VENTURE CAPITAL FINANCING CHECKLIST
CheckList
____ 1. Work with your investor
____ 2. Make sure investors are accredited
____ 3. Have the right mindset and be ready
____ a. Don't be a pushover
____ b. Don't be unreasonable
____ c. Be determined
____ d. Know your business in and out
____ e. Have all of your presentation and background materials ready
____ f. Know your potential investor
____ g. Have your corporate governance in order
____ h. Know your strengths and weaknesses
____ 4. Understand startup math
____ 5. Set the precedent for future investors
____ 6. Don't sell the same shares at the same time to different individuals for different prices
____ 7. Don't ignore red flags
____ a. Equity investors should have no more than 1x liquidation preference, no participation
____ b. Excessive dividends
____ c. Don't allow for excessive downside protection
____ d. Be careful of preemptive rights
____ 8. Watch for any values that are outside of the reasonable ranges
____ 9. Keep in mind the overall SYSTEM and don't get distracted
Checklist & Explanation
STRUCTURE
____ 1. Work with your investor
I always, always, always advocate a good working relationship between the company and the investors.
It's stupid and naive when people think of investors as enemies and vice versa.
They aren't trying to steal your idea and company away from you. If they do, that's your fault. But that doesn't mean to be combative. Nor does it mean to be weak. Be strong, be firm, but also be respectful and cooperative.
The best run startups I've seen have investors and founders working together. They understand that they are working together on the same goal--to build and grow the company. Yes, there are times when the two parties are on opposite sides of the table, but both are fundamentally on the same team.
This goes beyond working with investors. I've seen different companies that have a relationship together fight, bitch, and bicker with such venom it's ridiculous.
This is true regardless of where you are. My observation as a startup lawyer in Houston and Dallas is that individuals in Texas are generally pretty good about working with each other. There are some individuals out there that are something else though.
If you do your homework, know what your limits are, and work collaboratively--it'll be fine.
____ 2. Make sure investors are accredited
If the investor is not accredited, I can be certain that you are running afoul of SEC/securities regulations and that everything is in jeopardy. Just don't do it.
Follow securities regulation. Investors need to be accredited.
- An accredited investor is an individual with an income of at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year; or
- Has a net worth of at least $1M not including value of primary residence; or
- A director, executive officer, or general partner of the company selling the securities;
Certain entities may also qualify as an accredited investor.
Don't mess around with this point.
____ 3. Have the right mindset and be ready
____ a. Don't be a pushover: I've seen entrepreneurs that were willing to take any deal possible. You could smell the desperation in them. It was pathetic. They were considering some of the worst deals I had ever seen when any self-respecting individual would decline it immediately. Don't be desperate.
____ b. Don't be unreasonable: At the same time--don't think you're the greatest thing ever. Because you're not. No one is. Know your value.
____ c. Be determined: If you want to raise money, be determined. If you want to make your product the best, be determined to do so. The best of the best entrepreneurs I've had the pleasure of working with are unbelievably determined. In fact--they are so determined, it can be scary to some people.
____ d. Know your business in and out: Competition is fierce. Practice and know your shit. Actually practice talking to others about your business. Know how much revenue you've generated. Know how much runway your business has. Know how much you are looking to raise. Know what your timeline looks like. Know your competition. Know your market. One time I watched two different groups approach investors back to back. Same idea. Same everything. One group was incredibly polished and knew their shit. One wasn't and stumbled all over the place. Who do you think ended up doing better?
____ e. Have all of your presentation and background materials ready: This includes documents like an executive summary, elevator pitch, business plan, etc. ready. There's enough literature out there to show you how to do this. A lot of this material may be unnecessary. In fact, many investors don't give a shit about 100 page business models. Be ready but also be reasonable about it. Don't waste all of your time on this kind of thing. Strike a balance within your system and focus on your business.
____ f. Know your potential investor: Many investors look to invest in sectors or industries that they have experience in. I've spoken to a number of investors who will only invest in biotech companies or energy companies. They have told me that they will only invest in A, B, C industries and won't bother with X, Y, and Z. Know why or why not your company is a good fit for these investors and how it affects the possibility of an investment.
____ g. Have your corporate governance in order: All of this stuff is going to come up in the due diligence process. Make sure all company paperwork is in order. Yes, corporate governance matters. Are your corporate charter, bylaws, agreements etc. properly placed? What about corporate resolutions and minutes? If these things are not in order, now is the time to get that stuff together. It will come up in due diligence so you might as well get it taken care of now. Get help if you need help.
____ h. Know your strengths and weaknesses: Your company is going to be strong in some areas and weak in others. Be prepared to be able to address these issues.
____ 4. Understand startup math
If you don't understand the basics of how the numbers are being crunched, you will be at a severe disadvantage at negotiation time. Read the article on the left regarding startup math and see how the numbers come together. This goes for both investors and entrepreneurs.
____ 5. Set the precedent for future investors
Later investors will get better terms than prior investors. If the first investors get extremely favorable terms (and terms that are not good for founders), later investors will get even more favorable terms--terms that are even worse for you. It's important to get it right the first go around.
TERMS
____ 6. Don't sell the same shares at the same time to different individuals for different prices
You are creating a potentially disastrous situation if, at the same time, the startup sells the same type of stock to different investors, founders, etc. at different prices.
You are NOT making things "simple" by doing this.
Why? Taxes.
If you paid peanuts for your shares and the investor paid thousands for the same shares, the IRS will determine that the amount the investor paid is the value of the shares and that you therefore received compensation. You'll have a tax liability of the difference between the actual value of the shares and what you paid for it.
Additionally, the startup sells shares to investors in order to raise money. Thus, those shares should arguably be relatively expensive. This sale has an effect of setting the fair market value of those shares. The employees who receive stock for incentive/compensation purposes need to receive a different stock from these investors. The reason for this is that setting the fair market value early on at a high price will hurt employees down the line who receive stock for incentive/compensation purposes. Recall that employees who receive stock for incentive purposes want to receive the stock at a low price so that they sell at a high price. They want that price delta.
____ 7. Don't ignore red flags
There's a story where Van Halen the band in their contracts with concert venues, would demand that the venue have a bowl of M&Ms in their band trailer. They oddly specified that there shouldn't be any brown M&Ms in the bowl. The contract detailed that brown M&Ms should be taken away. This sounds like bullshit diva rock star behaviour. But there was a good reason for this. The brown M&Ms served as a red flag. If the band saw brown M&Ms in their trailer that meant that there's likely something wrong elsewhere with the band's demands and that they need to comb through the whole venue contract and make sure everything else such as light equipment, safety mechanics, and electric wiring is properly set up.
So look out for something that doesn't seem right. If you see a term that is not important but is way out of line, then think through things carefully. Some times these other terms being out of line makes sense. But if that's the case, understand why it's like that. Here are red flags to be on the look-out for:
____ a. Equity investors that have greater than 1.5x liquidation preference, no participation
If there is one solitary term that can turn the deal on it's head it's the liquidation preference. This term can make or break the deal completely.
1x liquidation preference, no participation is now the norm. I've talked to investors that realize this and have told me that they're not interested in screwing the entrepreneurs over. That's a sign of a reasonable investor. In difficult times and markets, you'll see higher liquidation preferences, but resist giving that out.
You can also use the liquidation preference as a gauge--a type of litmus test. If it's reasonable, you know that the investor is willing to play ball. If it's something stupid, then forget about it.
____ b. Excessive dividends
Yes, I know that in the chart I labeled these as unimportant. But I really pay attention to excessive dividends (or excessive interest in a convertible note deal.) It's an extremely quick way to see if the parties are properly playing ball.
I was just looking at a deal and saw a % that was absolutely bullshit. I instantly knew that this deal wasn't right and that something was wrong. I didn't even have to read the rest of the deal documents. And I was right--the deal was garbage. But just seeing the % was an easy red flag to spot instantly.
FYI: Dividends are used in very late stage companies and are often seen in more private equity deals for big money like in the oil and gas industry. They aren't frequently seen in venture capital--startup deals. If you see a deal for an early stage financing where the investor demands a dividend and a liquidation preference, understand that that is not the norm.
____ c. Excessive downside protection
Investments are naturally risky. An investment is not a loan. Investors that are overly focused on their downside protection don't want to make an investment. They want a guaranteed loan with upside. Screw that.
____ d. Excessive preemptive rights
Preemptive or pro-rata rights are the right for an investor to invest in future financings in order to protect their level of ownership. If an investor owns 10% of the company and has preemptive rights, in a future financing, that investor can invest and purchase 10% of the financing. Be particularly careful and comb through and understand the preemptive rights being granted because people can play games with this provision. Have the preemptive rights expire after a certain point in time such as when a Series A or greater financing is done when granting preemptive rights in early/small deals. Also, avoid super pro-rata rights.
____ 8. Watch for any values that are outside of the reasonable ranges
Use the table and the foundation piece to know what is reasonable or not. Pay particular attention to the categories marked as important or highly important. If something is not within the reasonable range, that can be fine. Every deal is unique in some way. Just understand the logic and underlying reason as to why something may not be in that range. It needs to make sense. If you have a good understanding of reasonableness, relax--you'll be fine.
LAST BUT NOT LEAST
____ 9. Keep in mind the overall SYSTEM and don't get distracted
Don't lose sight of the forest for the trees. Keep the big picture in mind. Like in life only certain things matter in a deal: your overall system, being able to work with people, money & control terms, and reasonableness.
Focus on the relationship with the investor. Use the terms chart to your advantage. Focus on the ones labeled as very important. Don't waste time finaggling over terms that are of low importance. Know the ranges of what is and what is not acceptable for your company. Make sure to abide by them except in the extreme cases. If something is not in the range of normality, understand why it's like that. Don't just accept something willy-nilly.
Every term or negotiation point that is brought up, think about how that point affects either money, control, or something else. There is a lot of paperwork. There is a lot of language. A lot of terms. Keep a balance of these two and don't worry too much about the other terms unless they are egregious.
Money and control are always going to be two important areas of a financing. You will not get both, and you don't want just one. Strike that balance and make sure that the money is right and that you have some control over the direction of the company.
Remember that it is not your job to know all of the ins and outs of deals. Have the proper advisors in place. Focus on what you're good at and don't waste your time.