First the good news. If you get a signed term sheet with a reputable angel or venture investor, there is a very good chance you will get a deal done. Unless, of course, you don’t.
Probably the most common element of every term sheet is the provision that states unequivocally that by signing the term sheet neither party is obligating itself to enter into an investment transaction, whether on the terms reflected in the term sheet or otherwise. Still, if the parties do reach agreement on a term sheet, there usually is a deal made, and usually on terms mostly consistent with the term sheet. That said, herewith a look at the most common reasons a “done term sheet” does not lead to a “done deal.”
The last couple of years have been pretty good for entrepreneurs seeking venture capital. Valuations have been going up, and financing terms have been loosening up. Something like 150 so-called “Unicorns” – VC-backed private companies valued at $1 billion and up – have débuted. Alas over the last couple of months a handful of those Unicorns have seen their valuations plummet well below $1 billion. Conventional wisdom tells us the age of the Donkey is nigh.
There’s been a lot of fretting lately about funding reductions for the UW system, including the flagship campus in Madison. There is no doubt that anything that reduces the real or perceived quantity and quality of either the research or educational output of the UW system has negative implications for Wisconsin’s economy. How much is a debate I won’t jump into. Instead, I’ll argue that the law of unintended consequences works both ways: that in some cases, including this one, the unintended consequences can be positive.
The situation with UW funding reminds me of something that happened in the Raleigh-Durham, NC area in the early 1990s. The “Research Triangle” as it is known, was at the time dominated by big companies (including IBM, whose RTP workforce was second in size only to the corporate HQ in Armonk) and the “Big Three” Universities (UNC, NC State and Duke). These organizations, public and private, seemed like permanent parts of the landscape. The high impact entrepreneurship and venture capital scene was very small: why take the risk, most people thought, of starting a new business when there were so many huge, established and prestigious places to work?
Convertible debt with an equity kicker – these days usually a discount on the conversion price – has been a part of the venture capital landscape for as long as I have been in the space, which takes it back thirty some years. In the beginning, it was used mostly in the context of bridging a company cash for several days or maybe weeks while the company and its investors tackled the complexities of moving money and documents around when FedEx was in its infancy, fax machines with crinkly paper were costly and unreliable, and word processing was a cost center run more or less like the typing pools of the 1950s.
In my previous blog, I wrote about two factors that distinguish investment due diligence in seed and early stage high impact investing from investment due diligence for more established businesses. On the one hand, seed and early stage due diligence is binary – every deal must have 10x return potential, but few deals actually deliver anything like that kind of return. On the other hand, it is more qualitative in that seed and early stage businesses don’t usually have the kind of track records needed to make financial modeling and forecasting more than a fanciful exercise.
On Friday, October 30, 2015, the U.S. Securities and Exchange Commission (SEC) finally adopted final rules for implementation of Title III of the JOBS Act, which allows companies to offer and sell its securities through the use of crowdfunding. The final rules are the culmination of a three-year process of proposed rules and delays.
I have had the privilege of knowing the folks at Aver Informatics since the team consisted of the two founders and the plan was on the back of an envelope. It has been quite a ride over the last few years, a ride that, alas, has taken the company from Green Bay to Columbus Ohio. As a strong advocate for high impact entrepreneurship and venture capital here in the Badger State, last year’s move to Ohio was disappointing. As a small investor in Aver – and having spent some time with the company and its lead investor in Columbus last week – I am a bit chagrined to say that, well, moving to Ohio was a great idea.
Most high impact entrepreneurs need capital to build their businesses. The amount of capital, and the timing of the infusion(s), is mostly a function of the kind of business/business model and the time it takes to get home – that is to an exit transaction. So, for example, an entrepreneur who happens to be a programming wizard with a simple, niche mobile app might need say $10,000 to develop, validate and sell his app/business for several million dollars in say 12 months (the assumptions here being that the app is in fact something that the market wants, and the execution by the entrepreneur is outstanding).
If you know anything about venture capital investing, you probably know that most plans that come across the desks of venture capitalists (and angels, for that matter) are not fundable. That is, they are of so little merit that no half-way competent investor would back them at any price.
While lots of plans get rejected because they are frankly bad, in my own experience as an entrepreneur, angel and institutional venture capitalist I have been struck by how many fundable deals get turned down by so many competent investors.
In a recent Washington Post commentary, DC-area entrepreneur Joel Holland cites four reasons he believes account for the recent emergence of the nation’s capital as a modest but real center of startup-driven innovation and venture investing. One reason he cites is a business and social culture that – in sharp contrast with Silicon Valley, he notes – supports more stable employment relationships. Holland posits that lower employee churn is something that gives DC-area innovators a competitive advantage over their Silicon Valley counterparts.
I beg to differ.
After launching my career in and around the high impact entrepreneurship space and venture capital in Silicon Valley in 1985, I moved on to North Carolina in 1990. After an .. exhilarating? … run as a venture capital investor (fund class of 1999 which, if you know the history of the business, is more than enough said) I proved to myself, at least, that sometimes you can just go home.
Every now and again, you hear about an entrepreneur achieving a solid exit after a single “A” round of venture capital financing. More often than not, however, venture-backed entrepreneurs go through several rounds of venture financing on their way to achieving the cash-out exit of their dreams. That said, the dynamics of “B” and other “follow on rounds” do not get as much attention in the entrepreneurial press as the dynamics of “A” rounds. Thus, some thoughts here on follow on rounds of venture financing.
Venture capital investors are not like the rest of us. When regular folks buy a share of stock and the stock subsequently trades for a lower price, they take their losses. All of them. When a venture capitalist buys a share of stock, and the company subsequently sells shares at a lower price, the venture capitalist doesn’t usually feel the full loss. Sometimes, the VC doesn’t take any loss at all. Welcome to the world of “price protection.”
When high impact startups outside the major venture capital centers start getting on the radar screens of larger established venture center investors, their angel investors will from time to time be faced with a choice: should they cash out (sell their angel shares into the new VC round) or hold on to those shares in anticipation of a much bigger exit down the road.
In an earlier blog (Capping Preferred Participation: A Compromised Compromise) I argued that the usual middle ground between entrepreneur-friendly “non-participating” preferred stock and investor-friendly “participating” preferred stock – capping participation at some multiple of an investor’s base preference – is seriously flawed. Herewith an alternative approach.
Ok, being a lawyer in the high impact entrepreneur space myself, writing this blog (well, posting it) is a bit awkward. But having seen – not only as a lawyer but also as a serial venture-backed entrepreneur myself, as well as venture capital and angel investor – so many entrepreneurs squander so much money, energy and time working with the wrong lawyers (and more than a few deals crater as a result), well, it just has to be done. So here goes: my advice to high impact entrepreneurs on picking a lawyer.
The hockey stick, that is.
High impact entrepreneurs know – or learn pretty fast – that most angel and even most venture funds outside of the major venture centers take a perverse satisfaction in telling entrepreneurs that they are being naïve when they build the proverbial “hockey stick” growth assumption into their business plans.
Last spring I wrote a blog with the headline, “Maybe It Can Happen Here,” touting a Wisconsin high impact business accelerator’s Launch Day for their Winter 2013 class of startups. The folks at gener8tor are at it again; Launch Day for the Summer 2013 class is coming up this Thursday in Milwaukee.
I have written several times suggesting that entrepreneurs not put price tags on their startups. For a variety of reasons, entrepreneurs should postpone the valuation discussion until an investor capable of leading the financing steps up to the plate and suggests serious interest in doing the deal. What if, as all too often happens, when less sophisticated investors are involved, an investor asks for a pre-money valuation in an initial presentation or even initial contact? Several thoughts.
Most of the things we shop for these days come with a sticker price. Even things we assume will have some room for negotiation–like cars and houses–usually come with a price tag. And so many entrepreneurs think they should put a price tag on their startup when they approach investors.