Raising VC money: how to negotiate the legal documents

This is the seventh post in a Friday series on “raising VC money.” I’ve really enjoyed writing these posts and to have an opportunity to interact with many folks. Thank you for the encouragement!

Today, we’ll cover the topic “how to negotiate the legal documents.”

So, you’ve successfully pitched the VC and his partners (more here) and have negotiated a term sheet (more here). What now?

First, you should really feel great about your accomplishments so far. Fundraising is a very intense time, filled with many highs and many lows. I know this. At Kepha, we’ve done three fundraisings. We’ve done it once in a good economy and twice during massive stock market collapses.

So, I say this as a fellow entrepreneur: enjoy this moment.

Once the term sheet is signed, you’re truly in the 9th inning. Lawyers for you and your VC will now take the term sheet and translate it into a longer set of final legal documents.

There usually isn’t much for you to do during this time, frankly. The lawyers will draft a document, circulate amendments and generally handle everything. A closing date will be set, you will sign the documents, and the money will be wired into your account.

It’s actually a weird and eye-popping moment to log into your company’s bank account and see a number with so many zeroes.

However, there are a few things you should consider doing:

Advice #1: continue to make progress and publicize any good news. A term sheet is not a binding document. A VC can withdraw from the financing at any time. So, you are still in the due diligence phase and everything you do or say will either help or hinder your cause. So, continue to make progress on your business, and if you do so, share the good news with your VC.

Advice #2: do not over-lawyer this process. Some very young and aggressive attorneys may try to “score points” with you by finding an arcane detail and trying to win it for you. These debates often can delay the closing. I think that good attorneys get deals done.

Make sure you decide and communicate to your attorney what is “must have” vs. “nice to have.” How you manage your attorney is a proxy for how you will manage employees, customers and strategic partners. Impress the VC with how you manage this part of the legal process.

Advice #3: stay in touch with the VC. Negotiating the legal documents takes three weeks at least. It sounds like a lot of time, but these documents are enormous and when one lawyer sends a draft to the other side, they need a day to read it, a day to get your comments, etc.

So, do not let the relationship with your VC go stale. Find a reason to reach out and have a meaningful interaction. One idea is to come up with some draft key milestones for the company and come to agreement on them. That is usually a meaty discussion that is fun, and most important, will create alignment between you and the VC.

A few years ago, a VC friend led a term sheet for a new financing and brought in a partner at one of the most well-known Silicon Valley VC firms. That California VC signed the term sheet, and then, went radio silent. The entrepreneur didn’t really engage that VC.

Suddenly, that west coast VC mentioned that he was pulling out of the term sheet. To this day, my friend has no idea why that famous VC would sign a term sheet and not follow through. But, it happened. So, my advice: be paranoid. You are still in the sales cycle. Make sure you close the VC.

Advice #4: be prepared for a Plan B. If the stock market collapses, or there is a terrorist attack, your VC may waver. I know this sounds unfair, but I remember many VC firms withdrew their term sheets after the March 2000 Web 1.0 crash and the September 2008 stock market collapse. It’s simply human nature. When the future is uncertain, some partnerships will want to hunker down until the dust settles.

The best thing an entrepreneur can do in this situation is create real progress with his/her company. You cannot control what a VC does or does not do. Nor, does it make sense to keep calling on other VCs when you’ve already signed a term sheet. This can be an enormously stressful time for an entrepreneur, but you have to stick to your knitting.

Such a cataclysmic event happened to us at Kepha (and I wrote about it here). We were raising money in the summer of 2008. Everything was fine. Then, as I wrote:

We targeted the closing for the fall of 2008. In September, suddenly, the stock market collapsed.

Lehman failed, bankruptcies started and untold layoffs started. Large investors wanted liquidity and fled from any commitments that locked up their capital, such as with hedge funds and venture capital. The very existence of the free market was being questioned.

Our investors went ahead with the funding. We’re incredibly grateful to them.

Behind the scenes, we were already making a Plan B in case the funding didn’t happen. We were prepared to slow down our investment pace to make sure we had enough dollars for the existing portfolio.

An entrepreneur can decide to go the angel route or skinny down the business plan to need less initial money.

The amazing thing about being an entrepreneur is this: you have total flexibility. Unlike large companies that cannot pivot, you can be very nimble and react instantly. Speed is a start-up’s greatest asset.

Advice #5: follow your gut. Just as the VC is continuing to watch your behavior, you are doing the same thing to the VC. If he ever starts to behave questionably, drop the financing immediately.

This is a very hard to decision. Your company needs capital and you’ve done a lot of hard work to get the money. Why walk away now?

Simply put, I think a VC financing is more than about the money. Ideally, it is about the partnership relationship between a VC and the entrepreneur. If you are feeling concerned about the VC before the closing date, don’t go ahead.

I write this because the downsides of a poor relationship are enormous. First, the VC will forever be a reference for you. For your next company, other VCs will call that VC. You won’t know that these calls are taking place, but I promise you, they happen all the time. And, VCs tend to be very honest with each other.

Second, you and that VC will be spending a lot of time together on very difficult issues. If you cannot have an open and trusting relationship at the beginning, you’ll have very strained interactions that will adversely affect the company’s prospects. Remember, you’re no longer just a founder but the founder of a company that will have employees and shareholders. You must do what is best for the company at all times, even if it is painful.

Third, venture capital money is like credit card debt. You have to pay it back with significant interest. The money isn’t free. Some entrepreneurs today are very focused on raising a big round at a high valuation. That’s all good. For me, I think that’s the beginning of the journey. And, the larger the financing, the higher the VC’s expectations.

So, ask yourself the following questions before your financing closes:

  • Is this VC adding real value?
  • Do I enjoy spending time with this VC?
  • Can I share bad news with this VC, and will he help me productively find a solution?

So, I hope this is helpful. Next issue, we’ll conclude the series with “how to have a strong start with your VC.”

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