Common Stock in venture-backed companies never have liquidation preference rights.  You will only see liquidation preference rights attached to Series Preferred Stock – the kind that VC funds purchase.  The Series Preferred investors will have a priority in receiving distributions from a liquidation, sale, merger, IPO or dissolution.  Each series of Preferred Stock will have its own liquidation preference and those rights will always be found in the company’s certificate of incorporation.  If you have multiple series of Preferred Stock liquidation preferences, then the preferences get stacked on top of each other with priority generally running “last in first out.”  The size of the liquidation preference is calculated by taking the original purchase price per share (or some multiple thereof) for the respective Series Preferred Stock plus, in some cases, accrued or declared but unpaid dividends.  The more layers of liquidation preference built into a company’s capital structure, the less sale proceeds that will be available to the holders of Common Stock (who typically sit at the bottom of the stack). 

There are three ways to structure a liquidation preference for Preferred Stock: 

• Non-Participating Preference – (a/k/a - straight preference).  In this case, the VC fund gets back its original investment plus, in some cases, accrued or declared but otherwise unpaid dividends.  In some cases, the VC Fund may get a multiple of its original investment, meaning that the liquidation preference may be something like “three (3) times the Original Purchase Price plus accrued but unpaid dividends.”  If the VC fund originally invested $2,000,000, then under the example of a 3X multiple the VC Fund would receive $6,000,000 off the top.  If you happen to be raising money in a difficult funding environment, then you can expect that the multiple will be higher.  Multiples in a regular market range from none to 2X.  Multiples creep up towards 4X – 5X in a difficult funding environment or if the company presents additional risk;
• Participating Preference without a cap - Participating Preferred Stock without a cap provides that after the VC fund gets its liquidation preference on the Preferred Stock, the VC fund then shares in the balance of the sale proceeds with the Common Stock holders on an as-converted basis (meaning that Preferred Stock will be treated as if they converted their shares into Common Stock).  In this case the VC fund may also have a multiple, although some company’s will argue during negotiations that the participating feature eliminates the need for a multiple at the preference phase; and
• Participating Preference with a cap – Participating Preferred Stock with a cap is effectively the same stock in the preceding bullet point with the distinction that the Preferred Stock holders will stop sharing in the balance of the sale proceeds once their aggregate return reaches a negotiated cap (usually being some multiple of the original purchase price per share).  As an example, if the VC fund negotiates for Participating Preferred Stock with a 5X cap, then it will stop sharing in the balance of the proceeds once its aggregate return (i.e., preference piece plus the shared piece) equals 5X its original investment.

All things being the same, companies gravitate to Non-Participating Preferred Stock and investors naturally gravitate towards Participating Preferred Stock without a cap.  The middle ground is Participating Preferred Stock with a cap.  It should be noted that not all VC funds just default to Participating Preferred without a cap.  Many funds save that structure for companies that pose extra risk, and thus should result in extra return.  Most funds, in an average funding environment, stick with Non-Participating Preferred Stock with some form of multiple. 

A fourth option exists for the VC fund.  Some cases exist where the investor may earn back a larger return if it voluntarily converted its Preferred Stock into Common Stock (a common right in venture deals).  What the VC fund obtains as a Common Stock holder may be considerably larger than its preference, participating or otherwise – it’s a matter of doing some calculations ahead of time and figuring out which is the best to own immediately prior to an exit. 

The following table shows in clear terms the return outcomes for stockholders in various levels of exits and with different structures of liquidation preferences.  Some interesting facts to note from the example below:

• The company in this example raised significant money.  The Series B investors put in $25,000,000.  In the case of a tiny exit (like the $10,000,000 example), no one other than the Series B investors will make any money off of the deal.  There’s no incentive for any of the Preferred Stock holders to voluntarily convert to Common Stock in this scenario. 
• In the $100,000,000 example, note the larger return to Common Stock holders in the Non-Participating Preferred scenario.  Also note the difference between the capped and uncapped Participating Preferred scenarios and the shift in returns from the Series A holder to the Common Stock holders because of the cap.
• In the $1,000,000,000 example, the capped and uncapped Participating Preferred differences should be noted.  In this scenario, if the Preferred Stock holders held the Non-Participating Preferred or Participating Preferred with a cap, those stockholders would be better off converting to Common Stock as it would increase their return significantly. 

So, as you can see, liquidation preferences have a great impact on how the proceeds of a sale are divided – more so than valuation, in my opinion.  If you are trying to figure out where to divide up your negotiating capital, I’d suggest putting a good piece of it behind this provision.  I welcome your comments or questions (use the “Ask VC Deal Lawyer” button on the homepage of the website at www.vcdeallawer.com).

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-ups, early-stage and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique law firm focused on providing corporate, transactional and operational legal services to start-up, early-stage  and emerging growth companies.

• Who at the strategic is actually responsible for the investment - operations?  corporate development?  corporate venture unit?  There is a reason that the VC model works (although many right now would argue that it is broken).  VC firms are designed to do one thing – deploy money, build and grow companies and then exit the investment (hopefully with a return).  Generally, you know where the VCs’ head is.  That’s not to say that some VCs don’t have their own agenda (see Mark Suster’s latest post “Choose Your VC Investor Carefully” - my favorite quote is “Beware of VC seagulls, who shit on you and then fly away”), but most are there for the right reason.  When it comes to most strategic investors, the reasons for investment go beyond just earning a return.  On a continuum, I would put most corporate venture units on the ends closest to the VCs.  I’d put the corporate development folks in the middle and the operations group on the opposing end.  If the operations group is running the show on the investment, I think you run more of a risk of countervailing priorities.  They may not be in the investment to grow a company, rather, they may be in it to test out a new product internally and maybe tinker with it to see if they can maximize it’s usefulness for their own good – not so much the greater good that earns top returns in the marketplace.  Follow your gut.  Also, the operations end of the continuum may have less sophistication in structuring an investment.  This may work to your favor in that there may be less valuation sensitivity.  As I’ve mentioned in earlier posts, however, if you structure that first round of outside money poorly, you run a great risk of complicating your later rounds of financing.
• Is this your first round of financing or have you already raised money?  To play off of my comments at the end of the prior bullet point, and to tie this in to the next bullet point, if the strategic is coming in on your first round and they are the only investor – beware how you structure the deal.  Don’t be penny-wise and pound foolish, you’ll live to regret it during your Series B round.  If, however, you’ve already raised some money (i.e., this is a later series round), then it is more likely that the strategic is just co-investing and thus the VCs are structuring the deal.
• Is this a group of strategics?  Is the strategic leading?  Or is the strategic investor just co-investing with a group of VCs?  One of my worst nightmares involved a company that I was representing in a $37 million Series C & D round, done simultaneously.  The company’s entire Series A round consisted of four extremely large strategic investors and industry heavyweights.  Part of the current deal involved taking out the entire Series A round.  I can only remember a few other deals that were tougher than this one because the internal folks at the strategics as well as their counsel were beyond difficult and lacked an understanding of how deals like this were structured.  When the other side suspects every move you make is suspicious (mainly out of ignorance), then getting the transaction done takes four times the amount of time (and paper).  A lot of effort, time, personnel and money resources went into getting that deal done because of the approach the strategics took.  Had they not controlled the entire round, maybe it would have been more efficient.
• Do the terms of the investment go beyond just money (i.e., are they offering to test out your product, to include it in their suite of technologies, to use it internally, are they looking to license it from you)?  In my opinion, the terms better go beyond just money, otherwise the strategic is nothing more than a VC and you are losing some potential to piggyback on the strategic’s platform.  Some strategics like to invest for reasons other than just the return.  They may be interested in the technology for their own internal use or they may think it is a great add-0n for their own suite of technologies.  Maybe they have testing or research facilities that you could not otherwise afford on your own.  Maybe all of this makes you think that this strategic ultimately may just buy your company for a huge multiple right out of the starting gate.  If the terms go beyond just money, try to forecast in your mind where those other terms may lead you.  Speak to other companies that have structured deals like that.  Speak to other portfolio companies of the strategic.  What happens if the internal champion of your product leaves the strategic and now no one internally wants to test out your product.  Can you say limbo?  Also, beware that aligning yourself with one or two particular strategics may limit the deals you can broker with other strategics due to anti-competitive concerns. 
• Is the strategic’s technology complimentary or competitive?  Are they a customer or a supplier?  This question is a good follow up question for the immediately preceding question.

Some other points to consider.  Early strategic investors don’t always participate in follow-on rounds.  They may not have the amount of dry powder that a fund has to continually participate in future financing rounds.  On the plus side, strategics may be able to provide superior name cache and credibility.  That can open doors and that is priceless. 

In retrospect, this article comes off negative on strategics.  Don’t get me wrong – I love strategic investors and I would never advise anyone to turn away money for that reason alone.  But the goal here is to size up the deal and put it all in perspective.  In my experience, the best approach is (i) don’t rely entirely on strategics – they are better served as co-investors, (ii) make sure that the deal with the strategic consists of more than just money – they bring a lot to the table and you want to leverage it as much as possible to make your company more valuable, and (iii) try to stick as much as possible with strategic partners that structure their investments through an internal corporate venture unit (although you should never walk solely because of this issue).

Angels are individuals that invest their own personal money in private companies, typically at a very early stage.  They are generally Accredited Investors under Reg D of the Securities Act of 1933 (meaning they have a net worth of at least $1M or that they made more than $200k the past three years or more than $300k, together with their wife, the past three years).  Most angels made their money themselves as entrepreneurs or executives.  A few of them deploy old family money, rather than their own.

What role do angel investors play in venture financing?

Angels bridge the financing gap between “friends and family” money and the initial institutional venture capital round.  As former entrepreneurs or executives, angels bring more than just money to the table.  They can be wonderful mentors and advisors.  Due to their backgrounds, they very often have specific industry expertise and/or operational or financial experience.  Also, many angels have stopped earning a paycheck full-time and they look forward to spending a little time in the trenches with the entrepreneurs that they invest in.  Some angels also have enormous rolodexes (for those of you younger than 20, that means contacts) from their own years of raising money and doing deals and can provide great contacts that may speed up the start-up process. 

Types of Angels

Angels come in all shapes and sizes.  At the bare minimum, they are all individuals.  Some desire to invest just that way and they will source their own deals and individually invest their own money. 

Over the past several years, however, many angels began to put some formal structure around their activities and angel networks or groups began popping up.  By involving themselves in angel groups, angels can be more efficient in reviewing possible investment opportunities, diligencing deals, negotiating terms and pooling money to take on slightly larger deals – all with the over-arching goal of achieving more competitive returns.   These groups can be loosely or highly structured.  Some may just be groups of individuals that come together quarterly to hear company presentations over dinner (usually 3-4 a night).  In these loosely structured groups, the ultimate decision to invest is the individual’s and they will all write their own checks.  The more structured groups tend to take on characteristics of funds, with capital calls, investment managers and due diligence teams.  Whereas individual angels would typically put from $10,000 to $250,000 into a company, the structured groups may put anywhere from $250,000 to $1,000,000 into a company.

I would refer to certain groups as angels since they invest at the angel level, even though they may not fit neatly into the categories above.  These groups come from a completely different angle by forming incubators.  Two well-known examples are TechStars and Y Combinator.  They put something like $20,000 into their incubated companies in return for 2-10% of the company and they provide the companies with high-end accounting, legal, operational, financial, sales and marketing support.  It’s sort of like the difference between a stove and a microwave.  Like the microwave, the likes of TechStars and Y Combinator seek to highly charge their start-ups in a short period of time, hopefully catapulting them past their competitors.

Where do you meet angel investors?

Finding angels is not necessarily easy.  They don’t advertise.  They are not in the yellow pages (if you find one there, I’d suggest you run in the opposite direction).  Some tend to like the obscurity because they don’t want to be overwhelmed with opportunities.  In fact, many angels rely on an informal network of filters to make sure that by the time someone does find them (sort of like when Dorothy found the great Oz), they’ve already been vetted a couple of times both from an opportunity as well as a personality perspective.  In that regard, the best place to hunt for angel investors is in your own network, through trusted advisors like accountants and venture attorneys (who interact with angel investors constantly), through institutional venture funds (some of these guys may even do some angel investing on the side with their own money), angel networks and angel groups. 

How do angel investors structure deals?

It can run the gamut from convertible debt, common stock or series preferred stock.  Most angels investors though will have a preferred method and will consistently invest the same way.  If you raise money by selling common stock or series preferred stock then you will have to negotiate a valuation with the angel investors.  This can lengthen the time to get an angel deal closed.  It can also, if you don’t engage the right kinds of advisors, wreak havoc on your next financing round (which, if all goes right, will be institutional venture money).  If the rights, privileges and/or preferences attached to the common stock or series preferred stock are too rich it may give the venture capitalists in your next financing round serious indigestion.  Not that you cannot overcome that, but it will greatly lengthen how long it takes to get the next financing round done (in addition to significantly increase your legal and accounting expenses).  Why?  Because some of the rights your angels have may have been more appropriate for a Series C round and now your Series A investor is saying – if the angels keep those rights we are not doing the deal.  The Series A investor is going to want the angel investors to restructure and re-align their investment so that it properly sits within a broader financing plan for the company.  If your angel investor decides he/she doesn’t like that, then you just bungled your Series A round and you’ll need to hit the fundraising trail again. 

One way angel investors avoid all of the subjective issues behind valuation and the rights, privileges and preferences associated with issuing stock is they structure their investments as convertible debt.  Some people are fine with this, others have issues.  To each their own.  I think it is a very acceptable way to structure an angel investment.  What you do is the angel investor loans the company money, rather than investing it as equity.  The loan is structured to be convertible into equity at a later date, with the conversion being automatic if the next financing round meets certain parameters (e.g., institutional venture fund money, minimum valuation, minimum aggregate amount raised, etc.).  Convertible debt provides the advantages of both debt and equity.  No time is wasted determining a valuation.  The financing is not dilutive to the entrepreneur unless and until they raise their first institutional round and the debt converts.  Convertible debt may or may not be secured.

Yes, angel investors earn interest on their debt.  But that is not the only compensation.  Angel investors deserve some sort of “kicker” for taking the risk of lending money (when no bank would) to a company with no assets.  In order to compensate for that risk, the company usually does one of two things:

• the company will issue the convertible debt accompanied with warrants to purchase common stock (usually at an exercise price of $0.01 per share).  The convertible debt will automatically convert at the next financing round (usually if it meets certain parameters as noted above) into the types of shares issued in that financing round and at the price per share of that financing round.  So if the angel investor loaned the company $250,000 and the next financing round sold Series A Preferred Stock at $0.75/per share, then the debt would convert into 333,333 shares of Series A Preferred Stock ($250,000/$0.75).  The angel investor keeps the warrant for taking the risk; or
• the convertible debt is structured to convert at the next financing round (again, usually if it meets certain parameters as noted above) into the types of shares issued in that financing round but it will convert at a discount.  The angel investor gets the discount for taking the risk.  Using the same example above, and assuming the discount was 20%, then the debt would convert into 416,667 shares of Series A Preferred Stock ($250,000/($0.75 x .8)). 

 Advice on raising angel money

• Be wary of the angel investor with only big company experience- I hate to generalize here, but for all the experience that former big company executives may have, the one thing they critically lack is startup experience.  In a startup, there are no big company budgets to create fancy marketing plans, or admins to run around making copies of the next investor pitch.  Not all former big company executives understand the mindset of an entreprenuer in startup mode.  These angel investors may disagree with you on where to spend your (their) money, how to market the product, etc.  At the same time, they may offer some big company strategies that fit well in the startup environment.  Just know the issue is there and be wary of it.
• Ferret out the tire kickers – In order to save enormous time during the fundraising period, do whatever background checking you can to ferret out which angel groups actually put money into companies versus which angel groups consist mainly of a bunch of bored retirees that just want to meet quarterly for dinner while networking and be entertained by company presentations.  The former is worth all your time, the latter you just need to ignore or use only as a practice run to work out the kinks in your presentation.
• Down economy means less angels- Many angels retrench in down economies.  Remember that these individuals invest their own personal funds.  When the economy hammers their portfolios, many angels will cut back on their angel investing.  This may seem contrarian since a poor economy may mean better investment opportunities (i.e., good companies with lower valuations), but it still happens.  See this article. 
• Take care to carefully craft the angel investment terms- As I noted earlier, a poorly structured angel investment could hamper or even kill your next financing round.  The goal is to provide the angel investor with reasonable terms without negatively impacting your next financing round.  One example of this is the discount rate on a discounted convertible note.  If the discount rate is too high, the Series A investors may take offense because the angel investors is buying into their round at a wonderful valuation.  Never mind that the angel investor is only being compensated for taking the early risk – it will still pieve the Series A investors and they may seek to have the angel investor adjust the discount as a condition to the financing round.

Other Interesting Articles On the Subject

• Article #1
• Article #2
• Article #3
• Article #4
• Article #5

My summary:  The typical round in Q2 2009, irrespective of series, was most likely a down or flat round (Fenwick study would say most likely a down or up round), most likely had a 1x liquidation preference with uncapped participating preferred stock, most likely had weighted average anti-dilution, most likely had drag along rights but no pay-to-play provision.

The following are some of the stats pulled from the reports.  All references to quarters are for 2009:

Fenwick & West Report

The report from F&W (which can be found here) analyzed venture financing rounds for 89 companies headquarterd in Silicon Valley and that raised money in Q2. 

Financing Rounds.   Of the rounds closed in Q2, 8% were Series A, 27% were Series B, 35% were Series C, 13% were Series D and 17% were Series E or higher, compared to 13%, 28%, 17%, 20% and 22%, respectively, in Q1.

Valuations.  In Q2, 46% of deals were down rounds, 22% were flat and 32% were up rounds, compared to 46%, 29% and 25% in Q1, respectively.  Some of the flat rounds clearly moved to up rounds.

The down rounds, broken down by series, were as follows:  Series B (16%), Series C (51%), Series D (67%) and Series E or higher (67%).  Q1 looked like the following:  Series B (38%), Series C (50%), Series D (39%) and Series E or higher (60%).

Liquidation Preference.  Forty-one percent (41%) of deals in Q2 had senior liquidation preferences, compared to 45% in Q1.  They were broken down as follows:  Series B (17%), Series C (52%), Series D (50%) and Series E or higher (53%).  Q1 looked like the following:  Series B (35%), Series C (38%), Series D (56%) and Series E or higher (55%).

Twenty-four percent (24%) of deals in Q2 had multiple liquidation preferences (i.e., more than 1x), compared to 28% in Q1.  The greater majority in Q2 had multiples between 1x and 2x (75%) where as 25% had multiples between 2x and 3x.  None had multiples in excess of 3x.  The use of multiples in Q1 was more spread out:  1x – 2x (80%), 2x – 3x (10%) and more than 3x (10%).

Forty-nine percent (49%) of the liquidation preferences in Q2 were participating preferred, compared to 51% in Q1.  Sixty-seven percent (67%) of the participating preferred rounds in Q2 were not capped, compared to 60% in Q1.

Cumulative Dividends.  Two percent (2%) of rounds in Q2 had cumulative dividends, compared to 10% in Q1.

Antidilution.  The greater majority (97%) of rounds in Q2 had weighted average antidilution protection, with 3% having full ratchet.  The Q1 numbers were identical.

Pay-to-play.  Fifteen percent (15%) of rounds in Q2 had pay-to-play provisions, compared to 14% in Q1.  Of all the play-to-play provisions in Q2, 100% converted into common stock if they did not participate in the follow on rounds, compared to 73% in Q1.

Redemption.  Twenty percent (20%) of the rounds in Q2 had redemption rights, compared to 24% in Q1.

Cooley Report

The report from Cooley (which can be found here) analyzed venture financing rounds for 75 companies that raised money in Q2.

Valuations.  The following were the median per share valuations for Q2:  Series A – $4.40, Series B – $17.10, Series C – $33.00 and Series D or higher – $73.00, compared to $3.38, $13.24, $26.70 and $30.00, respectively, in Q1.

Of the rounds closed in Q2, 25% were up rounds, compared to 12% in Q1 and 56% were down or flat, compared to 66% in Q1.

Liquidation Preference. 

Series A.  In Q2, 90% of the rounds had a 1x or less preference, 5% had 1x to 2x preference and 5% had 2x to 3x preference, compared to 100% of the rounds in Q1 being a 1x preference.

Series B.  In Q2, 82.1% of the rounds had a 1x or less preference, 14.3% had 1x to 2x preference and 3.6% had 2x to 3x preference.  Whereas in Q1, 77.3% of the rounds had a 1x or less preference, 9.1% had 1x to 2x preference, 4.5% had 2x to 3x preference, 4.5% had more than a 3x preference and 4.5% had no preference.

Series C.  In Q2, 71.4% of the rounds had a 1x or less preference, 21.4% had 1x to 2x preference and 7.1% had 2x to 3x preference.  Whereas in Q1, 42.9% of the rounds had a 1x or less preference, 42.9% had 1x to 2x preference and 14.3% had 2x to 3x preference.

Series D.  In Q2, 80% of the rounds had a 1x or less preference, 10% had 1x to 2x preference and 10% had 2x to 3x preference.  Whereas in Q1, 61.5% of the rounds had a 1x or less preference and 38.5% had 1x to 2x preference.

Participating Preferred.  In Q2, 60% of the rounds had participating preferred stock, compared to 61% in Q1.

Series A.  In Q2, 66.7 % of the participating preferred rounds had no cap, 13.3% had a 2x cap, 13.3% had a 3x cap and 6.7% had a cap greater than 3x.  Whereas in Q1, 64.3% of the participating preferred rounds had no cap, 7.1% had a 2x cap and 28.6% had a 3x cap.

Series B.  In Q2, 61.5% of the participating preferred rounds had no cap, 7.7% had a 2x cap, 15.4% had a 3x cap and 15.4% had a cap greater than 3x.  Whereas in Q1, 57.1% of the participating preferred rounds had no cap, 14.3% had a 2x cap and 28.6% had a 3x cap.

Series C.  In Q2, 75% of the participating preferred rounds had no cap, none had a 2x cap, 12.5% had a 3x cap and 12.5% had a cap greater than 3x.  Whereas in Q1, 80% of the participating preferred rounds had no cap, none had a 2x cap and 20% had a 2x cap.

Series D.  In Q2, 62.5% of the participating preferred rounds had no cap, 25% had a 2x cap and 12.5% had a 3x cap.  Whereas in Q1, 60% of the participating preferred rounds had no cap, 10% had a 2x cap, 10% had a 3x cap and 20% had a cap greather than 3x.

Pay-to-Play.  Thirteen percent (13%) of rounds in Q2 had pay-to-play provisions, compared to 26% in Q1.  Five percent (5%) of Series A rounds had pay-to-play, 14.3% of Series B rounds, 21.4% of Series C rounds and 10% of Series D or higher rounds.  In Q1, the breakdown was 13.6% of Series A rounds, 31.8% of Series B rounds, 21.4% of Series C rounds and 38.5% of Series D or higher rounds.

Drag Along Rights.  Sixty-seven percent (67%) of rounds in Q2 had drag along rights.  Sixty percent (60%) of Series A rounds had drag along rights, 86% of Series B rounds, 43% of Series C rounds and 50% of Series D or higher rounds.  In Q1, the breakdown was 50% of Series A rounds, 64% of Series B rounds, 71% of Series C rounds and 46% of Series D or higher rounds.

Antidilution.  In Q2, the vast majority of deals utilized broad-based weighted average antidilution provisions.  Stripping away broad-based provisions, here’s what the universe looks like:  50% of all rounds had full ratchet, 21% had narrow based weighted average and 29% had no antidilution.

I also enjoyed Jeff Bussgang’s article In VC deals, Price Doesn’t Matter – But the “Promote” Does.  It is a great add-on to my previous entry entitled Negotiating Term Sheets:  Should Entrepreneurs Focus on Valuation or Everything Else?  Jeff proffers a new term he calls the “promote,” in an effort to communicate the real value behind a deal and to take the focus off of pre-money valuation or post-money ownership.  It’s worth the read.

Finally, I thought David Feinleib’s article entitled When You Are the Product had some thoughful bearing on my previous entry Venture Conference Presentations.  He differentiates between pitching a customer (where you focus on the product you are selling) versus pitching an investor (where the focus is on selling yourself (and your company, market opportunity, team, model, etc.)).  One of my favorit points he makes is that it’s easy to forget that investors aren’t buying your product, they are buying a piece of your company.  So try and focus on the latter when you are pitching investors.

But with all things, entrepreneurs need to put valuation in perspective.  There’s more to a venture round than just valuation and to focus solely on that issue will come at a great cost.  That’s not to say that you ignore valuation, not by any means.  An entrepreneur should always make sure that the valuation resides somewhere within a reasonable range (those that see frequent deals, such as accountants and lawyers, can help with this) and then expend the balance of their leverage negotiating the remaining terms.  Valuations are subjective, but the other terms are tangible and could have a far greater impact on the overall economics of the deal.

Here are some examples of classic mis-steps:

The inexperienced entrepreneur downplays the liquidation preference believing a higher valuation (i.e., resulting in a larger stake in the company) means more money upon exit.  One thing, and one thing alone, has the greatest impact on how sale proceeds are divided:  the almighty liquidation preference.  If you fail to properly negotiate the liquidation preference, I don’t care how high your valuation is – your take of the proceeds will suffer.  Run the numbers yourself and you’ll see the impact a liquidation preference can have.  In particular, when you enter the realm of participating preferred rounds (where venture firms get a multiple of their investment and then share pro-rata in the balance along with the common stock holders), the impact can be greater.  This isn’t to say that the venture firm may not deserve the liquidation preference, but as an entrepreneur you need to understand its result.  Valuation may be rendered irrelevant.

The entrepreneur fights hard for his/her high valuation, thus retaining a large stake in the company (everyone’s dream), only to find out in the next round that he/she was dead wrong on valuation – oh yeah, it’s down round time!  Be careful what you wish for, you might just get it.  If you manage to obtain an excessive valuation the excitement may be fleeting if, following a less than stellar execution of your business plan, your next round of financing is a down round (i.e., at a lower valuation then previous rounds).  A down round will trigger anti-dilution provisions for earlier venture investors and could significantly dilute the founders and everyone else below the venture investors.  You might wish you had spent more time in the earlier round negotiating for a weighted-average anti-dilution provision instead of just accepting a full ratchet.  A more reasonable valuation alone in the beginning might have avoided the later down round.  Even if it didn’t, your weighted-average anti-dilution provision would have at least softened the impact.  You need to take future financing plans of the company into consideration when negotiating that first round valuation. 

While focusing so closely on valuation, the entrepreneur neglects to understand the impact of including the option pool in the pre-money valuation.  As you can see from the previous examples, it pays to focus on how certain provisions in a term sheet are drafted.  You might also want to see if your option pool is included in your pre-money valuation.  Venture firms like to include those shares in the pre-money valuation because they don’t want to be diluted later by such issuances.  In addition, including the option pool lowers your actual valuation (by including more shares in the calculation, the actual price per share effectively goes down).

For sure, more time could be spent on this subject, but the simple fact is that you should not waste all of your negotiating capital on valuation – fight the urge.  Build a great business and a great valuation will naturally follow.

You may ask - if I follow your advice and focus on the other terms, which of those terms take some priority?  Terms like registration rights (which are hardly ever exercised) and redemption rights (if you ever reach a point in time where a venture firm wants to be redeemed, it’s likely there’s no money left to conduct such a redemption anyhow), in my opinion, have little or no impact and should fall to the bottom of the negotiating priority list.  Spend more time negotiating the following provisions (I’ve put them in my own personal order of importance):

• Liquidation preferences – as you’ve seen above, this can make or break you.
• Anti-dilution provisions – this may never get triggered, but if it does you’ll wish you had read it.  Back in the early 2000’s when the first bubble burst, every venture-backed company that was raising money was doing a down round or a cram-down financing.  For the first time, in a long time, everyone was taking out the anti-dilution provisions to see how they worked.  For some, it was a real-life education.
• Protective provisions – this provides a level of control above and beyond your level of stock ownership.  Absolutely worth negotiating.  The list of protective provisions tends to be fairly standard, but there are ways of softening their blow.
• Board seats – is what it is, but always an issue of control.
• Drag-along rights – these aren’t in every deal, but if they are I’d include them in what you negotiate.  Again, experienced venture lawyers have techniques for softening the blow of these provisions.
• Dividends – everybody seems to pick a number between 8 – 10%.  Focus less on the number and more on whether they are cumulative, compounding, etc.
• Rights of First Refusal/Co-Sale Rights – these tend to read the same in almost all deals, but they should still be reviewed thoroughly.

My last piece of advice would be to hire a lawyer with solid venture finance experience (ignore the bias here on my part – this truly is an important point).  The right lawyer can help you understand the relative importance of certain terms as they exist in your term sheet.  The value such an attorney brings greatly exceeds his/her cost.  Hire such an attorney before you even incorporate – do it right from the start and they will make sure your entity and all the formation documents are prepared in a manner that venture firms are familiar with.  It will save you time and money in the long run – you don’t want to delay your venture financing because you need to do some housekeeping.

Of course, I am talking about WSGR’s term sheet generator which was launched publicly a few weeks ago.  If you read WSGR’s web site, you get the impression that this tool is only part of a larger quiver of tools used internally on deals.  Most impressive.

Given that I am a lawyer practicing in the venture community, you might ask why in the world my first post would spotlight another law firm’s services in the same field.  First, I think that lawyers can always be more entreprenurial.  WSGR deserves credit for their creativity with this term sheet generator and I believe it takes being an entreprenurial law firm to a whole new level.  Second, I believe in recognizing a job well done – competitor or not.  For those of you who haven’t tested it out, you need to.  I spent about an hour running it through its paces and I was left very impressed.  Putting aside its great functionality, the generator also has tremendous depth in the variety of deal terms it can add to a term sheet (the generator accounted for almost every term sheet curve ball I could throw at it).  

Now, does the generator replace “smarts” or a level of understanding of these types of deal terms that can only be learned through experience?  My answer is no.  On the other hand, does it provide an additional tool to help VCs and angels round out their term sheets – absolutely. 

Some VCs have asked me – why in the world would WSGR put this on the Internet for free?  In my opinion, solid, well-vetted term sheets have become so prevalent and accessible to the masses that the value provided by lawyers at the term sheet stage isn’t so much novel drafting (although this is certainly required in some deals to the extent the deal has a unique structure or terms), but in making sure that the provisions in the term sheet actually jive with the deal that the parties think they’ve agreed to.  The other legal value-add at the term sheet stage is making sure that the term sheet doesn’t omit a necessary provision. 

Either way, as lawyers, you try not to re-invent the wheel at the term sheet stage.  As WSGR’s free term sheet generator indicates, the real value-add by lawyers in a venture deal is their ability, crafted through experience, to document, negotiate and actually close the deal.