) as alternative to traditional stock options
- RSUs represent promise to issue shares upon vesting, avoiding exercise price complications
Alternative Funding Structures
Convertible Debt Instruments
- Convertible notes function as short-term loans that convert to equity in future funding rounds
- Interest rate accrues until conversion or repayment
- rewards early investors for taking on more risk
- sets maximum valuation for conversion, protecting investor upside
- Benefits include delaying valuation discussions and simplifying early-stage fundraising process
- specifies when note becomes due if not converted earlier
- Conversion triggers include qualified financing rounds, acquisition, or IPO
SAFE Agreements and Variations
- SAFE (Simple Agreement for Future Equity) created by Y Combinator as alternative to convertible notes
- No interest rate or maturity date, simplifying terms compared to convertible notes
- Converts to equity at trigger event (usually next priced funding round)
- Valuation cap and/or discount rate determine conversion terms
- Post-money SAFE introduced to clarify ownership calculations
- Defines investor's ownership percentage based on post-money valuation
- Simplifies cap table management and future dilution calculations
- MFN (Most Favored Nation) provision allows investors to adopt more favorable terms from later SAFEs
Due Diligence
Comprehensive Due Diligence Process
- Due diligence process involves thorough investigation of startup before finalizing investment
- Legal due diligence examines corporate structure, contracts, and intellectual property
- Review of articles of incorporation, bylaws, and shareholder agreements
- Verification of patent filings, trademarks, and licensing agreements
- Financial due diligence analyzes historical financials, projections, and accounting practices
- Examination of revenue recognition, expense allocation, and cash flow management
- Assessment of financial models and growth assumptions
- Technical due diligence evaluates product, technology stack, and development roadmap
- Code reviews, architecture analysis, and scalability assessment
- Evaluation of technical team's capabilities and development processes
- Market due diligence assesses competitive landscape, market size, and growth potential
- Customer interviews to validate product-market fit
- Analysis of market trends, regulatory environment, and potential disruptors
- Operational due diligence reviews business processes, team structure, and operational efficiency
- Assessment of key performance indicators (KPIs) and metrics
- Evaluation of supply chain, distribution channels, and operational risks
Key Terms to Review (27)
Acquisition: Acquisition refers to the process of obtaining control over another company or its assets, often through purchasing the company's shares or assets. This process can occur in various contexts, including venture capital and private equity, where investors seek to gain ownership stakes in startups or established firms. In mergers and acquisitions (M&A), an acquisition can be a strategic move to enhance market share, diversify product offerings, or achieve synergies that improve overall business efficiency.
Anchor Pricing: Anchor pricing is a psychological pricing strategy where a reference point is established to influence the perception of value and price for a product or service. This technique plays a crucial role in negotiation and structuring deals, as it helps investors and entrepreneurs frame their expectations and perceptions of fair value, making it easier to reach an agreement during discussions.
Anti-dilution clause: An anti-dilution clause is a provision in investment contracts that protects investors from the dilution of their ownership stake in a company during future rounds of financing. This clause ensures that if a company issues new shares at a lower price than the investors originally paid, the affected investors will have their ownership percentage adjusted to maintain their investment's value. This feature is crucial during negotiations and structuring of venture capital deals, as it safeguards investor interests against unfavorable market conditions or company valuations.
BATNA - Best Alternative to a Negotiated Agreement: BATNA refers to the most advantageous course of action a party can take if negotiations fail and no agreement is reached. This concept is crucial in negotiations as it empowers parties to understand their options outside of the deal being negotiated, which in turn influences their bargaining power and decision-making process. Knowing one’s BATNA helps in setting realistic goals during discussions and can lead to better outcomes by establishing a clear baseline for acceptable agreements.
Conversion Discount: A conversion discount is a financial term that refers to a reduction in the price per share for investors when converting their convertible securities into equity. This discount acts as an incentive for early-stage investors to convert their investments into equity, especially when the company raises new capital at a higher valuation. The conversion discount is crucial in venture capital deals as it helps determine the financial structure and potential return on investment for both investors and founders.
Convertible Note: A convertible note is a type of short-term debt that converts into equity, usually during a future financing round. This instrument allows investors to provide funding to a startup in the early stages while deferring the valuation of the company until later, which can be beneficial for both the investor and the entrepreneur.
Drag-Along Rights: Drag-along rights are contractual agreements that allow majority shareholders or investors to force minority shareholders to sell their shares in the event of a sale of the company. This mechanism is crucial in venture capital deals as it ensures that potential buyers can acquire 100% ownership, making the company more attractive for acquisition and facilitating smoother transactions.
EBITDA: EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It’s a financial metric that helps assess a company's operational performance by focusing on its earnings from core business activities without the influence of capital structure, tax rates, or non-cash accounting items. This metric is essential when analyzing a company's profitability and is often used as a proxy for cash flow, making it crucial in various stages of investment and financial assessment.
Equity Dilution: Equity dilution refers to the reduction in existing shareholders' ownership percentage of a company due to the issuance of additional shares. This often occurs during financing rounds when new investors come on board, thereby increasing the total number of shares outstanding and diluting the value of shares held by existing shareholders. Understanding equity dilution is crucial in negotiations and structuring of deals, as it directly impacts ownership, control, and potential returns for all stakeholders involved.
Information Rights: Information rights refer to the legal and contractual entitlements that investors, particularly venture capitalists, have to access information about a company's financial performance, strategic direction, and operational status. These rights are crucial for investors to monitor their investments effectively and to protect their interests as they navigate various aspects of the deal-making process, governance, and risk management.
Internal Rate of Return (IRR): Internal Rate of Return (IRR) is a financial metric used to evaluate the profitability of potential investments, defined as the discount rate that makes the net present value (NPV) of all cash flows from an investment equal to zero. In the context of venture capital deals, IRR helps investors assess the expected returns from their investments and compare different opportunities. A higher IRR indicates a more attractive investment, which is critical during negotiations and structuring to determine the terms that align with the interests of both investors and entrepreneurs.
IPO - Initial Public Offering: An Initial Public Offering (IPO) is the process through which a private company offers its shares to the public for the first time, transitioning into a publicly traded company. This event allows the company to raise capital from public investors, which can be crucial for growth and expansion. An IPO not only provides liquidity to early investors and employees but also establishes a market value for the company, significantly impacting its future fundraising capabilities.
Lead Investor: A lead investor is a venture capitalist or institutional investor that takes the primary role in a funding round, often setting the terms and conditions of the investment. This investor typically commits a significant amount of capital and often serves as a key decision-maker, guiding the negotiation and structuring of the deal to align with their strategic goals. The presence of a lead investor can also signal credibility to other potential investors and help attract additional funding.
Liquidation Preference: Liquidation preference is a term used in venture capital that dictates the order of payouts to investors in the event of a company’s liquidation or sale. It ensures that investors, especially preferred shareholders, receive their initial investment back before any remaining assets are distributed to common shareholders, providing a layer of security for their investment. This term is crucial in negotiations and deal structuring, influences the components found in term sheets, and plays a significant role in investment modeling and financial projections.
Maturity Date: The maturity date is the specified date on which a financial instrument, such as a loan or bond, is due for repayment. It marks the end of the investment period and is crucial in determining when the investors receive their principal back along with any interest payments. Understanding this term is essential for negotiating terms in venture capital deals, as it influences cash flow planning and investor expectations.
Post-money valuation: Post-money valuation is the estimated worth of a company after it has received external financing or investment, reflecting the new capital added. This figure is crucial in determining the ownership percentage that existing and new investors will hold, directly impacting negotiation strategies, terms laid out in agreements, and investment modeling practices.
Pre-money valuation: Pre-money valuation refers to the estimated worth of a company before it receives new investment or funding. This figure is crucial in determining how much equity investors will receive in exchange for their investment, and it sets the stage for negotiations on deal terms. Understanding pre-money valuation helps all parties involved grasp how much a company is valued prior to the capital influx, influencing negotiations, investment structures, and financial modeling.
Preferred Equity: Preferred equity is a class of ownership in a company that has a higher claim on assets and earnings than common equity. It typically offers fixed dividends and comes with specific rights and privileges that are not available to common shareholders. In venture capital deals, preferred equity is often structured to protect the interests of investors by providing them with priority in cash flows and liquidation events, which makes it an essential element in negotiations and deal structuring.
Pro-Rata Rights: Pro-rata rights are provisions in investment agreements that give existing investors the option to maintain their ownership percentage by participating in future funding rounds. This right is crucial for investors as it allows them to prevent dilution of their equity stake when new shares are issued. These rights are often negotiated during the initial investment and can significantly influence the structuring of venture capital deals.
Right of First Refusal: The right of first refusal (ROFR) is a contractual agreement that gives an individual or entity the first opportunity to purchase an asset before the owner sells it to someone else. This term is commonly seen in venture capital deals, where investors may want to maintain control over their investment by having the first chance to buy additional shares or interests in a company. It acts as a protective measure for investors, ensuring they can increase their stake without competition from outside buyers.
SAFE - Simple Agreement for Future Equity: A SAFE is a financing contract that allows investors to provide capital to a startup in exchange for the right to receive equity in the future, typically during a subsequent financing round. This agreement simplifies the investment process by eliminating the need for immediate valuation of the company and providing a straightforward mechanism for converting the investment into equity when specific conditions are met.
Syndicate: In the context of venture capital, a syndicate is a group of investors who come together to pool their resources and invest collaboratively in a startup or venture. This arrangement allows for the sharing of risk and capital while also enabling access to larger deals that may be beyond the reach of individual investors. Syndicates often include venture capital firms, angel investors, or other entities, and they can help leverage collective expertise and networks to support the growth of the funded company.
Tag-along rights: Tag-along rights are contractual agreements that allow minority shareholders to sell their shares alongside majority shareholders if the latter decide to sell their stake in a company. This provision protects minority investors by ensuring they have the opportunity to participate in a liquidity event, thus mitigating the risk of being left with an illiquid investment. It plays a crucial role in negotiations and deal structuring, as it influences the dynamics of ownership transfer, terms within term sheets, governance provisions, and risk management strategies during investment exits.
Term Sheet: A term sheet is a non-binding document that outlines the key terms and conditions of an investment deal between parties, often serving as a foundation for negotiating a formal agreement. It highlights the essential elements of the proposed transaction, such as valuation, investment amount, ownership structure, and governance rights, making it crucial for understanding the economic implications and structuring of venture capital deals.
Valuation Cap: A valuation cap is a term used in convertible notes and SAFEs (Simple Agreements for Future Equity) that establishes the maximum valuation at which an investor's investment will convert into equity during a future financing round. This cap protects early investors by ensuring that they receive equity at a favorable valuation compared to new investors if the startup's valuation increases significantly. It serves as a negotiation tool, balancing the interests of both entrepreneurs and investors during the structuring of venture capital deals.
Vesting schedule: A vesting schedule is a timeline that outlines when employees or founders earn their rights to benefits, usually stock options or equity in a company. This process ensures that individuals must remain with the company for a specified period before fully owning their granted shares, aligning their interests with the company's long-term success and mitigating the risk of short-term exits. Vesting schedules play a crucial role in negotiations and structuring of deals, as well as in incentivizing management by fostering a sense of ownership and commitment.
Waterfall Structure: The waterfall structure is a financial arrangement commonly used in private equity and venture capital that dictates the order in which distributions are made to investors and stakeholders upon a liquidity event, such as the sale of a company. This structure ensures that investors receive their returns in a specific sequence, often prioritizing certain classes of investors based on their risk profile and investment agreements. It is crucial for understanding how profits are allocated and can significantly impact negotiations and structuring of deals.