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Venture capital funding is a critical step for many founders looking to scale their startups. When asked “How do you decide to fund one company and not another?” Our team points to the Six Ts: theme, team, terrain, technology, traction and terms. In our Startup Growth Toolkit series, we explore the six Ts that founders should consider when growing their startup – wrapping up with Terms.
By this point, you have made a connection with venture capital investors and secured interest in your business – congratulations! Now, it all comes down to dollars and ‘sense’, or the venture capital deal terms. The meetings may have gone smoothly up until this point, but now the investors and founders need to agree on the final deal terms.
Expectations & Goals When Establishing Venture Capital Deal Terms
At Blumberg Capital, our goal and overall belief when investing in new companies is to try and achieve ‘alignment of interest’. When you win, we win. For early stage investments in particular, we aren’t seeking to take control of your company.
The relationship between early-stage investors and entrepreneurs is a partnership – and terms play a significant role in setting this foundation. For example, when we first met with the Nutanix founders, our focus was on being flexible and providing them what they needed. Other investors had expressed interest in investing significantly more capital from the get go but in turn, expected broader control.
How to Know When Deal Terms Negotiations Will Lead to Agreeable Partnerships
It is just as important for entrepreneurs to choose the right investor, as it is for investors to choose the right investments. Sometimes we joke that a ‘good’ partnership is formed after a healthy negotiation on terms where neither party leaves happy – it shows we reached an agreeable partnership that will be beneficial for both the venture capitalists and the company.
In a meeting with potential venture capital investors, entrepreneurs should be prepared to negotiate on the terms that will have an outsized impact on the future growth of the business. Venture capital deal term negotiations may include:
Valuation is the term that most entrepreneurs zero in on. While it’s certainly important, what really drives terms in the future is simple supply and demand. If the founders execute on meaningful milestones as promised, then you will likely remain “in control” of your company with future financings. Conversely, if you fall short, and there is little demand from new investors and/or you need to go back to your initial investors, then they are in control of your company. So, be careful what you promise. Try to under promise and over deliver.
How do VCs determine valuation? There are various financial methods, like discounted cash flow analysis, but the real challenge is when we typically invest, there may not be any customers, revenue or even a product. There is a general ‘rule of thirds,’ where investors target ownership of one third post-funding with the remaining two thirds staying with the founders and reserved for future employee hires. Once again, supply and demand can influence the above in either direction.
From our experience, entrepreneurs focus their attention on the valuation the most and not enough on the other items on the venture capital deal term sheet which could potentially have a much greater impact on the future of the business.
This is an extremely important term for entrepreneurs to pay attention to, as it can have a significant impact on their return. Founders should model out potential exit scenarios and values in order to understand the actual dollar differences between various liquidation preference formulas.
Remember, liquidation preferences are only relevant for companies that exit via M&A or by selling off assets in a bankruptcy or recapitalization. It isn’t relevant for public exits, as IPOs typically convert preferred shareholders into common shareholders automatically. With the vast majority of exits being M&A, this potential preferred return from senior liquidation preferences can negatively impact both entrepreneurs and early investors.
Veto rights are part of protective provisions that provide investors with special veto powers over key business decisions. For example, veto rights might empower investors to decide if/when financing events occur, potential timing for an M&A event and even decisions around who should be hired or fired.
In a terms discussion with investors, entrepreneurs must review each veto right in relation to the other terms being set (i.e. a higher valuation may not hold as much value if the investor is proposing strict veto rights).
This is really a question of who controls the company. At Blumberg Capital, our philosophy (and advice) is that entrepreneurs should have a voice on the board and potentially even be in a position of control, especially in the early stages. In our experience, adding one or two independent board members who have relevant senior industry expertise as early as possible is a huge win for the company. Regardless, entrepreneurs should expect to be the minority on the board in subsequent financing rounds. For example, we were the lead Seed investors in Braze and actually conceded our board seat for Phil Fernandez, an independent board member who was previously the CEO and Chairman of Marketo.
In a VC funding deal terms discussion, it’s critical for entrepreneurs to have a constructive discussion about board makeup to ensure that everyone is aligned on the goals, governance and mission of the company moving forward.
Finally, a vesting schedule for stock option grants is a must-have for founders and investors who want to protect the future of the company. It’s a way of rewarding those who have worked hard to build and grow the business. For an early investment, a common schedule is vesting over four years with a one year cliff.
Beyond what’s on the deal term sheet, the most important thing is to provide entrepreneurs the room they need to flourish, while the investors serve as active mentors and coaches. Instead of looking at our relationships with entrepreneurs as a ‘deal’, we like to view it more as a value-added service. We vow to be a supportive partner and aspire to under promise and over deliver.
At the end of the day, the intangible term for entrepreneurs is knowing you have a lifecycle investor who will be there for you throughout the highs and lows of your business. Remember, it’s commonly stated that when you take investment from a VC, it is like a long-term marriage. With no divorce option, make sure you choose wisely.
This post is the final in our Startup Growth Toolkit series that explores what founders need to successfully pitch their business to investors to secure venture capital and growth their startup.
For more on the role terms plays in venture capital funding, take a look at our other deep dives: