Andrew Romans, 7BC Venture Capital. What VCs Want.

In this episode of "10,000 Startups: Legal Strategies for Startup Success," venture capitalist Andrew Romans from 7BC Venture Capital discusses key aspects of venture financing. He highlights the importance of valuation, emphasizing that it is a mix of art and science, particularly for pre-revenue companies. Romans explains the significance of liquidation preferences, board control, and protective provisions in term sheets. He advises founders to focus on management, market potential, and technology when seeking investment and underscores the necessity of having experienced legal counsel. Romans also touches on the dynamics of founder liquidity and exit timelines.

• Valuation is a critical topic for angel investors, venture capitalists, and startup founders, as it influences the investment decisions and strategies for all parties involved.
• In Silicon Valley, valuation is a blend of art and science, differing from the more formulaic approaches used in publicly traded equities.
• Early-stage companies, particularly those that are pre-product and pre-revenue, face unique challenges in determining their valuation.
• Founders should aim to make their initial financing rounds attractive to investors while avoiding excessive dilution that could hinder future funding opportunities.

"In the ancient times people basically used to say like if you talk to the band of angels going back into like the early 90s a company that's just two two people in a garage or five people in a garage starts off being worth one million dollars and they raise like a hundred grand or 250 Grand that's really changed."

• The traditional valuation model for startups has evolved, with initial valuations now typically ranging from $3 million to $5 million for pre-revenue companies.

"If you raise a first 250k um to 500k it's probably coming in on a convertible note or a safe so you don't have any legal expenses with that."

• Early-stage funding often involves convertible notes or SAFEs to minimize legal costs and complexity, with valuations adjusted according to market trends and investor expectations.

• The valuation of a startup is influenced by the management team, market potential, and technology, with management being the most critical factor.
• Startups are expected to pivot, making the quality and experience of the management team crucial for navigating changes and challenges.
• A large market potential and innovative technology are essential for attracting venture capital and achieving significant growth.

"If real estate is location location location as the most four important things I think in early stage pre-revenue investing and even throughout the Spectrum it's management management Market technology in that order."

• The focus on management, market, and technology underscores the importance of these elements in evaluating a startup's potential for success.

"If you're not doing that now you know we're probably not interested you know in investing in that."

• Venture capitalists are particularly interested in startups that leverage technology to automate workflows and utilize data effectively, aligning with current trends such as AI.

• Founders can enhance their credibility by building a strong advisory board and leveraging the expertise and connections of industry leaders.
• Offering equity to advisors and involving them as early investors can open doors and attract further investment.
• Demonstrating a unique distribution strategy or a "magic secret" can differentiate a startup and make it more appealing to investors.

"It's not a bad idea to maybe offer uh three to five percent of the company to an Advisory board if you're not from Silicon Valley and you kind of don't know anybody and just kind of gift them a little bit of equity."

• Engaging experienced advisors and offering them equity can significantly boost a startup's credibility and attractiveness to potential investors.

"If he becomes your real estate super expert is it LPN or fun like you get a guy like that on your Advisory Board and I have to take the meeting."

• Having influential figures on an advisory board can compel investors to engage with the startup, providing a strategic advantage in securing funding.

• Valuation is critical in assessing potential returns from investments, but it's not the sole focus for investors.
• Investors anticipate a minimum of 50% dilution from the entry point, affecting the expected returns.
• Early-stage investments aim for significant multiples due to high failure rates among startups.
• Late-stage investors often seek more modest returns but with reduced risk, focusing on concentrated portfolios.

"We do and we don't care about valuation... If I'm investing in a company at a 10 million dollar pre-money valuation and it sells for 100 million... you're not being a 10x, you're making more like a 5x."

• Valuation impacts the expected returns, considering dilution and other factors that reduce the theoretical returns.

"If you're investing really early stage, you are shooting for a big multiple... they expect and need a very big multiple because they're going to have a high death rate."

• Early-stage investments require high returns to compensate for the high risk of failure among startups.

"The late stage investor can be have a more concentrated portfolio... they're kind of shooting for a 2X to 4X on what they're doing."

• Late-stage investors aim for lower multiples but benefit from reduced risk and potentially higher capital security.

• Venture Capital (VC) provides not just funding but also strategic advice and connections.
• Board composition is crucial, with a preference for small boards to maintain control and efficiency.
• Founders should aim to recruit mutually agreed board members to demonstrate domain expertise.

"The reason you take Venture Capital money is not just for the money... you're taking money that's going to give you really good advice on how to run your company."

• VC funding offers strategic benefits beyond capital, including advice and network opportunities.

"You want to have like a board of three people... you might have two Founders on it and then one investor might take a board seat."

• Small boards are preferred for early-stage companies to maintain control and governance efficiency.

"Try to be the person that recruited that mutually agreed to board member... show the VCS that you have domain expertise."

• Founders should leverage board appointments to enhance credibility and demonstrate expertise.

• Protective provisions and liquidation preferences are common in term sheets, often surprising founders.
• Liquidation preferences ensure preferred shareholders are prioritized during company liquidation events.
• Understanding these terms is essential for founders to avoid conflicts and ensure fundability.

"I remember the first time I got a term sheet... I was like can you explain what Redemption means and why is it there."

• Founders often find protective provisions daunting, highlighting the need for understanding these terms.

"Liquidation preferences is that when the company is liquidated... preferred shareholders have a preference, they get their money out first."

• Liquidation preferences prioritize preferred shareholders during liquidation, impacting founder returns.

"The more you're fluent as a founder and all this stuff, the more fundable you are."

• Knowledge of financial terms and conditions is crucial for founders to be seen as fundable and competent.

• Liquidation preferences protect investors by ensuring they get their investment back before the founders in the event of a company sale.
• A 1X liquidation preference is common, meaning investors get their original investment back before any distribution to other shareholders.
• Toxic liquidation preferences can be detrimental, offering exorbitant returns to investors and wiping out other stakeholders.
• Participating preferred shares allow investors to receive their investment back and then participate in the remaining proceeds, whereas non-participating shares force a choice between the two.

"If we invest a million dollars and we negotiate a liquidation preference, we say upon the sale of the business, we don't just get one-third of that 500K; we get our one million dollars back."

• This quote explains the basic premise of a liquidation preference, which ensures investors recover their initial investment before any distribution of sale proceeds to other shareholders.

"The most common thing is a 1X liquidation preference."

• A 1X liquidation preference is the industry standard, providing a fair balance between investor protection and founder equity.

• Participating preferred shares allow investors to receive their initial investment back and then participate in the remaining proceeds based on their ownership percentage.
• Non-participating preferred shares require investors to choose between reclaiming their initial investment or participating in the distribution of proceeds.
• Participating preferred shares were more common before the dot-com meltdown, but non-participating shares are now the norm.

"Participating preferred means I get my money back 1X or maybe 2x... and then after I get my preference out, then I get my 20% if I own 20%."

• Participating preferred shares offer investors the ability to reclaim their investment and participate in the distribution of proceeds, potentially increasing their returns.

"These days it's been a long time since I've seen anything other than 1X non-participating."

• The industry has shifted towards non-participating preferred shares, which are simpler and more founder-friendly.

• Dividends in venture capital are not traditional profit distributions but can increase the liquidation preference over time.
• Convertible notes often include interest rates, caps, and discounts, providing early investors with additional benefits if the company is sold or goes public.
• Accumulating dividends and interest incentivize founders to achieve liquidity events instead of treating the company as a lifestyle business.

"A dividend is not the company paying part of the retained or part of the profit for that year out to shareholders... it's a backdoor way of lifting the liquidation preference."

• Dividends in venture capital are structured to increase the investor's return over time, rather than distributing profits annually.

"There's kind of like an incentive for the founder to not mess around and turn this into a lifestyle business."

• Interest on convertible notes encourages founders to pursue growth and exit strategies, as the cost of capital increases over time.

• Standard legal terms provide clarity and reduce negotiation time, benefiting both investors and founders.
• Experienced legal counsel ensures terms are industry standard, avoiding unnecessary complexity and risk.
• Non-standard terms can lead to confusion and potential disputes, emphasizing the need for experienced legal representation.

"When you're doing your own legals for your own series a financing, try to go as industry standard as possible."

• Adhering to industry-standard legal terms simplifies the investment process and minimizes potential conflicts.

"I like standard terms... I like to know the name of the lawyer representing the company and then I feel good immediately."

• Familiarity with standard terms and reputable legal counsel provides confidence in the investment process and outcomes.

• Founders must understand the implications of voting rights and blocking rights when engaging with venture capitalists (VCs).
• VCs may not have majority control but can possess rights to block company sales or financing, influencing company decisions.
• The relationship with a VC is likened to a long-term marriage, emphasizing the importance of chemistry with the lead partner.

"As a Founder, you should really understand even if the VCs do not have a majority control of the share capital and the board of directors, they might have the right to block a sale of the company."

• This quote highlights the potential influence VCs can have on company decisions, even without majority control.

• The time delay between investment rounds (like Series A) and exit fluctuates based on market conditions.
• Historical events, such as the dot-com crash and geopolitical issues, impact exit strategies and market valuations.
• Recent events like the COVID-19 pandemic and geopolitical tensions have extended exit timelines.

"With the Putin Invasion of Ukraine and the Crash the stock market, people are not so excited about exiting."

• This quote underscores how geopolitical events can deter exits due to unfavorable market conditions.

• Founders seeking liquidity must be evaluated on a case-by-case basis, balancing personal needs with company growth.
• Secondary markets provide opportunities for founders to sell shares without a full exit, offering financial relief.
• Excessive founder liquidity can extend the timeline for investor exits.

"If I see that the company has been growing value for a long time... why not just sell a little bit of founder stock?"

• This quote suggests that founder liquidity can be justified if the company has demonstrated substantial growth.

• Founders should seek guidance from experienced advisors, such as seasoned angel investors or knowledgeable legal partners.
• Having an advisor who understands market norms and venture capital intricacies is crucial for navigating investment terms.
• Poor advice, such as raising on an uncapped note, can have detrimental effects on a startup's future.

"It's important to have someone in the orbit of the company that is like a super experienced angel investor or former VC."

• This quote emphasizes the value of having knowledgeable advisors to guide founders through complex investment landscapes.