Not all financings are created equal. This is especially true when you factor in the different stages that your company will evolve through over its lifetime. Each financing stage—seed, early, mid, and later stage—has different key issues to focus on.
While seed deals have the lowest legal costs and usually involve the least contentious negotiations, seed deals often allow for the most potential mistakes. Given how important precedent is in future financings, if you reach a bad outcome on a specific term, you might be stuck with it for the life of your company. Ironically, we've seen more cases where the entrepreneur got too good a deal instead of a bad one.
What's wrong with getting great terms? If you can't back them up with performance when you raise your next round, you may find yourself in a difficult position with your original investor. For example, assume you are successful getting a valuation that is significantly ahead of where your business currently is. If your next round isn't at a higher valuation, you are going to be diluting your original shareholders—the investors who took a big risk to fund you during the seed stage. Either you'll have to make them whole or, worse, they'll vote to block the new financing. This is especially true in cases with unsophisticated seed investors who were expecting that, no matter what, the next round price would be higher.
As with seed deals, precedent is important in early stage deals. In our experience, the terms you get in your first VC-led round will carry over to all future financings. One item that can haunt you forever is the liquidation preference. While it may not seem like a big deal to agree to a participating preferred feature given that most early stage rounds aren't large dollar amounts, if you plan to raise larger rounds one day, these participation features can drastically reduce return characteristics for the common stockholders.
Another term to pay extra attention to at the early stage is the protective provisions. You will want to try to collapse the protective provisions so that all preferred stockholders, regardless of series, vote together on them. If by your second round of financing you are stuck with two separate votes for protective provisions, you are most likely stuck with a structure that will give each series of stock a separate vote and thus separate blocking rights. This can be a real pain to manage when you have multiple lead investors in multiple rounds that each have their own motivations to deal with.
Mid and Late Stages
Later stage deals tend to have two tough issues—board and voting control. The voting control issues in the early stage deals are only amplified as you wrestle with how to keep control of your board when each lead investor per round wants a board seat. Either you can increase your board size to seven, nine, or more people (which usually effectively kills a well-functioning board), or more likely the board will be dominated by investors. If your investors are well behaved, this might not be a problem; but you'll still be serving a lot of food at board meetings.
There isn't necessarily a good answer here. Unless you have massive negotiating power in a super-hot company, you are likely to give a board seat to each lead investor in each round. If you raise subsequent rounds, unless you've worked hard to manage this early, your board will likely expand and in many cases the founders will lose control of the board.
The last thing to consider is valuation. Much like issues that we've seen in seed deals, there have been some deals that have been too good and have forced the VCs to hold out for a huge exit price. The net effect was that by raising money at such a high valuation, the entrepreneurs forfeited the ability to sell the company at a price they would have been happy with, because of the inherent valuation creation desires of the VCs who paid such a high price.
Excerpted with permission of the publisher John Wiley & Sons, Inc. from Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld and Jason Mendelson. Copyright (c) 2011 by Brad Feld and Jason Mendelson.