How does securing venture capital funding actually work? What’s the difference between an asset deal and a stock deal when selling your company?
In their book Venture Deals, Brad Feld and Jason Mendelson share insider knowledge about startup financing, from term sheets to venture loans to acquisition strategies. Drawing from decades of experience as founders and investors, they break down complex concepts into practical, actionable advice.
Keep reading to discover how to navigate the world of venture capital, protect your interests during negotiations, and set your startup up for long-term success.
Venture Deals Book Overview
In their book Venture Deals, Brad Feld and Jason Mendelson offer a roadmap for entrepreneurs navigating the complex world of startup financing. VCs are individuals or firms that provide capital to startups and early-stage companies in exchange for equity. Feld and Mendelson, co-founders of Foundry Group, a VC firm that invests in early-stage technology companies, have decades of experience in the startup world—as both founders and investors.
In the book, they demystify the process of securing VC funding by breaking down legal and industry jargon, explain the key players in the ecosystem, and offer practical advice. Exploring key concepts like pre- and post-money valuations, term sheets, venture debt, and acquisitions, the book aims to empower founders to make informed decisions and secure favorable terms with investors.
In this overview, we’ll start by walking you through the term sheet, the document that will outline your deal structure and govern your relationship with your investors. With that understanding in place, we’ll explore the benefits and drawbacks of venture loans. Finally, we’ll help you navigate the intricacies of selling your business once you’ve taken on VC investors.
Part 1: Understand the Term Sheet
Feld and Mendelson write that understanding the term sheet is crucial when negotiating with venture capitalists (VCs).
The term sheet outlines the deal structure that will shape your company’s future—it’s the blueprint for your relationship with potential investors. A well-written term sheet sets clear expectations for both sides, establishes a valuation for your company, and provides a roadmap to navigate potential disputes or misunderstandings down the line.
Feld and Mendelson break down the components of a term sheet into two main categories: finance terms and governance terms. Let’s explore each.
Finance Terms
Finance terms include all the economic aspects of the deal. The authors explain that these include elements like pre-money valuation, the option pool, liquidation preference, and the cap table. We’ll explore these terms next.
Pre- and Post-Money Valuation
Feld and Mendelson say pre- and post-money valuations are key components of the term sheet. Pre-money valuation is what VCs think your company is worth before they invest. This valuation depends on factors like founder experience, industry, product potential, intellectual property, economic conditions, and interest from other investors. Post-money valuation is the company’s value after the investment.
The authors warn, however, that VCs might have a lower pre-money valuation in mind than you have for your company, which could result in them owning a larger post-money share of your company than you expected. For example, say you’re the founder of a tech startup that you believe is worth $2 million before any investment (your pre-money valuation). You’re seeking a $500,000 investment from a VC, for a post-money valuation of $2.5 million. In this scenario, you’d expect the VC to own 20% of your company post-investment ($500,000 is 20% of $2.5 million).
However, after negotiations, the VC’s final offer might estimate your pre-money valuation at only $1.5 million based on their assessment of factors like market size or competition. This would put the post-money valuation at only $2 million. If they still invest $500,000 based on that lower pre-money valuation, they’ll own 25% of your company post-money ($500,000 is 25% of $2 million)—not the 20% you initially expected.
The Option Pool
The option pool is another key component in a term sheet, according to the authors. The option pool is like a reserved pot of shares of stock in your company that you can offer to employees as part of their compensation package. Option pools provide an incentive for employees to join your team or stay with the company because they stand to benefit if the company does well.
Think about your company as a pie and shares of stock as slices. The more people getting a slice, the smaller each slice has to be. Thus, creating an option pool increases the total number of shares (slices) your company has. This dilutes the value of existing shares—including those owned by you and any investors—because now each share represents a smaller percentage of ownership in your company. The authors note that the size of this dilution effect could affect your company’s valuation.
This can impact negotiations with investors since they’ll be looking at what percentage (or slice) they get in exchange for their investment. A larger option pool could mean that you as a founder end up owning less of your own company. The authors explain that VCs often insist on expanding the option pool before investing. This move dilutes the founders’ equity and lowers the pre-money valuation because it increases the number of shares without adding any new capital.
Let’s illustrate this with an example: Assume you have a startup valued at $4 million (pre-money) with an existing 10% option pool. You’re seeking $1 million in investment for what you expect would give VCs 20% ownership of a $5 million post-money company. However, if your VC insists on expanding your option pool to 20% before investing, it changes things. The expanded pool comes out of your pre-money valuation, effectively reducing it to $3.6 million (that is, $4 million – $400,000 for the expanded option pool). Now, when the VC invests their $1 million, they get roughly 22% (that is, $1 million/$4.6 million) instead of 20%.
The authors suggest that entrepreneurs should negotiate both their valuation and their option pool size simultaneously since they are interrelated. If a VC insists on a large option pool, you might counter by asking for a higher valuation to offset your dilution. They also note that another option is to keep your initial option pool as small as reasonably possible while still being able to attract talent. You can always increase it later in subsequent funding rounds when, hopefully, your company’s increased value would mean less dilution for you.
Liquidation Preference
The authors write that liquidation preference is another key term sheet idea, one that determines who gets paid first and how much in the event of a sale of the company. They note that if you’re not careful about how you structure your liquidation terms, you could wind up with nothing when your company gets sold. Let’s look more closely at how this works.
Preferred stockholders, typically the investors, are first in line during such an event and get paid based on contractually defined ratios. Common stockholders, often including the founders themselves, get their payout next—if there’s anything left to be paid out after the preferred stockholders get their payday.
This order of payment can significantly affect what (if anything) common stockholders receive from an acquisition. If the sale price is less than what VCs have invested, common shareholders may end up with nothing.
For example, let’s say you’ve raised $4 million from VCs in exchange for 25% of your startup, and your term sheet stipulates that the VCs receive preferred shares with liquidation preference equal to their investment amount. Unfortunately, market conditions change drastically, and after some time, you have no choice but to sell your company for just $3 million. Here, due to the liquidation preference clause in place, the VCs get to recoup their $4 million investment before anyone else gets paid. However, since the sale price is only $3 million, that entire amount goes toward fulfilling as much of that original agreement as possible—leaving nothing for you.
The Cap Table
The cap table tracks all shares or ownership units in your company and who holds them. This includes you and your co-founders, investors, and employees with stock options. Understanding your company’s cap table is crucial for tracking changes in ownership over time; calculating the value of individual stakes in your company; informing decisions about fundraising, acquisitions, or profit distribution; and providing a clear picture of how ownership may dilute with future funding rounds.
Governance Terms: Controlling the Board of Directors
In addition to finance terms, the term sheet includes governance terms that outline how VCs will influence your company’s decision-making processes. If finance terms are about money, governance terms are about power and control.
According to the authors, the composition of the board of directors is a key governance term. The board is a governing body that oversees the management and direction of a company. It’s responsible for setting broad policies, hiring top executives, and safeguarding the interests of the shareholders.
VCs often seek to influence the board of directors in various ways—for example, by securing a board seat as part of their investment deal. Securing a seat gives them a say in the company’s strategic decisions, which allows them to steer its direction to match their interests.
Part 2: Venture Loans
The book explores term sheet items and the different factors entrepreneurs need to consider when working with VCs and exchanging company equity for startup capital. But, what if you want to raise money without sacrificing equity? This requires a distinct type of venture finance called venture loans.
The authors explain that venture loans, also called venture debt, are specifically designed for startups and high-growth companies. Instead of borrowing from a bank and sacrificing equity, you get loans from specialized lenders who understand the unique risks and needs of the startup world. Next, we’ll explain the biggest benefit and some drawbacks of this type of funding.
Benefit: Greater Flexibility
According to the authors, the major benefit of venture loans is that venture debt can offer greater flexibility than equity financing. The terms of the loans are often negotiable and can be tailored to suit the specific needs of your business.
For instance, you might negotiate a flexible repayment schedule. This could mean making smaller repayments in the early stages when your startup is still finding its feet, with larger payments coming due once you’re more established and generating higher revenue.
Alternatively, you might arrange for repayment conditions that align with your startup’s growth trajectory. For example, if you expect a significant increase in revenue after launching a new product or entering a new market, you could structure the loan so that repayments increase proportionally with expected revenue growth.
Importantly, note the authors, unlike with VCs, you’re not tied down by investor expectations about where their money should go; instead, you have more freedom to allocate resources according to what’s best for your business.
Drawbacks
The authors warn that while venture loans offer opportunities, they also come with significant risks for your startup. You need to carefully consider these potential drawbacks before taking on venture debt. Let’s explore two major drawbacks: high cost of capital and financial covenants.
High Cost of Capital
Feld and Mendelson note that venture debt typically carries higher interest rates and fees compared to traditional bank loans. Therefore, it increases your business’s overall cost of capital—that is, the total expense of securing financing. Since it’s a more expensive form of financing in the long run, venture debt can negatively impact your profitability and cash flow, limit your financial flexibility, and potentially hinder your ability to invest in growth opportunities.
Financial Covenants
The authors also warn that venture debt agreements often include financial covenants that your startup must adhere to. These might include maintaining certain financial ratios or performance metrics. Breaching these covenants could lead to default and other serious consequences, potentially putting your entire business at risk.
Imagine, for example, that you’re the founder of a tech startup, and you’ve secured venture debt from a lender to fuel your growth. As part of the agreement, the lender includes financial covenants that require your company to maintain a minimum cash balance of $500,000 at all times. Now, suppose there’s an unexpected downturn in the market, or perhaps a key customer fails to renew their contract. As a result, your revenue takes a hit and you burn through cash more quickly than anticipated while trying to keep operations running smoothly. By the end of quarter three, you fall short of the agreed upon $500,000 minimum cash balance.
In this scenario, you’ve breached your financial covenant, which could trigger serious consequences—like defaulting on your loan. If you defaulted on your loan, all outstanding debt would become immediately due, and your lenders might also be able to claim assets as repayment.
Part 3: Managing an Acquisition
Feld and Mendelson explain that receiving an attractive acquisition offer is often the end goal for many startups and their investors once the company has achieved a certain level of financial success. However, they warn that acquisition is a complex process involving multiple parties—from the acquiring company to shareholders, board members, lawyers, and other stakeholders. We’ll cover two concepts you should understand when going through an acquisition: how letters of intent work and the differences between asset deals and stock deals.
Letter of Intent (LOI)
A letter of intent (LOI) signifies a potential buyer’s serious interest in acquiring your company, indicating that they’re ready to discuss terms more formally. It outlines the basic terms of an agreement before the actual deal is finalized, laying out key elements like purchase price, structure of the deal, due diligence process, and timeline. While it’s typically nonbinding, the LOI does set the stage for deeper discussions by clarifying initial expectations and priorities between you and the buyer.
Exclusivity Clauses
The authors advise you to be aware of exclusivity clauses in LOIs—terms that prevent you from engaging with other potential buyers for a certain period. Exclusivity clauses can limit your options and hinder your ability to negotiate with other potential investors for a specified period of time after presenting your pitch. This might leave you in a vulnerable position if the initial VC decides not to invest or delays the process.
The Due Diligence Process
If you’re OK with the terms of the LOI, you can sign it to keep things moving forward. After signing, expect the buyer to conduct a thorough due diligence process, in which they verify the information you’ve provided and assess the financial and legal health of your business. The LOI should outline what this process looks like, including its scope and expected duration.
The authors explain that due diligence can be an intensive process. To uncover any potential risks or liabilities, buyers will want to scrutinize everything from your financial records and customer contracts to intellectual property rights.
For instance, the buyer may discover that your company is involved in a legal dispute. This could be a lawsuit from a former employee claiming wrongful termination or a patent infringement claim from a competitor. These kinds of legal issues represent potential financial and reputational risks that may discourage the buyer from proceeding with the acquisition. Similarly, if the buyer discovers that major customer contracts are about to expire without any guarantee of renewal, that would impact future revenue projections and, as such, may make them think twice about the deal.
Feld and Mendelson advise you to prepare for the due diligence process well in advance by keeping detailed records of all business activities. They also suggest working closely with your legal team during this phase to ensure all requests are handled properly. Most importantly, they caution against hiding or withholding information during due diligence, since any discrepancies found could lead to renegotiation or even termination of the deal.
Asset Deals vs. Stock Deals
Feld and Mendelson outline two main types of acquisitions: asset deals and stock deals. Below, we’ll explain the differences between the two, as well as their respective implications for both buyers and sellers.
Asset Deals
The authors note that, in an asset deal, the buyer purchases specific assets and liabilities from the target company rather than acquiring the company itself. This method allows the buyer to choose precisely which components of the business they want to take on, such as equipment, intellectual property, or customer contracts, along with any associated debts or obligations. Buyers often prefer this structure when they want to select only those assets and liabilities that align with their business objectives, effectively “cherry-picking” the components that offer them the most value. This approach helps a buyer avoid liabilities or non-essential assets that might come with a full company acquisition.
The authors warn that asset deals may not be such a great deal for you as the seller. This is mainly because in an asset deal, the buyer acquires only the assets of the company—not its liabilities, which you could still be responsible for.
Stock Deals
In contrast, write the authors, the buyer acquires all outstanding shares of the target company’s stock—so a stock deal gives the buyer ownership of the entire company, including all assets, liabilities, contracts, and obligations. As the seller, you relinquish your shares in exchange for the agreed purchase amount, resulting in a complete transfer of ownership and operational control. In this scenario, you exit the company entirely. This tends to be more favorable for you as the seller, since you get to transfer all your company’s liabilities along with its assets, leaving you free from any obligations after the sale.
