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Sourcing and Screening Investment OpportunitiesDue diligenceInvestment Terms, Negotiation, ClosingPost Investment MonitoringExits
Valuation or percentage of ownership at the point of investmentInformation rights/board seatAbility to invest in future rounds to maintain pro rata ownershipLiquidation preferences
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Venture Capital
Overall Investment Process
Where Venture Capitalists Source Deals
Sources of Investments
Source
Positives
Negatives
Accelerators and incubators/demo-days
Large volume of vetted opportunities. Best suited for seed investors
Overcrowding—the best start-ups are funded prior to demo-days. For some start-ups, valuation can get inflated very quickly.
AngelList/online matchmaking sites
Access to opportunities, no geographic barriers.
Stimulates herd mentality of stock market.
Peer investors/other venture practitioners
Speedier due diligence in trusted relationships.
Lame horses can be parlayed as great opportunities.
Attorneys, accountants, and consultants
Can provide some level of prescreening based on fund criteria and fit.
Caveat emptor: All clients who pay $800 an hour look great!
Banks/venture debt providers
Can mitigate risk; may have skin in the game.
Senior lenders have first lien on assets.
Serial entrepreneurs
Well-vetted ideas, better understanding of investor mind-set, recognition of challenges.
May not have any skin in the game.
Economic development/nonprofit professionals
Volume, access to a larger network.
Quality may be suspect.
Business plan competitions and venture forums
Prescreened and vetted, this may be a good source of opportunities for early-stage investors.
Watch for students who participate for the sake of participating and winning—not building a business.
University tech transfer offices, federal research labs
Diamond in the rough! May need to invest time to build the business strategy and team.
Watch for technology in search of an application.
Corporate spinouts
Potential for joint development, coinvestments
Market size may be limited. Patents may have limited shelf life.
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Typical Percentages of Investment
VC Screening Percentages.
Type
New Opportunities
First Screen
Meetings
Due Diligence
Closing
Typical
100%
6.5%
5.1%
3.2%
2.3%
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Due Diligence Checklists
VC Criterias and Standards
Criteria
Standard
Product or service
The product or service is described completely and concisely. The need for the product or service is evident. The stage of development—prototype, first customer, multiple customers—is identified. A development road map is included.
Customers, revenue, and business model
The customer value proposition is quantifiable, high, and recognizable. The market need is established, and the customer has an urgency to act. The product price points are identified, along with gross margins and costs.
Market size
The current target and addressable market size is estimated. It is a large and growing market, quantifiable to a certain degree.
Management
The key team member(s) have the expertise and skills needed to run this type of business. Is there clarity on additional hires and timing of recruitment? What are the significant holes in the team?
Competitors and competitive advantage
The product or service is better than the competition based on features and/or price. Is current and future competition identified and evaluated for weakness or significant barriers?
Capital efficiency and value creation
A reasonable milestone event chart with value drivers, date, and capital needs is identified.
Financials
Are plans based on realistic assumptions with reasonable returns? Does it contain reasonable, justifiable projections for two to three years with assumptions explained?
Exit assumptions
Is there a reasonable exit time frame? Is there some clarity on the target universe of buyers?
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VC Criteria by Stage
Subject
Seed
Early
Growth
Management
What is the founder's expertise and understanding of the market pain? Does management have the ability to let go and attract smarter people at the right time?
Based on market needs, can the management team take a prototype and develop a commercial product? Technology development? Sales? Financial?
Can the team achieve high growth, high margins? Explore geographic expansion? Manage resources—people and cash— effectively? What are the board dynamics?
Market
Is there a need in the market? Is it a growing market? Will the market expand to accommodate breakthrough products?
Gauge the ability to cross the chasm from early adopters to mainstream market.
Look for the arrival of me-toos, competitive pressures.
Technology
IP assessment. Freedom to operate. Laboratory scale data. Can you make it once?
What are the features and alignment with market needs? What are the market/customer level data? Can you make it many times?
Look at deployment and operational efficiencies. Can you make it consistently, with high quality, while maintaining costs?
Financials
Is this a shot in the dark? Look for milestones and capital needed to reach value creation.
What is the test pricing and what are the revenue assumptions, gross margins?
What is their margin erosion? What is the ability to improve or sustain gross margins? Assess detailed financial analysis of past (1) income statement, (2) balance sheet, and (3) cash flows.
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VC Negotiation Points of Conflict
The entire philosophy of term sheets is summarized in Steven Kaplan and Per Stromberg's words: “The elements of control: Board rights, voting rights and liquidation rights are allocated such that if a firm performs poorly, the venture capitalists obtain full control. As performance improves, the entrepreneur retains/obtains more control rights. If the firm performs very well, the venture capitalists retain their cash flow rights, but relinquish most of their control and liquidation rights. [italics added]”
Key Investment Terms in Equity Rounds
While negotiating equity rounds, the key elements VCs focus upon are:
Battlefield Needs and Wants
Timing
Startup Wants
VC Wants
Battlefield Terms
Pre-investment
1
Maximize valuation
Lower valuation; potential for up rounds and target returns
Price per share and amount of investment leading to valuation
At point of making an investment
3
Adequate capital to meet and exceed milestones
Capital efficiency; reach breakeven/financial independence rapidly
Amount of investment, use of proceeds
Avoid loss of control
Exert control if the milestones start to slip. Ensure that the team, strategy, and vision are aligned
Employment agreements, vesting of founders’ stock, structure of board, independent board seat choices
Freedom to operate their businesses. No micromanagement.
Ensure that execution is per predetermined milestones.
Board and governance matters; milestone-based financing
Between investment and exit
2
As needed, investors should assist with future financings, strategy, and customer connections
If opportunity grows rapidly, maintain pro rata ownership
Preemptive rights or right of first refusal
Stay in control and experiment despite inefficiencies
If it doesn't grow as well and ends up in the “living dead” category, VCs should have the ability to liquidate their holdings.
Antidilution, redemption, or liquidation, drag-along rights and tagalong rights
Exit
1
May choose an early exit to accomplish personal financial goals, or delay/avoid an exit to achieve ego-driven needs (like world domination).
Speed to exit and maximized value is critical.
Redemption, dividends, liquidation preferences, and registration rights
VCs Investment Terms
Type
Term
What it Means
Importance to Investors
Key Negotiation VariablesSeen as
Key Investment Terms
7
Valuation
Establishes value of a company
Project potential internal rate of return
Percentage of ownership, price per share
Liquidation preference
Creates a waterfall of distribution—who gets paid first and how much—when a liquidity event occurs
Improves returns at exit, protects investment at lower exit values
Multiple (1X, 2X), participating preferred, cap/no-cap
Antidilution
Prevents dilution of investors’ ownership if a down round occurs
Minimizes downside/protects ownership
Weighted average/full ratchet
Dividends
Allows investors to declare dividends
Improves potential returns
Percentage, cumulative/noncumulative
Preemptive rights/right of first refusal (ROFR)
Allows investors to buy additional shares in future rounds
Allows for increasing ownership if opportunity gets stronger
Time frame for decision, pro rata share
Redemption of shares
Allows investors to redeem their ownership/shares after a certain time frame. Ensures that investors are able to trigger the timing and conditions of an exit; drag-along and tagalong rights allow one party to sell his or her shares if the other party is able to find a seller.
Allows for exits; redemption is especially important when the company has minimal upside potential. Registration rights depend on the strength of the company and state of the public markets.
Time period (number of years), fair market value.
Registration rights, conversion to common at public offering, piggyback rights, drag-along rights/tagalong rights, co-sale agreements
Seen as Boilerplate, Meant to be ignored, Shouldn’t be ignored.
These are exit-related provisions, and the implication is that “savvy” practitioners do not waste much time negotiating these supposedly standard or boilerplate terms.
Negotiate for good reason especially not normal. Check this.
Governance Terms
4
Board composition
Number of seats for Series A, common, and independent shareholders
Allows for control and protection of security
Number of seats, how the board structure can be changed, rights of preferred shareholders vis-à-vis the rest
Board-approval items
Board approves hiring of executives, employment and compensation agreements, issuance of stock options, annual operating plan, and incurrence of debt obligations or contracts above a certain financial limit
To protect the ownership and equity, board would approve key business decisions that may impact the operations or the equity structure of the company.
David Cowan of Bessemer Venture Partners says, “As long as the ink is black—if the company is doing fine—I don't care much about control provisions.”*
Protective provisions
Allows for protection of security interests
Preferred shareholders will approve all changes to securities, board structure, mergers, redemption of stock, and amendments to articles of incorporation
Most of these terms are standard, and very few practitioners open these up for negotiation.
Employment and vesting for management
Keeps management team focused on building the business
Aligns interests of founders and investors
Employment agreements, stock vesting, restrictions on co-sale, creation of option pool, key man insurance, noncompete provisions
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