"rutschgefahr!" founders terms in german venture capital contracts

multiple liquidation preferences, full ratchets and founders warranties are on the rise on the german startup market. the positions for founders and new investors in new financing rounds get worse in 2010, as a bearish venture capital (vc) market dictates tougher conditions.

in order to avoid "rutschgefahr", german for slip hazard, when negotiating an investment round, read on to get the facts right.

a recent study of the german "mlawgroup" on "vc deal terms report 2010" (german only) gives quantitative insights into an often less transparent market. take the waring, plenty of numbers coming up - plenty of facts to get the own expectations right.

the study is based on feedback on 30 seed fundings, 36 series a and 16 series b rounds. the german "high tech gründerfonds" was taking the lead with 27 investments of 66 early rounds, thus making it the first address for young german startups.

so what to expect as a founder team, when sitting down with investors?

founder vesting is dominant, in 73% of the seed investments. vesting periods are between two to four years. allowances on the vesting are the minority with just 40% of the deals for only 25% of the founders shares.

good leaver/bad leaver clauses gain 18%, up from 32 to 50% of the investments. most good leavers can expect to gain a fair valuation of their shares (73%, up from 49%) though.
venture capitals seek for preferential rights in 78% of their investments. simple (1x) liquidation preferences are seemingly unavoidable in the seed stage (73%), while multiple preferences (2x) are a minority with only 7%. 20 percent of the feedback forms contained no answer on that question though.

exit preferences are common (53%) with an average of 5% interest p.a. on capital invested (8% last year) , although a maximum of 20% was reported.

while founders warranties remain an imperative (95%), pay to play seems to become a scare species. no seed round saw such rulings, series a rounds just in 23% of the cases.
non compete clauses for founders are enforced in 100% of the seed and in 75% of the a rounds with average durations of 2 years. on average founders get a half year salary in return.

anti dilution provisions are either weighted averages (51%) or full ratchets (35%), with a clear rise in the latter.

mlawgroups commented the tightening of conditions for founders as questionable. they could not understand how the worsening positions of the founders could help to prepare the founders (and existing investors) well for exits. for a law firm, this is a rather strong statement.

so much on the numbers. good thing with the study is, that it provides a useful basis to get one own´s negotiation aims right.

read more on general terms & conditions of vc contracts in "legal gibberish of investors in plain english" and in the series "six steps to venture capital".

"negotiations" part 5.2 of the series six steps to venture capital

the negotiation process is key for a good contract. in "negotiations" part 5.1 of the series "six steps to venture capital" the general framework got laid out. in part 5.2 it is all about the details.

key points first

time line, term sheet, contract. in that order. never avoid any critical topic at the beginning. they will sooner or later surface anyway, so they shall be dealt with directly.

know the aims
it is vital to know the aims of the negotiations before they take place. the negotiation team has to decide beforehand what they aim for and how much compromise is acceptable.
one way to do that is to sit down for half an hour, discuss, decide and write down the aims to visualize and remember. then destroy the paper, as it must not be seen by the vc by any accident in the meeting afterwords. this holds for each separate meeting. no-one alone compromises the agreed terms in face of the investor. if a rethinking of the agreed aims is necessary, a break out session is necessary.

break out sessions
they are a common way to take speed or emotion out of tense negotiations. every party gets time to rethink, to cool down or to gather required information. start.ups can co-ordinate their negotiation aims. whenever necessary break-out. rather one break out session too much than having agreed to anything without realizing what it means. having experts on stand-by is recommended.

experts on stand-by
lawyers, technical experts, general advisers or friends are source for support during negotiations. they are to be informed ahead so they can be reached when required.



know the terms
drag along, take along, liquidation preference, right of first refusal, pre-post money valuation, milestones, catch-up, pay to play, ratchet, signing-closing, advisory board, due-diligence,... they all can be looked up. e.g. on investopedia or wikipedia. this is investment language, nothing really complicated about. one just has to be able to deal with them, know them by heart and be able to „play“ - meaning negotiate on the different aspects - them.

tiredness
bad negotiation results can not be excused with tiredness. if necessary take break outs, get food, go scream on the balcony - whatever is necessary. then get back and keep negotiating hard.

socialize
vc are (also) humans. they have hobbies, family, worries, hopes. they are like everyone else. avoid the hawks through checking their references (discussed here).

heart & hard
being respectful and friendly is key. negotiating hard at the same time is no contradiction. not only for the negotiations and the daily life after with vc. it also holds for customers, suppliers, sales partners or employees.
at the end of a long negotiation process both parties are supposed to be unhappy with the results - but still happy to have closed the deal. with the negotiations finalized and vc money injected it is all about fulfilling and surviving. more on why it is necessary to deliver in the upcoming sixth and final part of „six steps to venture capital“.


recommendations: 1) define aims: time line & term sheet key elements, 2) take break outs, 3) have experts on stand-by and 4) know the terms.

in the final part of the series six step to venture capital read on how to survive after the investment. clearly not a trivial task.

"negotiations" part 5.1 of the series six steps to venture capital

finding the right vc is difficult. getting a good investment deal is worse. though with the right preparation, much can be done to achieve a result, which is mutually favorable.

this is the 5th part of the "six steps to venture capital" guide, where the systematic approach to acquire venture capital for a start.ups is discussed. after the motivation got sorted out in step 1, the a-b list of potential investors in part 2 (part 1, part 2) got filled. the battleground got prepared in step3. now it is all about bringing home the money.

experienced investors will take advantage of unprepared start.ups. therefore key topics have to be covered before going into the actual negotiations. to know more about strategy and preparation, see sun zi, moltke and douglas adams for start.ups. basically every contact with the vc can be considered as part of a negotiation process.

overall
time line - term sheet - contract signing & closing are the cornerstones of vc- negotiations. after the 2nd meeting the vc should have figured out the idea, market, business model, competition, exit channels and team - the investment story of the start.up. that done, it is all about nailing down a deal. that´s the same for the potential investor as for the start.up.

time line
the time line outlines the time frame from the beginning of the negotiations until the money flows. agreeing on the time line is rather non controversial and allows to get know to each other. simple does not mean irrelevant. by committing to a time line (especially) the vc has to reserve resources, meaning money.

term sheet
next thing is the term sheet. using common (non lawyer) language, all the important topics of the investment get outlined in it. it is basically a multi-page text document which both parties sign. example see here. whatever key topic relevant to the start.up or vc has to be part of the term sheet.
struggling for compromise is part of this process. moving key topics to be solved „afterwards“ or through proposals of lawyers in the final contract often leads to late break ups. thus involving high lawyer bills and wasting weeks of negotiations. typical time line to reach a term sheet is four to eight weeks. every party covers their own costs. granted that the negotiations were successful, it´s then about fixing a contract.

contract
the final contract gets drafted on the basis of the term sheet. it should merely be a reformulation in lawyer-language. a common lawyer between the vc and the investee reduces costs. based on a well negotiated term sheet, it rarely leads to a break-down of the investment process. the paperwork can produce contracts between 35 to 100 pages.

the costs are typically covered by the start.up after the investor injected money. a maximal allowance for the cost should already be settled in the term sheet, anywhere around thirty thousand dollars/euros. anything above is to be covered by the respective parties.
time line for the contract should be four weeks. two weeks for signing and another two to four weeks for closing finalize the process.

giving the general line (term sheet - contract signing & closing), there are some topics which deserve an in depth coverage, like knowing the terms, break-outs or tiredness.
this will be covered int the upcoming part two on "negotiations" of the series "six steps to venture capital"

linktip: for the MIT 100k participants: executive summaries

"approaching venture capitalists", part 4.2 of the series six steps to ventture capital

at the 2nd round meeting it goes along the same lines as on the first round. know your pitch, stick to your talking time. know who answers which questions. do not correct each other giving answers.

now it is time to hand out your references. and again: set up the schedule (yes or no, negotiation schedule, term sheet, final contract signing-closing). this tests the real interest of the vc, namely through assigning resources for the evaluation. having mastered the 2nd meeting, this either leads to a „no“ or a jump directly into the negotiation part. this will be the next part of the series.

having reached the 3rd round brings one positive problem: the vc´s approached until now were form the b-list. the leanings form the presentations and meetings will pay off, through refining the approach, the pitch. based on this, it is then time to go ahead on a-venture firms. keeping the b-vc as back up can be helpful.
following the same procedure as outlined above it is about making it to the 3rd round with two a-vc. the main difference now being, not to learn & to improve but getting qualified a investors.

there remain some side topic on approaching vc, which are worth looking at: timeframe, lawyers, costs, consultants and exclusivity.

as a general time frame, 6 month from the start of approaching vc until closing an investment are a reasonable timeframe for europe. 4 month are more seen in the anglo-saxon world.

lawyers are generally only necessary after drafting the term sheet. until then common sense suffices as singning anything which would cause obligations on the start.ups side are not necessary.

until a term sheet is signed, no costs of any kind should be accepted from the start.up by a credible investor.

if any kind of corporate finance/m&a,... -consultants which promise to bring investors to the start.up are involved, special care is required. upfront payments may sound plausible but as cash is a scare resource, only success fees should be accepted, based on real cash inflow on the start.ups account. generally start.ups have more then sufficient capabilities to acquire vc interest - if they do their homework. and paying a consultant just to be told to do the homework could be seen a waste of money. the combination of a compelling idea with preferences (see part 3) opens vc doors without the help of others.

recommendation: 1) approach 3 b-vc, 2) follow up after one week, 3) fix 1. meeting/conference call, 4) be prepared, 5)push for go/no + next meeting, 6) reach 2. & 3. meeting. 7) watch timeframe, lawyers, costs, consultants and exclusivity.

how to succeed in the negotiations with the investor will be the focus on the 5th part of the "six steps to venture capital" guide. that much can already be said: the aim is, that both parties are unhappy but still want to close the deal.

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