A friend of mine sent me a 10 page VC Rejection Letter (that landed in his inbox). I am going for put this into the “almost must read category”. It completely cracked me up, and will either make you (i) hate VCs, (ii) realize that VCs can find a way to get to “NO” under almost any circumstance, (iii) realize that the letter actually has some very good tips for those raising $$ and/or (iv) make you laugh.
Enjoy….here it is. Venture Fundraising Rejection Letter.
I read an article this morning in DealBook titled “In Venture Capital Deals, Not Every Founder Will be a Zuckerberg“. Go ahead and give it a read. I actually like the Deal Professor very much and think he usually writes good stuff. But this time he missed a few things.
My first reaction was “no kidding” and that was just to the title of the article. I hope that does not need much explanation. Here are a few other thoughts:
1. The article states “When venture capitalists invest, they typically demand preferred shares that accrue a yearly dividend of about 8 percent. The dividend goes unpaid until the company is sold. In a sale, the original amount and the interest all come due. It must be paid out before the common shares, which are typically held by the founders and other employees.” What this describes are “cumulative dividends” where the dividends actually accrue over time. This is RARE in VC deals. Most deals are done with non-cumulative dividends that are NEVER paid. Huge difference!
2. The article also states that “But venture capital investments are structured to ensure that the venture capitalists are paid before founders and employees.” And to this I think “yeah, that makes sense.” If the VCs invest say $18 million in a company, and assuming that the employees have been getting paid for their work, then it makes sense that the first $18 million available on a sale transaction would go back to the investors to repay their investment. It is ONLY once the VC’s liquidation preference is cleared that the common stock held by founders and employees is worth anything. And I think that makes 100% sense. Yeah, I am a VC so you might think I am biased, but it really does make sense.
The legal case that the Deal Professor writes about is one of the fringe cases where actions by the board of the company may be called into question for breach of fiduciary duty to common stock holders, who, in this case, included founders who had been let go many years prior. Fiduciary duty law is well settled, and, no, directors cannot approve dilutive financings without regard to common shareholder interests.
It will be interesting to see how this legal case plays out.
Much has been written about crowdfunding and the SEC’s highly anticipated rules that will make equity crowdfunding available for non-accredited investors. Equity crowdfunding involves actually selling stock (i.e., equity) to investors via a crowdfunding portal. This is vastly different from sites like Kickstarter where the company raising $$ does not offer equity, but rather other perks like a pre-order of a product or product purchase discount.
BTW, a great website for crowdfunding resources and statistics is crowdsourcing.org. And in particular this infographic is terrific.
I read an article recently in TechCrunch called “Is Equity Crowdfunding a Threat to Venture Capitalists?” Is has some great analysis.
However, one point that I feel is routinely overlooked in the crowdfunding vs VC debate is this: a company that equity crowdfunds and gets a whole bunch of non-accredited investors essentially, in my view, takes away its ability to raise VC $$ later. The reason is that active VCs do not want to deal with throngs of non-accredited investors in the company’s cap table. There are real liability issues (lots of VCs take board seats), deal issues (corralling SHs is often a painful process for future transactions), and people issues (the more SHs a company has the more likelihood of SH complaints).
My advice is to keep this reality in mind if you plan on utilizing equity crowdfunding once the SEC issues its rules…..whenever that might be!
I just read the lead article from today’s PEHUB Wire. It is so funny that I had to share in case you did not see it. Here it is in its entirety. I can relate to about 85% of this….perfectly. Gospel for the VC ages.
| So God Made a Venture Capitalist! |
| By Mahendra Ramsinghani
And on the 8th day God looked down on his planned paradise and said, “I need a caretaker for all those entrepreneurs – the crazy ones!” So, God made a venture capitalist (VC)! I need somebody who can raise funds, come up with a new “unique defensible investment strategy” every three years. Strong enough to convince institutional LPs to part with a billion (or two) with no due-diligence. Yet gentle enough not to squish dreams of MBA students. Somebody who perpetually resides in the top-quartile. Someone who negotiates carry yet never sees a return, fights for attribution, tames cantankerous LP side-letter requests…. Someone who could find a way to survive with just 2% fee-income, be able to feed the family some bread (flown in from France). So, God made a VC! God said I need somebody to sit and patiently listen to thousands of pitches, even get up before dawn and have conference calls and sit in board meetings all day, make sure those portfolio CEOs are doing fine, eat sushi while driving a Prius. And then go to a demo-day and stay past midnight listening to more pitches, empathizing with entrepreneurs about how hard it is to start a company. So, God made a VC! God said “I need somebody that can shave their head and hide their grey hair away, wear funny shoes and fit in with an age demographic of their grand-kids. Someone who will finish his forty-hour week by Tuesday noon. Negotiate a $20 million pre-money with a 19-year-old founder CEO. Then, take one more meeting, emerge from a smoke-filled room and put in another seventy-two hours at the worlds largest office hours. So, God made a VC! God had to have somebody willing to tweet, blog and yet take care of the portfolio CEOs, run at double speed to prevent cash challenges, ahead of the economic downturns and yet stop on mid-field and race to raise another fund when he sees the first smoke from an exit with a positive IRR. So, God made a VC! It had to be somebody who’d know-it-all-social, mobile, cleantech and greentech or the “internet of things”. Somebody to see beyond the waves, to observe and predict, pretend and challenge…and pontificate and spray and pray. Somebody to do “portfolio value-add” with a straight face, replenish the mojo of a depressed CEO who did not get featured in TechCrunch….and then finish a hard days work with a five mile drive to the home-by-the-sea. Somebody who’d bale a portfolio together with the soft strong bonds of liquidation preferences, who’d laugh and then sigh… and then respond with a soft-whisper “NFW”, when his portfolio CEO says he wants to spend his life “doing what a VC does”. So, God made a VC! About the author: Mahendra Ramsinghani, a pretend-VC has reinvented himself as a pretend-farmer. He is the author of “The Business of Venture Capital”, and co-author (with Brad Feld) of “Startup Boards”. |
Having a relatively small about of convertible debt on your balance sheet prior to your Series A financing is not a bad thing. I am a big fan of convertible debt (with appropriate terms). Typically the convertible debt automatically converts in a Series A round of at least $X within Y time frame. So $X might be at least $1mm and Y time frame might be within 18 months of the convertible debt issuance. The X and Y are negotiated, with the Y typically being a date shortly before the convertible debt is all used up by the company in its operations.
One interesting point that comes up a lot is how to factor the convertible debt into the premoney valuation of the Series A round. Let’s assume the following:
So, to calculate the Series A share price, you take the premoney valuation of $3mm and divide it by the number of premoney shares, which again will typically include the whole option pool. So, $3mm/(3,400,000+500,000) = $.7692 per share. That would be the share price of the Series A stock being sold to new Series A investors.
But, what about the convertible debt? The convertible debt has what I like to call “purchase power” equal to ($62,000+$13,700)/(1-20%)= $94,625. That is how much Series A stock will be issued to the debt holders.
If you don’t factor this purchase power into the premoney valuation, the Series A new investors are going to end up with less than what they expect. In our example, if the premoney is $3mm and the Series A new investors are putting in $1mm, then they expect to own 25% of the company after the closing ($1mm invested/$4mm post money). But, when you factor in the convertible debt purchase power, the post money valuation is actually $4,094,625 (just $3mm premoney plus $ amount of Series A sold). So the new Series A investors end up with 24.4% ($1mm/$4,094,625). Granted, that is not much dilution, BUT what if there were like $600K of convertible debt instead of $62K. Ouch, then the dilution is real.
The easiest way to deal with this issue (and the way I like to deal with it), is to simply subtract the convertible debt purchase power from the negotiated premoney valuation. So, in our example, the new premoney valuation would be $3mm minus $94,625 = $2,905,375; the new Series A share price would be $2,905,375/(3,400,000+500,000) = $.7450 per share (note how it is lower than the per share price calculated above). And the post money would be $2,905,375 + $1,094,625 (which is the total Series A sold including the convertible debt) = $4mm. And, viola, the new Series A investors who put in the fresh $1mm own 25% post money.
The one big issue to keep at the front of your mind is that the more convertible debt you have on your balance sheet prior to the Series A round the bigger the impact on the “true” premoney valuation (in the downward direction). It can get painful so make sure to manage your expectations.
ithaca VC 