Term sheet purgatory can seem like is an eternity for a startup, although it may last from one week to over one month. Usually, the investor is just prepping the field to make the investment. While progressive discussions with an investor about the investment are fine and most revolve around pre-diligence matters, sometimes these discussions shift towards the pre-money valuation and investment amount. And this has potential negative consequences for the startup.

It can be a mistake to arrive at a consensus with your investor on pre-money valuation & investment amount before receiving the full term sheet. Terms like the option pool, liquidation preference, and board composition are just a few other investment terms that have a meaningful impact on your startup. You’ll feel real solid about that $6,000,000 pre-money until you receive the term sheet and it specifies a 25% option pool, 1X participating liquidation preference, and an investor-favorable board.

Of course, you can re-negotiate the pre-money and/or investment amount, but it still makes for potentially awkward conversations and/or feelings of mistrust. Neither is a good way to kick off your relationship with your future investor. (Even worse, a startup may feel like they can’t re-negotiate because they’ve already “agreed” to those numbers.)

Thus, if your potential investor continues to verbally discuss investment terms with you, consider asking for the term sheet.

Even if you are comfortable negotiating verbally on one facet of your startup’s capital raise and blindly on the rest — what’s the point of talking about the color of your corsage if you haven’t received a (non-binding) invitation to the dance?

Request that all key terms of the investment are laid out in front of you in the form of a term sheet. This may be the quickest way to get you out of term sheet purgatory and avoid negative consequences along the way.

Give us the background on your fund and what you guys are up to?

Sure – AOL Ventures is the VC arm of AOL, focused on early stage investing in consumer internet businesses. We formally launched the fund in January of this year and are a small team of investment professionals supported by some great Senior Advisors and the entire AOL family.

Overall, we focus exclusively on investments where we can add the most value, blending our personal expertise with some element of parent company involvement. We’re broadly interested in a bunch of different opportunities within the consumer web, and tend to focus on Seed and Series A investments in content, advertising, mobile and local spaces in the US of A.

What stage of startups are you looking at and what do you look for initially?

We’re a small fund with $30M of committed capital, so we focus on Seed and Series A opportunities. Typical investment amounts at the Seed level range from $50k to $500k and from $500k-$3M at the Series A level.

Other than the standard things, we like to play around with a working prototype at the Seed level and like to see some key inflection points met if you are looking for Series A funding. We also tend to focus on repeat entrepreneurs but are not opposed to funding first time founders who have significant domain expertise.

Have you invested in any startups thus far?

We’re just through our first year and pleasantly surprised with where we’re at – Rather than single anyone out you can see a full list of our announced portfolio companies and other relevant investment information on CrunchBase. (CrunchBase Profile for AOL Ventures)

What are you not looking for and/or what is a bad way to pitch you?

People email me sometimes and say, “if we only had AOL’s traffic we would be huge!” I get it, but that’s not a logical investment thesis for us to deploy capital against. We’re not looking to be anyone’s 80% customer and we frankly pass on a lot of entrepreneurs who have unrealistic expectations about what they want out of the relationship with us (it is a marriage after all).

We are not really interested in anything other than consumer Internet, so it’s not good to send me your telecom idea or new consumer electronics device that you need to raise money for. Later stage opportunities are also out of the mandate of our fund.

I’ll make a point here – we are not opposed to getting emails from people seeking partnership opportunities and recognize that this is a product of where we sit. By virtue of our gig we are highly accessible to the external world and also know almost everyone or can get to anyone within our parent company. If you think there is a relationship that doesn’t make sense from a funding standpoint but might be interesting to AOL, Inc., we’re happy to make the intro and they are definitely open for business. Feel open to approach us and don’t be shy.

How active or passive is AOL Ventures in deals?

That really depends on how involved the entrepreneur wants us to be. We tend to be passive-active in nature and will help when asked, but most of our entrepreneurs honestly like us to get pretty involved.

During the investment process we really try and hone in on exactly what the entrepreneur wants out of the relationship and what are the specific tasks that we need to accomplish to help them take the company to the next level. If these align with our own abilities and we feel we can meet the expectations then we’re happy to get involved.

Do you look at portfolio companies as future acquisition targets?

Not really. While we definitely understand that AOL is a large media company and acquisitive, we’re not really involved in those discussions. Remember we’re a minority investor in early stage companies, so the best we can do for our companies is present options for them – at the end of the day those decisions are up to the entrepreneur and the company board.

What’s the difference between Corporate VCs and Independent VCs and how is AOL Ventures similar/different?

Assuming a Corporate VC is operating a traditional fund vehicle and not just investing off of the balance sheet (probably the first real difference), I would say the most recognizable difference is in the single vs. multiple LP structure. Corporate VCs tend to have their parent company investing in their fund whereas Independent VCs tend to have multiple LPs (like endowments, pension funds, etc) investing in their fund. In addition to the nuts and bolts of things like governance, investment committees, etc, also being different Corporate VCs have also tended to be more strategic in nature, making investments in companies that have significant strategic value (and potential BD or M&A synergies) back to their parent company.

Note that this is a broad generalization and I’ll caveat it by saying that with the emergence of models like Intel Capital, Steamboat Ventures, Comcast Interactive Capital, Genecast and new players such as us and Google Ventures, the model of non-strategic Corporate VC is also starting to play a meaningful role in the early stage ecosystem.

In terms of our day-to-day, I would say there isn’t much difference. We think and act like any fund from a sourcing, diligence, execution and management of investments standpoint.

Where do you see corporate venture as a meaningful piece of the ecosystem?

That’s an interesting question. Historically I’d say that corporate venture has been most meaningful at the later stages of a company’s life cycle but that has primarily been product of fund sizing and strategic mandate of the corporate funds. I’d say it’s a relatively new phenomenon that corporate venture funds play in the early stages of a company’s life. While I am a believer that corporate venture can also be meaningful at the early stages, the fact is that it is largely unproven and pretty new in the overall game.

Corporate VC generally has gotten a bad rap – what are some of the things that you think you need to do to be successful?

Haha, who said it has a bad rap?! In all seriousness though, I think there are a few key issues that we looked at from the outset and felt needed to be in place to make this model work effectively.

First and foremost, we have carry in our fund and share in the upside if we earn a financial return for our LP. I don’t think many Corporate VCs operate this way and we feel it creates a lot of mis-alignment with entrepreneurs.

Second, we operate autonomously with a small investment committee (3 ppl) and separate governance structure. We’ve written a check as quickly as 72 hours (obviously not ideal but we have done it). We believe in the ‘quick yes / quick no’ philosophy and we’re not out to waste an entrepreneurs’ time. We co-invest with people we know and don’t ask for any egregious terms above and beyond the lead investors terms.

Third, we tend to only invest in situations where we can add measurable value and really give entrepreneurs that unfair advantage they need. The perfect deals for us are those where we can blend our personal expertise and value-add with a flavor of parent company involvement and value-add.

Thanks Mike!

Not all startup founders understand this tenet.

Case Study

Earlier this year, this issue presented itself when a client was the lead investor in a Series A round of about $2MM at a $4MM pre-money. The term sheet was pretty much a done deal, when the startup’s CEO demanded a salary of $25,000. Per month.

My client countered with a reasonable startup CEO salary, but the startup’s CEO didn’t back down from his $300,000/year figure. You can guess what happened to the deal.

In addition, here’s an example of how a startup CEO’s huge salary didn’t help his startup: CEO’s $500,000 Salary Burns Startup Into Fire Sale.

The Importance of Startup CEO Salary

The startup community focuses most of the term sheet discussion on liquidation preferences and anti-dilution, but startup CEO salary is nonetheless an important issue. According to Peter Theil, Startup CEO salary is a predictor of a startup’s success:

“The lower the CEO salary, the more likely it is to succeed.

In practice we have found that if you only ask one question, ask that.”

If a startup CEO’s post-Series A salary is too high, he or she may not have a true sense of urgency to implement and/or create shareholder wealth.

This doesn’t mean a startup CEO must continue to make Costco runs for ramen noodles. But if the startup’s CEO gets a huge salary, the startup CEO could likely view his or her equity stake as “house money” (i.e., even if the startup fails, the CEO won’t feel too bad because he still received got a hefty salary).

Furthermore, a demand for a high startup salary can signal that you don’t believe all those things in your investor pitch.

I’ve seen it defined in legal documents in the following way:

“Fully-Diluted Basis” shall mean the assumption that all options, warrants or other convertible securities or instruments or other rights to acquire Common Stock or any other existing or future classes of capital stock have been exercised or converted, as applicable, in full, regardless of whether any such options, warrants, convertible securities or instruments or other rights are then vested or exercisable or convertible in accordance with their terms.

The definition of fully-diluted basis matters especially for founders in financings. Typical VC financing deals will calculate the Series A share price on a fully-diluted basis, and the investors have an incentive to capture as much shares as possible in the definition of fully-diluted basis. The larger the amount of shares calculated by the definition of fully-diluted basis, the lesser the Series A share price.

Non-local investments made by venture capital firms based in the Valley, Boston, and New York outperform their local investments.

This is according to a working paper titled “Buy Local? The Geography of Successful and Unsuccessful Venture Capital Expansion” just published by Henry Chen, Paul Gompers, Anna Kovener, and Josh Lerner.

The authors conjecture that local underperformance is due to venture capital firms having higher hurdle rates for non-local investments. But I’m pretty sure most of you entrepreneurs are thinking it has something to do with less visits from the VC.

Overall, the working paper attempts to demonstrate how geography affects performance of venture capital firms. It’s a somewhat long, but very interesting read.

PEHUB posted the entire working paper on Scribd here.

This tool will generate a venture financing term sheet based on your responses to an online questionnaire. It also has an informational component, with basic tutorials and annotations on financing terms. This term sheet generator is a modified version of a tool that we use internally, which comprises one part of a suite of document automation tools that we use to generate start-up and venture financing-related documents.

Furqan Nazeeri at altgate.com seems to have the scoop on the evolution and future of the term sheet generator in his post here.

I’ve only had a few minutes to check out the term sheet generator, but like most other open sourced legal documents, I think it’s great.

I’ve always felt introductions, whether to an accountant, potential co-founder, or investor is just part of the benefit of hiring a startup lawyer. And while I heart FINRA, I’m not sure I want to register with them or the Texas State Securities Board.

If you want to hook your lawyer up for an introduction, send him a box of your startup’s t-shirts. Even better, rave about him or her to your network. And if you are an investor (angel or VC) and happen to read this blog, reach out to me so I can increase my electronic rolodex and get more t-shirts.

Reports are that Google will commit about $100MM to the fund. According to their blog post, they plan on investing in other sectors than just Internet and software:

We’ll be focusing on early stage investments across a diverse range of industries, including consumer Internet, software, clean-tech, bio-tech, health care and, no doubt, other areas we haven’t thought of yet.

During the rumors in July 2008, Fred Wilson wrote a great piece about why Google SHOULDN’T launch a venture capital arm. It’s a great read about why venture capital returns aren’t fit for large corporations like Google.

Check out the new Google Ventures Website here.

There were only 6 venture-backed IPOs in 2008 and the common thought is that 2009 won’t do much better. So an early 2009 venture-backed IPO could bode well…but of course registering for an IPO doesn’t always mean the IPO goes through. At least 36 venture-backed companies cancelled their IPO plans in 2008.

As for OpenTable, I remember using its online restaurant reservation system in 2000 while living in San Francisco. Who knew I was an early adopter?

In summary, 2008 saw 6 venture-backed IPOs (down 93% ) and 260 merger & acquisition deals (down 27%). And as you might expect, the prospects aren’t that great for 2009.

So what does this mean for your new startup company? It’s not good, but at some point you just need to turn off the news and develop your product. If you are just fresh into your startup, your exit isn’t coming along for some time. But in the meantime, anticipate that a VC firm will give you less than you might expect and that the terms of their investment will be more investor-favorable.

If you would like to do further reading on venture-backed exits in 2008, the National Venture Capital Association released a report last week, which you can find in PDF format here.

The article, “Killing the Billable Hour: One Op-Ed At a Time” is from Above the Law which is basically the go-to gossip site for us lawyer nerds.

In my practice, I use project prices (i.e. fixed fees) as much as possible. If you are interviewing a lawyer for your startup, don’t be afraid to ask for project pricing. Most of the work a startup needs can be done per project, but don’t expect a firm to handle a VC financing for a fixed fee. Although, I believe fixed fees for financings will inevitably happen. But as a general rule, the chances of using fixed fees dwindle when negotiation and multiple parties are involved in a transaction.

But should your founding team be offended if your venture capital firm exercises its dilution protection provisions when your startup goes through a down round? In a word: No. But many times founders are upset with their VC when their VC exercises anti-dilution provisions.

Of course, dilution is an understandably upsetting event for founders. They worked extremely hard and risked everything to get that $5,000,000 pre-money in the Series A round, but now due to various factors, they need more cash and will get lower valuation in the Series B than they got in the Series A. After the initial investor exercises its anti-dilution provisions, the common stockholders will be left with even less equity in the startup.

But being upset about the dilution doesn’t mean you should be upset at your VC.

First, the anti-dilution provision was part of your funding. You accepted it and to some extent you should be accountable. Even if your late round financing would only be nominally dilutive to your investor, such anti-dilution protection was a material term in getting funded in the first place. Sure, anti-dilution protection can seem like a huge equity squeeze to the common stockholders, but no one forced the startup to take the investor’s cash.

Second, keep in mind that the venture capital firm (through its fund) has limited partners (and fiduciary responsibilities thereto). Venture capital firms are in the business to provide great investment returns for their limited partners. By exercising the anti-dilution provision, the venture capital firm is hoping that the larger amount of shares will help the venture fund improve its return to THEIR investors. (And if they can’t improve their return to investors, the investors will stop investing with such a firm.)

I took a look at the survey and found some interesting results:

92% of VCs believe overall venture capital investment will decline in 2009, but 53% believe they will invest in the same or more amount of companies. I read that as implying that your startup may have the same chances of getting funding next in 2009, but expect the amount of funding to be less. So that’s not entirely bad news…but

96% of VCs believe it will be harder for new companies to get funded in 2009. Thus it sounds as though their 2009 investments may be slanted towards expansion and late investments.

72% of VCs believe the venture backed IPO market will return in 2010…at the earliest. As you may know the, the IPO market for venture backed companies just isn’t there. Don’t expect a return any time soon. (But you can still find an exit via acquisition)

Steve Fredrick, General Partner of Grotech Ventures released the following statement about 2009 and how the VC industry might react:

“Predicting trends for 2009 is extremely daunting but we can look to certain investment strategies that are attractive during challenging economies. For years firms have talked about writing smaller checks, but we’ve seen few venture investments under $1,000,000. This will see a huge shift. Cash efficient, early stage companies with solid business plans which require modest financing to reach viability will be compelling targets. The trick for VCs will be to manage an expanded portfolio with appropriate levels of involvement. If done well, the upside for both the start-up and investors will be tremendous.”

And I’ll leave you with an invaluable quote from NVCA President Mark Hessen:

There is no recession on innovation and great ideas will still get funded[.]”

For the PDF charts by the NVCA, click here.

For the PDF paper by the NVCA, click here.

For a PDF of more quotes from VCs regarding 2009, click here.

And yesterday, Guy Kawasaki echoed my NDA-VC sentiments in “The No-Bull-Shiitake Investor Wishlist,” Guy’s latest post on the Open Forum by American Express. In his post, he gives some candid advice to those of you debating whether to hand over your nondisclosure agreement to a venture capital firm for a signature:

[D]on’t ask any potential investor to sign a nondisclosure agreement (NDA), because asking them to do so will make you look clueless. Venture capitalists and angel investors are often looking at three or four similar deals, so if they sign an NDA from one company and then fund another, they expose themselves to legal action. If you find an investor who is willing to sign an just to hear your idea, you probably don’t want his or her money.

I’ve never heard of a venture capitalist or angel investor ripping off an idea—frankly, few ideas are worth stealing. Even if your idea is worth stealing, the hard part is implementing the idea, not coming up with it. Finally, continuing the dating analogy, you probably won’t get very many dates if the first thing out of your mouth is “Will you sign a prenuptial?”

Guy’s advice about NDAs is just the tip of the iceberg in his post, as he also lays out the characteristics of an “attractive and fundable date” for a venture capitalist or investor. I strongly suggest reading the full post here.

In response to the current state of Series A pre-money valuations, Ackerman said:

Depending on the situation, you’re seeing pre-money valuations come down from 25 percent to 50 percent [for Series A deals].

According to Ackerman, there’s bad news for those you planning a Series B or C deal:

Bs and Cs have collapsed entirely because the capital in the pipeline isn’t moving.

And finally, Ackerman made a prediction about the future of the venture capital industry:

[F]rankly a lot of VCs are going out business — I’d say 25 percent of them will disappear.

Read the full interview here.

Pay By Touch is now bankrupt and investors contend in multiple lawsuits that the startup burned cash at a rate of $8 million per month and Rogers’ frequent partying and constant drug abuse impaired his business judgment. Rogers’ suspected drug use apparently led to a hotel-room “intervention” in a Vegas hotel room.

Read the entire story here.

If a VC firm asks to your to pee in a cup before your pitch, you can thank Mr. Rogers.

(On a personal note, I’m glad to see Lance Williams found the time to write a story on someone other than Barry Bonds.)

When you get a term sheet from a VC or angel investor, you need to decide whether the economics of the deal feel right. And you also have to understand that there’s more to a term sheet than economic terms like pre-money valuation. There’s control, liquidity, and management terms to carefully consider.

Do some background research on your prospective investor. Have they published a list of their portfolio companies?

Finally, resist the temptation to use one submitted term sheet to obtain another term sheet with a better pre-money valuation. Even though you may not be prohibited from shopping the deal, remember that the investor community tends to be close-knit.

You can shop deals simultaneously, but don’t try to leverage one venture firm against another. Remember that some deals are financed by more than one firm. And even if your deal is a one-firm deal, the serial entrepreneur in you will likely have you back in front of venture firms in the years ahead.

VentureBeat and Private Equity Hub have put out articles this afternoon about how limited partners of venture capital and private equity funds are having difficulty meeting capital calls from the general partners of such funds:

Cash panic sweeping VC industry: The capital calls problem (VentureBeat)

LPs Are on the Ropes (peHUB)

When a venture firm raises a fund, it gets the limited partners (think large institutional investors like banks and pension funds) to commit to a certain capital amount known as a “capital commitment” in exchange for its limited partnership interest. Thus, the limited partner does not fully-fund the venture fund with their capital commitment when they sign the fund’s limited partnership agreement. Rather, the limited partnership agreement spells out the procedure how the general partner makes capital calls, including notice provisions, minimum amounts, and penalties for late payments.