Venture Capital.

As I’ve emphasized, venture capital is not right for every startup. But if you decide you want to go hiking along the venture capital trail, here is everything you need to know for your journey! Wear good boots for this hike; it may get muddy. 

It’s typically a series of financings.

The illustration above shows the typical financing progression of a venture-funded company. It usually begins with a little bit of pre-seed money from friends and family, then a seed round from angel investors structured as either convertible notes or SAFEs, and then the first round from a venture capital fund, then maybe additional rounds of venture capital, and then eventually an IPO (where stock is sold to the public), and all the equity holders get rich. Venture capital financings are typically called Series A, Series B, etc., because in the old days would print out a series of stock certificates after each equity financing round. Today, stock certificates are typically digital and managed by a service like Carta, but the naming convention lives on.

These are equity financings. 

Venture capital financing is nearly always structured as equity. Seed-stage financing might be structured initially as a convertible note or a SAFE, but those instruments eventually turn into equity. 

Equity holders are looking for eventual liquidity and exit. 

The whole reason an investor would want to buy equity in your company is so that when you sell the company to Google for a billion dollars or have an IPO, they will be able to sell their equity at a large premium over what they paid for it. Remember that venture capital is not debt; there is no repayment obligation, so they are looking to sell their equity at some point in order to get liquidity. 

Lawyers will love you. 

In venture capital financing, you are selling stock to private investors, which is tightly regulated by the US Securities and Exchange Commission (SEC). You will need a good law firm for this process, and it will be very expensive. One of the reasons that early (seed-stage) financing is done as SAFEs is that you’re not actually selling stock; you’re selling an instrument that can be redeemed for stock later, so the legal fees are much lower. Eventually, you have to pay the piper, and in the Series A financing everything goes to equity and you will need a good law firm. Don’t be surprised if the term sheet from the venture capital firm says that your startup will pay their legal fees as well as your own. As unfair as that sounds, it’s their way of having all the costs of the financing transaction come from the fund. 

First, dance with angels.

Seed-stage financing typically comes from angel investors (individuals investing their own money), not VC funds. Because angels are investing their own money, they can make the sort of gut-level investment decisions an early-stage startup needs.  You don’t yet have any operating history, you don’t have any technology, you’re just a passionate entrepreneur certain they can be successful. You need someone who just believes in you, and that will typically be an angel investor, rather than a venture capital fund. 

Then, the venture capital ball.

Venture capital firms typically invest after there’s some operating history, the idea has been proven, risk has been mitigated, and your company is ready to scale. As a VC friend of mine says, “I’m looking for just-add-money opportunities.” Most VC firms don’t come in at the idea stage, they come in at the ready-to-scale stage. 

There will be math.

Equity financing always follows one simple formula: the percentage of the company owned by the investors equals the amount they invested divided by the post-money valuation of the company. Let’s say we have a company currently valued at two million dollars (pre-money valuation), and the investors are dropping one million dollars in cash into the company (new money). After the financing, the company is worth what it was worth before plus the new cash in the bank, a total of three million dollars (post-money valuation), so the investors now own 33.3 percent of the company. Because math. 

Valuation matters.

In the formula above – which applies to every single equity financing – the math is very easy.  The hard part is determining the company’s valuation before the financing (the pre-money valuation). This is especially true of early-stage companies with no operating history. It’s just a passionate team and a bunch of optimistic slides—how do you objectively put a dollar value on that? Sometimes founders and investors will back into the formula; in other words, if the investor says, “If I put a million dollars in at this point I would expect to own a third of the company,” and the founder ponders that and responds, “I think that’s reasonable, a million dollars for a third of the company’s equity,” then you have just implicitly agreed upon a pre-money valuation of two million dollars. It’s the exact same math. 

Liquidation preferences rule. 

Equity investors want to be first in line when the company is sold or wound-down, so they will ask for preferred stock to represent their equity. This stock has a liquidation preference, meaning that when the company is liquidated (either through a sale or a wind-down), they get money before common shareholders (you and your employees). This preference will typically be an amount equal to their investment. In other words, if they invested a million dollars, when the company is liquidated they will get the first million, and then the rest of the money is evenly distributed amongst all the shareholders. In some instances, they may ask for 2x liquidation preferences, meaning they’re putting a million in, but if the company is liquidated they get the first two million before anything goes to you and your employees. This is a crucial point to understand.

Understanding voting rights.

Some entrepreneurs fear that VCs just want to take over your business and fire you. Actually, this is pretty much the opposite of what they want to do. Their whole model depends on you doing all the hard work to run the company while they relax and make money! But it’s important to understand how corporate governance works and what rights they are requesting as part of their investment. The standard corporate governance is that shareholders elect a board of directors, and the board hires and fires the CEO. So, if the investors own thirty percent of the company, and you own seventy percent, then you still control the board, which means you still control the CEO. But the term sheet they present to you when offering financing may have slightly different rules. A typical term sheet might say there will be a five-person board with three members chosen by the common shareholders (you) and two members chosen by the preferred shareholders (them). Just pay attention to what you are agreeing to, and make sure it keeps everyone’s interests well-aligned!

Get familiar with how the VC business works. 

If you’re gonna pitch to VCs, it’s important to understand how their business works. Venture capitalists manage other people’s money, much like a mutual fund. When the general partners decide to raise a fund, they go out and pitch individuals and organizations on putting money into that fund; these are called limited partners. Two percent of the fund annually goes toward operating expenses (like fancy offices on Sand Hill Road) every year. After ten years, the fund is dissolved, and eighty percent of the profits are paid out to the limited partners, while twenty percent go to the general partners who managed the fund and made the investment decisions. This is called the “two and twenty” system and is used by nearly every VC firm. 

Most of the money in venture funds comes from pension plans, university endowments, and other large institutional investors. It is a business about high-risk/high-return investments with binary outcomes: each investment ends up either bankrupt or worth billions. Historically, about seventy-five percent of a venture fund’s investments fail, but the other twenty-five percent succeed wildly and make the whole fund a success. The average partner at a VC firm will look at somewhere around 400 startups a year, and invest in 4 of them. 

What does all this mean for you?

As with anything else, you’ll always do better in negotiations if you understand the other party’s world. In that context, here are what the above points mean to you:

Because they’re not investing their own money, a VC firm has a fiduciary responsibility to its investors (limited partners). This is a key concept to understand. Angel investors, on the other hand, are investing their own money and so have a wider latitude in their investment decisions.

If you’re looking for a little bit of money to create a nice little business, it’s just not a fit for traditional venture capital. Their model depends on finding the billion-dollar unicorns. Because they are buying equity, the only way they make money is from eventually selling the company (either to an acquiring company or through an IPO). 

A fund’s lifespan is typically ten years, and a venture firm typically has several different funds under management at any given time. The first two to three years of a fund is spent making investments, the next three to four is sitting on boards and managing those investments, and the final two to three is trying to get liquidity on those investments by selling the company or aiming it toward an IPO. You should always ask which fund they might be investing from and what the current life-cycle stage is for that fund.

As with any asset class, venture capital firms want to put together a diversified investment portfolio. They may say “no” to you just because they already have some investments like your startup and are now trying to round out the portfolio with some different sorts of startups. 

Cap Tables (avoid my mistakes!).

In the world of venture-funded startups, few documents are as consequential as the capitalization table (commonly called a Cap Table). Conceptually, it’s just a list of who owns what percentage of the company. But it can get complicated in a hurry, with co-founder agreements, stock options issued, lawyers who hold stock warrants, investors who own preferred shares, advisors who were promised equity, and many other twists and turns.

It becomes a sacred document, and every investor you talk to for each round of financing will ask for a current cap table. Your lawyers will need it. The bank will ask for it. Contracts with large customers will sometimes require that you provide a copy. You will be asked to sign affidavits attesting to its accuracy. It’s the Rosetta Stone for your company’s equity structure.

One of the most embarrassing (and expensive) experiences in my career was when I sold a company, everything with the transaction was going great, and we all felt great about it. Suddenly, an angel investor from many years earlier said, “Hey, remember, you said you’d give me some extra shares for that additional help I gave you?” I had no memory of it, and it wasn’t represented on the cap table, but he produced documentation that I had indeed promised him those shares. When I brought this up to the other shareholders, they shrugged and said, “That’s not our problem; it’s not on the cap table.” In the end, I had to pay the guy $130,000 out of my own pocket to make good on the promise I had made but never entered on the cap table. Ouch. Be smarter than me. 

The good news is that what was once a hairy Excel file being forwarded around is now typically kept centralized in an online service like Carta. Pretty much everyone is doing it this way these days, which at least makes the cap table easier to manage (and there’s one canonical copy).

Dilution Happens (here’s how to mitigate). 

Each round of financing dilutes everyone on the cap table, so a series of financings can result in pretty substantial dilution for the founders. Today, Mark Zuckerberg only owns 12.8 percent of the company he founded (but let’s not cry too much for him).

Dilution also happens every time you create stock option plans for your employees, give stock warrants to key partners, and give stock options to advisors. Every startup founder wants to preserve equity for themselves but also wants to use equity to drive the venture’s success. Here is some advice to keep in mind with regard to dilution of your founder equity:

Make sure everything is carefully documented! In the embarrassing story I told you above, I gave out some shares and then forgot to record it on the cap table. This is surprisingly common and can be an expensive mistake (it certainly was for me). 

Don’t raise more money than you need. In another one of my many mistakes, I was once shopping for a five-hundred-thousand-dollar seed round and got talked into five million. It’s seductive to be offered more than you were looking for, but you’re also giving away more equity in the company than you need to.

Use SAFEs cautiously. SAFEs are a commonly used lightweight seed-stage investment instrument that isn’t equity today but turns into equity in the future based on pre-defined terms (see glossary in the refence section of this book). I’ve seen founders hand out SAFEs like tissue paper, then two years later when the SAFEs convert to equity, they are horrified at the dilution (see glossary at the back of the book). 

Do cap table modeling. Use a good tool like Carta to model different cap-table scenarios so that you choose a financing path (through multiple financing rounds) that yields an optimized equity outcome for you and your co-founders.

Beware the full ratchet. Make sure you have a really good attorney to consult with before you accept any term sheet from an investor. They may well be asking for terms that sound reasonably innocuous on a term sheet but have the potential of being painfully dilutive in the future.

Vesting schedules are your friend. A vesting schedule simply means that, when you give stock to an employee, they have to stay with the company a certain number of years in order to get the full amount. Make sure that any stock you give out is on a vesting schedule, even for co-founders. The Silicon Valley standard is four years. I’ve seen cap tables show that the company is twenty-percent owned by a co-founder who quit two weeks into the venture and whom nobody has heard from in five years. That’s not a good look. 

These are just a few of the steps you can take to optimize your founder equity as you grow your company. There are many other considerations, including a right of first refusal associated with stock agreements. Having a good corporate attorney is key.

Underrepresented startup founders.

There has been a lot of attention focused in recent years the fact that less than three percent of all US venture capital has historically gone to startups led by women, and even less to founders of color. That is a troubling fact. I would like to think it’s much different now, looking forward, but we’ll have to see where the numbers sit in a few years.

There was a time when almost all the venture capitalists on Sand Hill Road were middle-aged white guys who went to business school at either Stanford or Harvard. Human nature is such that after you’ve been successful you tend to think that success looks like you, so you (consciously or unconsciously) find people who look like you to invest in. 

Fortunately today, if you look at any VC firm’s investing partners, you will see more diversity than ever before. The past twenty years have seen people of all stripes develop very successful careers and then go into venture capital. While the problem still exists, to be sure, we now have a generation of diverse people making investment decisions, and we’re seeing more diversity in the founders they invest in. 

Today, I am seeing an increasing number of venture capital firms put a diversity rider into their term sheets, with text similar to this:

“In order to advance diversity efforts in the venture capital industry, the Company and the lead investor, [Fund Name], will make commercial best efforts to offer and make every attempt to include as a co-investor in the financing at least one Black [or other underrepresented group including, but not limited to LatinX, women, LGBTQ+] check writer (DCWs), and to allocate a minimum of [X]% or [X] $’s of the total round for such co-investor.”

There is still much work to be done in order to create true diversity and equity, but progress is being made. There are many great organizations out there helping to support underrepresented founders, including All Raise, How Women Invest, Project W, and many more.

Venture Capital Summary

Venture capital is the most expensive possible sort of capital, so you are making the decision that it’s worth the price to be able to scale at a pace faster than you could ever scale organically. For companies like Uber and Airbnb, this turned out to be a good choice. Make sure it’s the right choice for you and your venture before you start down the venture-capital path.  

With any financing structure, what you’re looking for is alignment of interests. Successful financing occurs when the investors’ interests are well-aligned with the founders’ and employees’.  Make sure you review term sheets carefully, and make sure you have a good attorney (one who knows the startup world) who can advise you and help you think through various scenarios. 

Many great companies have been scaled using venture capital with satisfying outcomes for all. Many others have crashed because venture capital wasn’t really the right choice. Make sure you look at all the different ways to finance your startup, then choose the one that’s the best fit for you and your venture.