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Venture Capital > Lecture 6 > Flashcards

Lecture 6 Flashcards

1
Q

What is the deal timeline main steps?

A
  1. Meet the company
  2. Begin the due-diligence process
  3. Bring idea up at partners meeting
  4. Continue due-diligence
  5. Make decision
  6. Win the deal
  7. Close
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2
Q

How long is the process from when the VC first meets the company to when they begin the due diligence process?

A

Could be days, weeks or months

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3
Q

What is the following/tracking process within the deal timeline?

A

You are always building your pipeline of potential investments
- You may meet a company today that is only a fit 2 years from now
- You may meet a company that is not even ready to raise

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4
Q

What must a VC consider in the due-diligence process regarding the deal timeline?

A

You assess how long you have to complete due diligence based on the competitiveness of the founder’s process.

Typically, you want to incorporate feedback from your partnership into the diligence process, so you must conduct several “phases” of diligence.

This is where you write your investment memo and make an investment recommendation to your group

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5
Q

How long is the process from the start of due diligence to the decision being made?

A

1 to 3 weeks

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6
Q

How do you win the deal as a VC when you are trying to attract a founder?

A

You must convince the founder to take
your money, and you need to figure out what
matters to them

Most top tier founders have many options for capital, how do you become their preferred option?

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7
Q

From making a decision to make a deal to actually winning how long does it usually take?

A

48 hours

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8
Q

From winning the deal to the close, how long does it usually take?

A

30 to 60 days

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9
Q

What happens if you go through the deal process and take a long time?

A

you will lose the high momentum deals, with the top tier founders

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10
Q

When does the VC give out a term sheet?

A

When the VC has made their decision

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11
Q

Why does the VC usually only give 48 hours to the founder to sign the term sheet?

A
  • the founder come back and explain why they need an extension (becomes a conversation)
  • the founders don’t go showing the term-sheet to everyone and asking other VC’s to one-up you
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12
Q

What happens if a founder tries to go to VC’s and say that someone gave them a term sheet to get people to give them deals?

A

Word travels around quickly in the VC world

–> If a founder tries to lie and say they have a term sheet from x then that VC will call his friend at the other firm to double check

–> Very small world

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13
Q

What is a term sheet?

A

A statement of the proposed terms and conditions for a proposed investment. Most of the terms are NON-BINDING, except for certain confidentiality and exclusivity rights.

–> Expression of interest
–> Unwritten code that you intend to hold up your side of the deal

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14
Q

Why would a VC back out of a term sheet? Do VC’s usually back out? Why or why not?

A

You would only back out as a VC if you found new information that you didn’t have when you wrote the term sheet
–> Don’t want to back out because it hurts the VC’s reputation
–> Demonstrates that they didn’t do proper due diligence and their assessment process is flawed
–> Also shows uncertainty and lack of confidence in investment decisions (deterring founders)

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15
Q

Besides the term sheet, what else might a VC do to help win the deal? What could be the problem with certain methods?

A

Send the founder perks to convince them to sign.

–> The problem is that VC will only start doing this stuff once the term sheet is out so it appears transactional rather than showing a long term investment

–> Founders value what you are bringing to the partnership
—> the earlier you show interest and that you care, the easier it will be to win a deal

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16
Q

Who is involved in the process, from the winning of the deal to the close?

A

Its completed by lawyers
–> this is when cash enters the bank

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17
Q

What is a lead investor?

A

An individual or organization who willingly takes on the role of SPEARHEADING the investment round for a startup.

They do this by putting up a SIGNIFICANT PORTION of the total amount being raised and also leading the negotiations

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18
Q

What is the round composition in early-stage rounds?

A

Lead VC (70%)
Smaller Institutions (20%)
Angels/Friends (10%)

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19
Q

What is the round composition in late-stage rounds?

A

● Lead VC (40%)
● Existing Internal Investors (20%)
● Strategics (20%)
● Crossovers / Wealth Managers (20%

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20
Q

Why does the lead not invest the whole amount?

A

Diversification of the cap table

–> If things go wrong, you get more people that can step up and save the company

–> The founder gets access to more networks, more help, more perspectives, more experts

–> Diversifying with these other people will help make the exit easier (easier acquisition story down the line)

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21
Q

Who bears the majority of the responsibility for the term sheet in the early rounds vs. later rounds?

A

Early Stage: The lead investor writes the terms sheet, valuation and do a lot of the work, and then send it to the other people at the cap table to sign

Late Stage: the lead investor does less of the work, and the other work is broken up between internal investors who already exist, strategics, crossover/wealth management

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22
Q

Why do I care about bringing in even more diversification of capital as I get to later stages as a founder?

A

Preparing for going public: I don’t want everyone selling at IPO
Preparing for acquisition: having strategics’ around the table early might be helpful

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23
Q

What is a pre-emptive round?

A

The pre-emption round enables existing company shareholders/new potential shareholders to purchase new shares issued by that business before offering them to new investors.

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24
Q

Why would a founder choose to complete a pre-emptive round?

A

● Not dealing in a competitive deal process

● More risk but only one looking at the deal

● This has often become the new normal

● Founders have liked this because they don’t have to wait for a formal fundraising process.

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25
Q

Why are the pro/cons of doing a pre-emptive round for the VC?

A

PROS:
● I beat everyone to the punch and got to fund the company ahead of their anticipated raise
● If I’m an existing shareholder I insure my shares are not diluted

CONS:
● you are investing before Series B, so you lose the potential higher valuation later on
● Almost always over-paying to convince VCs to take the cash

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26
Q

What is a fast-follow round?

A

Completed right after the Series A round

The company already got funding, and you (as the VC) missed the chance but still want to get into the deal.

Almost always over-paying to convince the company to take the cash.

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27
Q

What are the pros/cons of a fast follow round fro the VC?

A

Pros:
● I get to invest in the company, be a part of the cap table, and they have a lot of cash on the balance sheet to grow and have a potentially higher ROI/ satisfy the power law

Cons:
● I paid a higher price than everyone else at the
same time and if it is not successful, I took more risk than everyone else involved

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28
Q

What are the different financial instruments that a VC can use?

A

SAFE
Convertible Notes
Equity Priced Round

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29
Q

What is an equity-priced round?

A

direct exchange of money for preferred shares at an agreed-upon price.

Instrument: EQUITY (shares)
Maturity: NEVER
Interest: NONE

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30
Q

What are the pros/cons of an equity-priced round?

A

PROS:
● Interests are all aligned

CONS:
● Most legal work to issue shares
● takes long
● must establish a price for the company
–> difficult to determine company value in seed stage

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31
Q

Why would someone at the seed stage not do an equity-priced round?

A

Requires you to value the company. At the seed stage, they probably have the foundation of this business, and an idea is hard to value (quantitatively)

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32
Q

Why did they invent the SAFE?

A

Establishing price for a company can be very difficult at a seed-stage
It doesn’t make sense to price at this stage

So they built something called a SAFE (Simple Agreement for Future Equity)

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33
Q

What does SAFE stand for?

A

Simple Agreement for Future Equity

34
Q

How does a SAFE work?

A

● Sign documents and give money now but value later and get shares later when the price has been established

● When the series A investor comes in and sets a valuation, that’s when the seed investor would get shares

Instrument: FUTURE EQUITY
Maturity: NEVER
Interest: SOMETIMES

35
Q

What are the pros/cons of a SAFE?

A

PROS:
● Don’t need to set a price for what the company is worth (get cash upfront, determine price later)
● In the seed round, founders don’t really want to release shares, get lawyers, draft contracts, etc.

CONS:
● Conversion mechanics can be confusing and unclear
● Potential dilution of equity for the VC

36
Q

Can a founder raise $10 and set the SAFE at that amount?

A

No! It has to be a qualified financed round

37
Q

What happens with a SAFE if the company gets acquired or merges?

A

Usually SAFE specifies about situations that happen if the company merges or gets acquired
–> Usually turns into equity to the VC before the merger or acquisition

38
Q

When would you use a SAFE?

A

Very early stage (pre-seed,
seed when the founder is in the driver seat

39
Q

How does a SAFE convert to equity?

A

It gets triggered by an event, such as an additional round of financing or the sale of the company.

You usually have a VALUATION CAP (sets max to pay in the future even if its higher which limits risk) and a VALUATION DISCOUNT (instead of a cap whatever is raised in the future the SAFE will be converted at say 20% lower than the valuation), usually no floor is established

40
Q

Give an example of a valuation cap and discount?

A

CAP: if the cap is $40M and I raise a
round in the future at a $60M valuation, I only pay $40M in my conversioN

DISCOUNT: if the discount is 20% and I raised at
a $50M valuation, my valuation will be $40M for my conversion

41
Q

What is a convertible note?

A

Debt, maturity date and MUST be repaid
(the difference between SAFE and convertible note). If company raises minimum amount of capital in the next 2 years the note turns into equity but if they don’t raise it, will become debt.

● If you don’t convert the note or don’t have the cash to pay it back, it turns into debt and is paid back before the equity holders.

● Forced to pay it out to creditors

● Almost always, interest and maturity date is 1-2 years

● Gives downside protection to the VC as you are sitting at the top of the stack to be paid back

42
Q

What are the pros/cons of a convertible note:

A

PROS: Provides downside protection to the noteholder

CONS: The downside protection sits at the top
of the liquidation stack, so it takes money away from the equity holder

Convertible notes usually need between $40,000-$50,000 in legal fees

43
Q

When do VCs in act convertible notes?

A

When they are in the driver’s seat. Preferred by investors but if you tried to do convertible notes with seed companies they may not will be willing to do it

44
Q

Would an early-stage founder choose to do a convertible note, if they had the choice?

A

● As an early company, you cant risk that much leverage

● Issued a lot of these during 2021 and caused a lot of founders to fall

● Must be paid back in cash if they don’t close on another round of VC

● You accrue interest on convertible notes in equity

● Interest is not paid out its added on to final payment

● Convertible note is seen as a “down round” because if the founder would have it their way they would have raised a price round because that would be the best option for both

45
Q

What happens to the relationship between a convertible note and equity holders as the company gets closer to maturity?

A

Their agendas don’t align

● Payment Priority: Convertible note holders have priority in repayment or liquidation

● Share value: When notes are converted (as they have a maturity date) it can dilute the existing equity holders as it increases the number of shares

● When the company becomes more successful, equity holders shares will have higher value but convertible note holders will receive more shares

46
Q

What is a bridge round?

A

Round between two round (such as Series A and B)

● Not easy to raise for founder because investors have leverage, and they don’t want the company to die

● They usually use a convertible note

● VCs don’t want to harm the path to success so they want to get money through equity and not

47
Q

What is an angel investor?

A

Angel investors typically invest their own money, meaning the capital amount will be less than a VC firm.

48
Q

What type of security do I want to hold when the market is high? What about when the market is low?

A

Market High:
VC is willing to take on more risk and get the good deals before competitors take it. Might choose to complete a SAFE or an equity round

Market Low:
Investors will be more risk-averse and focus on preserving capital. Will want to invest in companies that are more resiliant in economic downturn and choose Convertible Notes to have more influence over market to protect themselves

49
Q

What happens to a SAFE if I never raise equity again?

A

the SAFE will continue in perpetuity without ever converting.

50
Q

What is usually included on a term sheet?

A

Issuer
Investor
Total Invested Amount
Securities being issued
Price

51
Q

Are term sheets formal?

A

No!
informal and can be workshopped

company pays for legal fees of the investor and the money comes out of the round

highest level terms that everyone needs to abide by but a little bit of a fluff

52
Q

What is pre-money and post-money?

A

Post-money
after the cash has been added in

Pre-money
before the cash goes in

53
Q

What is a warrant?

A

Allow investors to buy more of the company later down the road at the same price

see if the company will be successful and deploy more capital

typically issued as part of an investment transaction

Includes:
- exercise price
-expiration date
- conditions

54
Q

How do you convince someone to take your money?

A
  1. Reputation / Brand
  2. Relationship
  3. Conviction
  4. Process / Speed
  5. Best terms / price
55
Q

What is a ‘no shop provision’?

A

The purpose of a no-shop provision is to prevent the company from actively seeking out higher bids from other potential investors after agreeing to a deal.

This provision gives the investor assurance that they will be able to complete the deal as negotiated without facing competition from other investors.

56
Q

How is valuation and share price determined?

A

Valuation and share price are negotiated between the lead investor and the company
○ The lead sets the valuation and others follow

Valuation informs what the share price will be
○ Share price = pre-money valuation / pre-money share count

57
Q

What is included in the pre-money share count?

A

○ All ESOP (Employee Stock Owned Plan)
○ All warrants
○ All common shares
○ All preferred shares
○ All SAFEs or convertible notes on an “as converted” basis

Called a fully diluted basis
–> Assumes that all of these things will convert into shares
–> Take the most Full diluted picture when calculating

58
Q

What is an ESOP?

A

Employee Stock Owned Plan:

An employee benefit plan that enables employees to own part or all of the company they work for
–> With every round it gets diluted so it has to be increased at every round of funding

59
Q

Does ESOP impact new investors?

A

ESOP is in the pre-money share count meaning its before the round, and that means the new investors don’t get diluted by it because they are in the post-money

60
Q

How do old and new investors feel about ESOP?

A

Old investors don’t want it to be high because they don’t want to get diluted

New investors want it to be high because they probably wont have to increase it again in the future and have their shares diluted

61
Q

Is pre-money share count fully diluted? What does this mean?

A

Fully diluted means to assume that all outstanding instruments convert into shares
(warrants, notes, options, etc) when completing the valuation

62
Q

How is the ESOP % determined?

A

The % of increase is a negotiation between the lead investor and the company

○ More % = beneficial to company to increase ownership
○ Less % = less dilution for investors

63
Q

Why is the ESOP done before the round?

A

So that it does not dilute the new lead investor

○ This means the new lead investor does not really care what % increase to give

○ It will dilute all existing investors, but not the new lead

64
Q

What are protective provisions?

A

Intended to protect the VC’s investment by giving them certain rights over important decisions made by the company’s management team and board of directors.

65
Q

What are the types of protective provisions?

A

■ Warrant coverage
■ Voting rights
■ Information rights
■ Board and observer rights
■ Spend control

66
Q

How do protective provisions work on the shares that VCs receive?

A

VC’s have the right to protective provisions on the shares that they receive

○ Preferred shares (get liquidated first ahead of common shares)

○ The liquidation preference is the multiple at which they get liquidated ahead of common

■ 1x liquidation preference is the standard

67
Q

What is a secondary transaction?

A

an investor purchases shares of a company from an existing shareholder, rather than directly from the company itself
○ Let founders take money off the table as a part of the deal
○ Let someone else buy them out

68
Q

Why would a VC encourage a secondary transaction and how does it impact the founder?

A

Allows founders to have enough money in the personal bank to get rid of student debt or house mortgage so they can be more focused on the success of the business
- would not be a large amount of money but enough to shift the founders priorities to promote the business success

69
Q

If a founder agrees to a 3x liquidation in a bear market what could be the future impact?

A

Having a high liquidation at around 3x during a bear market could be seen as the optimal option at the time, however, later when it is a bull market it could make funding for future investors more difficult (they might not want to do the deal or ask for amendment)

70
Q

What are ways that the VC can try to win the deal?

A

ESOP top up
secondary transaction
low-oversight

71
Q

What is an ESOP top-up?

A
  • Give the founders more ownership
  • Remember, this does not dilute you as the new lead, it only impacts old investors, so why not give founders more to help convince them to take your deal
72
Q

How would a VC enact the promise of low oversight to win the deal?

A
  • Don’t restrict them in their ability to operate the company
  • Go light on the protective provisions
73
Q

What are the potential problems with using terms as a path to winning deals

A
  • Dilution in the future
  • Impact reputation of VC
  • Lack of relationship with founder
  • Minimal alignment in mission between the investor and founder
  • Puts company in the driver seat instead of the VC
74
Q

What is the term sheet structure in a bear market?

A

VALUATION:
○ low
LIQUIDATION PREFERENCE:
○ 2-3x
BOARD:
○ Actively Engaged
○ Oversight involved
○ Financial Guardianship
ESOP:
○ little room
WARRANTS:
○ high coverage
ROUND SIZE:
○ Very strictly enforced (i will not put in my
money unless you raise at least $x)

75
Q

What is the term sheet in a bull market?

A

VALUATION:
○ high (maybe overvalued)
LIQUIDATION PREFERENCE:
○ 1x
BOARD:
○ non-structured
ESOP:
○ lots of room for management
WARRANTS:
○ none
ROUND SIZE:
○ loosely defined

76
Q

What is pro-rata rights?

A

The right of an investor to participate in future funding rounds of a company to maintain their ownership percentage.

77
Q

Pro-rata vs. warrant

A

Pro-rata:
○ give an investor the right to participate in future funding rounds to MAINTAIN their ownership percentage in a company.

Warrants:
○ give the holder the right to BUY a certain number of shares in a company at a certain price

78
Q

Why might valuation be unchanged in a bear market in some cases?

A
  • Fundamental strength
  • Relative value
  • Long-term outlook
  • Investor sentiment
  • Investor uncertainty in market conditions
79
Q

What is a flat round? Who prefers them? When does it change?

A

a company raises capital at a lower valuation than its previous financing round, and it usually preferred during insider rounder
–> The company gets capitalized, and nothing changes
–> It usually changes when a new investor comes in and wants to re-write the valuation

80
Q

How do VC’s protect themselves in case of downturns?

A

🡪 protective provision
🡪 voting agreement
🡪debt amount

81
Q

What is a bridge?

A

internal investors saving the company
🡪 usually a convertible note

Venture Capital (10 decks)

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