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So you've built a product and got some traction. You've even got some interest from VCs for your Series A Round. Now its time to structure and close your Series A round, on the best terms for you...
Negotiating and Closing your Series A: 10 questions you must ask your VC
Setting out a clear understanding of each other's position early on is key - you want to avoid nasty surprises along the way. Terms such as Option Pool Shuffle and Participating may not mean much at the outset, but can cost you 5%-15% of your company later on.
When a VC first discusses your Pre-money Valuation, you should ask them the following 10 questions. Many can be answered with a simple answer "Yes" or "No", and all should be understood by any VC:
- Option Pool: is your proposed option pool of 5-15% acceptable?
- 10% is standard
- Awarding options: how can options be awarded?
- This should be a Board Decision above a certain threshold - see control later
- Vesting: how do the options vest?
- Normally monthly over 48 months, with a 1 year cliff (nothing award in year 1; but 12/48 at the end of month 12
- Left over options: who gets unawarded and unvested options these should they not be awarded at exit - the VC or the Employees?
- Ideally you want these defaulting to the employees. This encourages the VC to allocate the options to employees as intended post closing the deal
- The Share Option Pool Shuffle: how does the VC treat the awarding of new options - using the VC Friendly, or Founder Friendly approach?
- The VC friendly approach will reduce the effective size of your option pool by the stake the VC gets (e.g. by 10-33%)
- Liquidation Preferences: will the VC round have a liquidation preference, if so, what is it?
- Either no Liquidation preference, or a Liquidation preference of 1 is common. The VC's argument for a Liquidation preference is (i) to incentivise the team to shoot for a big outcome (they will get nothing at low valuations) and (ii) to de-risk the VCs investment
- Participating: if they have a liquidation preference, is the round participating or non-participating?
- We hate participating with a 1x Liquidation Preference - it feels egregious to us, but can be a tool for a VC to recoup economics if they've agreed to a very high pre-money valuation. However, we also hate the lack of alignment between the VC and Founder in the cap table immediately above the repayment of the Liquidation Preference. So we'd prefer a lower Liquidation Preference, e.g. 0.25x to 0.5x and participating. But this isn't common, so may difficult to get past your VC's investment committee (see later)
- Fees: does the VC charge any fees for completing the investment, or along the way e.g. if they have board seats?
- The VC may recharge some of its legal or DD fees to the company when the deal is done. This can happen in later stage rounds. So you will want to know what fees will be taken off the investment made to you
- If fees are charged along the way, these should be on commercial terms, and, for example, you should have the right to replace their paid-for non-executive director. But you may always need to grant them a free observer seat in these circumstances. Otherwise the VC is just recouping their investment through fees
- The Convertible Debt Shuffle: how does the VC treat the conversion of convertible debt, that may trigger as part of the Series A round - using the VC Friendly, or Founder Friendly approach?
- This may have a big impact on your earliest investors, so you'll want to know what message to take back to them
- Control provisions: what control provision does the VC want; and what constitutes Board Approval? For example, do they need to vote in favour to pass a major proposal, and under what circumstances, if any, can they replace you and the team?
- The VC may be able to produce an example of a control provision schedule from a previous deal. All you really need to know right now is how Options can be awarded and allocated)
How to trade these items
The biggest elements to trade are the valuation, option pool mechanics and liquidation preference. Let's say a VC wants to invest $3M and gives you the following two choices (you currently own 100% of the company):
- The pre-money valuation is $9M
- There is a 15% option pool; which you can allocate up to 5% to yourself as CEO
- There is no liquidation preference
- The VC charges no arrangement fee, and nothing for their board observer seat
- The Share Option Pool shuffle is Founder Friendly
- The pre-money valuation is $12M
- There is a 5% option pool; you can't allocate any of this to yourself
- There is a liquidation preference of 1x and the round is participating
- The VC charges a 3% arrangement fee, and $50k per year for a board observer seat
- The Share Option Pool shuffle is VC Friendly
So which would you choose: Option 1 - a pre-money valuation of $9M or Option 2 - a pre-money valuation of $12M?
You may think Option 2 is the clear winner. After all, the valuation is 33% higher. But let's look at this a few ways: your overall shareholding, and your expected returns at three different exit valuations:
|Option 1: $9M pre-money||Option 2: $12M pre-money|
As you can see, Option 1 with the lower pre-money valuation, delivers you higher returns under lower valuations. It's only until you get an exit above $34M that Option 2 becomes preferable. And that shouldn't be a surprise. The VC wants to drive you to a large outcome.
The point here, is to be conscious of the impact of other terms aside from the "big one": pre-money valuation. And to understand that you can concede a lower pre-money valuation if you can compensate in other ways: issue more options, remove a liquidation preference, etc.
What's important for the VC?
The headline elements for a VC are:
- The amount to be invested
- The pre-money valuation
- Their fully diluted position
Following close behind are:
- Whether there is an option pool
- The terms of the investment (e.g. Liquidation Preference & Participating)
There are plenty more things that are important to the VC. But these will have been considered prior to the VC taking the investment to this stage, and aren't directly related to negotiation and structuring: e.g. geography, sector etc.
What terms can I expect?
Taking the key elements in turn:
The amount to be invested will have been discussed early on, and will be consistent with other investments the VC has made in the past. It should give you 12-18 months of cash runway. And you may want to know whether the VC has a policy of following their investments or not (will they invest in subsequent rounds). Each VC will have a different policy on this
The pre-money valuation is the value placed on your company. This is one of the most emotive areas of negotiation, but other aspects - like your share option pool - can have just as big outcome on your final shareholding (see later)
Their fully diluted position sets out the percentage that the VC ends up with after the round. Most VCs are minority investors (want less than 50% of the company), and will typically get 10% - 33% from each investment round. Working out their Fully Diluted position can be tricky, but you can use Reportally's cap table builder to model and share an agreed position with the VC. The VC's investment committee (see below) will be very focused on the Fully Diluted position.
Finally, who are you negotiating with?
There are two tiers to every VC firm:
- Your contact: the partner in charge of your "deal" or investment
- The Investment Committee: the other 3-4 partners of the VC firm who decide which deals are done, and on what terms
Why does this matter?
Your contact will only be able to negotiate within certain parameters laid out by the Investment Committee. This ensures that investments are made on consistent terms across the portfolio, and in accordance with the strategy of the VC firm (as set out in their own fund documentation and agreed with LPs). Only in exceptional circumstances (e.g. 1 investment out of 20) may the standard terms of the fund be overwritten.
Your contact won't take a deal to the Investment Committee unless it complies with most, if not all, of the standard terms of the VC firm's investment strategy. Otherwise it will get rejected. And that's a waste of their time... So don't expect a $billion-dollar valuation just because you're awesome.