Raising money, even in the best of funding environments and with the hottest idea, is time-consuming and challenging. The terminology used in term sheets--"pre-money," "priced round," Series A," "participating Preferred"--can be like a foreign language. And you're supposed to successfully learn and handle this process all while you're growing and running your company!?
The following tips should prove helpful in navigating the equity financing arena, particularly in your first angel or venture capital round.
There is no one size fits all.What makes a term sheet good or bad depends on a number of factors, including the stage of the company, the nature of the existing and new investors, the credentials of the management team, the "hot" fundable ideas du jour, the amount and terms of funds you've raised to date and the investment environment.
Raise enough money to take you to the next valuation inflection point. Fundraising is tremendously time consuming and you will almost always need more money than you think to get to the next stage. How much funding do you need to achieve one or more milestones that will truly make your company more valuable in the next round of financing?
Evaluate the proposed valuation in the context of the entire term sheet and the quality of the investor.The highest valuation may not be the best overall deal. And a high valuation can lead to unhappy investors if the next financing is at a lower valuation. Also, if you have the luxury of choosing among lead investors, consider who will make the best partner to work with going forward--who shares your vision, really understands the space, and shows enthusiasm and trust.
Build your own pro forma cap table showing post-deal equity ownership. Include the cap table in the term sheet. This will help you understand the impact of the proposed economic terms on management and existing investors, and will reduce the chance of a misunderstanding between the company and the investors regarding how the proposed terms actually work. The cap table should include an equity pool reserved for employees and other service providers that is adequate to attract the necessary talent to take the company to the next level (typically 10-20% of total shares).
The principal factor affecting "real" valuation is the liquidation preference. Is the preferred stock participating or non-participating? Is the participation capped? Prepare a model of how the proceeds of a sale of the company would be split among the equity holders at different sale prices.
Control of the company is driven by the terms of the investment documents, not just the percentage ownership. Investors will have veto rights over later financings, the sale of the company and certain other actions, no matter what percentage they own. Also, the agreements will address investor representation on the Board of Directors and typically dictate the "slots" for the entire Board and Board committees. Try to build a balanced Board of Directors, including industry experts who are neither management nor investors.
Do your own diligence on the investors while they do theirs on you and the company. What is their industry knowledge and network, their "dry powder" for later rounds, how have they conducted themselves with other portfolio companies?
Pick your issues.Don't negotiate every term. Make sure you understand what each proposed term means, whether it is "standard" and what the alternatives are.
Understand the role of the CEO/founder in the term sheet negotiation. As CEO, you are negotiating on behalf of the company (your stockholders/members), not on behalf of yourself. You can-- and should--make sure you are adequately incentivized, but that is a separate and parallel negotiation. Note that employment agreements are rare in early stage companies.
Engage an experienced lawyer to assist the company in the transaction. Your "friend" or "personal lawyer" may be the closest to you and the least expensive on an hourly basis, but having a lawyer who has handled numerous venture transactions and represented numerous emerging companies will, in the end, make the transaction go much more smoothly and at a lower overall cost.
The important thing to remember is that valuation alone may not be the most important measure of the best term sheet. If you follow these tips, you will be a few steps closer to closing a successful financing.
This post and others like it can be found in the Springboard-curated book Been There, Run That, edited by our Chairperson Kay Koplovitz.
Ellen Corenswet has over 35 years of experience representing emerging companies and investors in the technology, media, life sciences, retail and financial services industries. She is the Co-Chair of Covington's Venture Capital/Emerging Company Practice Group and resides in the New York office. Ellen is passionate about working with the founders and management teams in early stage companies. She takes a hands-on, pragmatic, business-focused approach to advising these companies. She typically acts as outside corporate general counsel to her company clients-providing day-to-day strategic advice as well as representing her clients in financings and commercial transactions. Ellen has helped companies prepare for IPOs and acquisitions. Ellen is on the Board of National Advisors of Springboard Enterprises, Inc. and has been a long-time advisor to Springboard companies in the tech, media and life sciences sectors. Ellen is on the Board of Directors of New York BIO.