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LLM INTERNATIONAL BUSINESS LAW
(2015-2016)
MASTER THESIS
“Venture Capital 2.0: The evolution of Term Sheet and the
impact of social media in venture capital industry.”
Name: Anna Maria Lygnou
ANR: 223413
Supervisor: Eric Vermeulen
Place and Date: Tilburg, June 2016
1
Abstract
This paper aims to examine the several phases that venture capital industry has
undertaken through the years and how the relationships between the venture capital firm and
its portfolio companies are structured. To this direction we analyzed the problem of
information asymmetries in entrepreneurship and consequently its implications on the
contracting behavior of the parties. Under this scope, we present a detailed overview of one
of the most important documents in venture capital financing, the term sheet. To follow on,
we try to analyze the link between the active presence of top ranked VCs in social media with
information asymmetries and elaborate on the importance of trust in VC’s investments that
we believe is tightly connected to the VCs’ extrovert behavior.
2
Contents 1 Introduction ............................................................................................................ 4
2 Venture Capital Financing ...................................................................................... 6
2.1 The history of Venture Capital in the United States ......................................... 6
2.1.1 Venture Capital in Europe ........................................................................ 7
2.2 The old-traditional model of venture capital ..................................................... 8
2.2.1 The legal structure ................................................................................... 9
2.3 The exit options ............................................................................................ 11
2.3.1 The Initial Public Offering (IPO) ............................................................. 11
2.3.2 Exit through M&As ................................................................................. 12
2.3.3 The new exit option: The secondary market ........................................... 12
2.3.4 The advantages of a secondary market. ................................................ 13
2.4 The evolution of venture capital .................................................................... 14
2.4.1 The new funding models ........................................................................ 15
2.4.2 The evolution of Business angels -“the Super angel fund” ..................... 15
2.4.3 The corporate venture capital ................................................................ 16
2.4.4 The online platforms .............................................................................. 16
3 Information Asymmetries ..................................................................................... 18
3.1 The information asymmetry in entrepreneurship ........................................... 18
3.1.1 Overcome the information asymmetries ................................................. 20
3.1.2 Common practices to mitigate information asymmetries used by the
venture capitalists ....................................................................................................... 21
3.2 Introduction to the term sheet ....................................................................... 23
3.2.1 The role of the term sheet ...................................................................... 24
4 The Term Sheet ................................................................................................... 26
4.1 THE ECONOMIC TERMS ............................................................................ 26
4.1.1 The Price/Valuation of the deal .............................................................. 26
4.1.2 Liquidation Preference ........................................................................... 27
3
4.1.3 Pay to Play ............................................................................................ 28
4.1.4 Vesting .................................................................................................. 28
4.1.5 Employee Option Plan/Option Pool ........................................................ 29
4.1.6 Anti-Dilution clauses .............................................................................. 29
4.2 THE CONTROL TERMS ............................................................................... 30
4.2.1 Board Composition ................................................................................ 30
4.2.2 Protective Provisions ............................................................................. 30
4.2.3 Drag-Along Clause ................................................................................ 31
4.2.4 Conversion-Automatic Conversion ......................................................... 31
4.3 OTHER PROVISIONS .................................................................................. 32
4.3.1 Dividend Rights ..................................................................................... 32
4.3.2 Redemption Rights ................................................................................ 32
4.3.3 Conditions Precedent ............................................................................ 33
4.3.4 Information Rights .................................................................................. 33
4.3.5 Registration Rights ................................................................................ 33
4.3.6 Right of first refusal/ Restriction on sales ............................................... 34
4.3.7 Co-Sales agreement .............................................................................. 34
4.3.8 Critical Overview .................................................................................... 35
5 Venture Capital 2.0 .............................................................................................. 36
5.1 Venture Capital 2.0 ....................................................................................... 36
5.2 The role of social media in entrepreneurship ................................................ 37
5.3 The evolution of VCs extrovert in social media ............................................. 38
5.4 The impact of VC’s social extrovert in entrepreneurship ............................... 40
5.5 The impact of VC’s social extrovert on the Term Sheet ................................. 41
6 Conclusion ........................................................................................................... 43
7 References .......................................................................................................... 44
4
1 Introduction
Venture capital is called the risk capital associated with investments in early stage
companies. Venture capital industry was formatted in the first decades of 20th century in the
United States and since then several transformations have followed as a result of the
evolution of the society and entrepreneurial innovation. The core idea behind the traditional
VC model is the financing of promising young firms, mostly in hi-tech industry but not limited
to it, in order to help them become growth companies and generate high returns for its
stockholders. The importance of venture capital investment in boosting economy by
supporting small and promising companies was highly acknowledged by regulators who tried
to take initiatives in order to maintain the capital flow. Although the Silicon Valley model
proved hard to replicate in other places of the world, such as in Europe, regulators work to
this direction in order to create a solid ground for investors and encourage more investments
in the future.
Over the years and especially after the dot-com bubble, venture capital cycle was
reshaped creating new tensions and trends in the start-up world. The problems of information
asymmetry and the agency costs associated with the early stage investments made venture
capital industry shift from young to more mature companies in order to avoid the high risks
existing in these investments. Plus to this, when venture capital firms were actually investing
in early stage companies they will have asked for extreme control and economic terms, which
in turn were resulting in opportunism from the venture capitalists’ side. In parallel, new funding
models, such as the angel groups, collaborative models and corporate ventures appeared, in
order to cover the gap in the venture capital cycle and provide the early stage company with
the necessary capital.
Following these changes in venture capital industry, the last years, it is again observed a
tension of venture capital firms to return to the traditional model of venture capital
investments, close to the risky investments of the past. The new breed of VCs seem to adopt
the lean model and use their power and influence to help entrepreneurial firms attract venture
capital investments by disclosing insights of the way the industry operates. This is where VC’s
extrovert behavior in social media intervenes and build an environment of trust in order to
educate entrepreneurs and facilitate future investments.
Based on this background, our thesis will try to describe these tensions, identify the
problems arising from venture capital investments in early stage companies and finally
explain why things are different today along with the role of social media on this change. In
the first chapter a brief history of venture capital industry will be presented along with a global
description of the venture capital cycle. The legal structure, the importance of exit options as
5
well as the introduction of the new funding models will help us understand the way the industry
works and introduce as to the main focus of this thesis, the relationship of the venture capital
firm with its portfolio companies.
The second chapter deals with the main problem, which discourages investments and
creates conflicts between the parties in venture capital deals, the information asymmetries.
Agency costs and opportunism create an unpleasant environment for investments and so we
try to analyze the main measures taken by VCs in order to moderate these conflicts and finally
we focus on the contracting solutions adapted and the term sheet. The term sheet is the main
document used to regulate the VC’s and entrepreneur’s relationship and we explain its high
importance for such a deal despite the fact that in its biggest part it includes legally non-
binding provisions.
Having analyzed the importance of the term sheet in venture capital deals chapter three
follows with an overview of the most common provisions included in the term sheet. We try
to present how a deal is structured and also explain in each term whether it is entrepreneur
or VC friendly in order to show later how the term sheet is affected by the new trends in the
industry.
Finally, the last chapter focuses on the meaning of trust in VC investments and how it
can help moderate the problems of information asymmetries from a different approach as
opposed to the past. Social media and VC’s extrovert behavior are the main points of this
analysis, which ends up with a discussion on the influence of social media on
entrepreneurship and eventually the term sheet.
6
2 Venture Capital Financing
2.1 The history of Venture Capital in the United States
In the 1930s and 1940s a premature version of the venture capital industry existed in the
United States and consisted of some wealthy families, such as the Vanterbilts, the Phipps,
the Rockefellers and the Whitneys, who started investing in high-risk new ventures with
potential for higher returns.1 At that moment, the market was completely unorganized and the
wealthy investors tried to discover upcoming and promising young companies to invest by
hiring professional managers.2
It was in 1946 when the first venture capital firm-similar to the model we know today- was
established, the American Research and Development Corporation (hereinafter referred to
as ARD). One of the distinguishing characteristics of ARD, compared to the high risk investors
of the past, was that the goal of the company was to provide its portfolio companies not only
with money, but also with professional knowledge and expertise in management issues in
order to maximize their chances to become growth companies.3 George Doriot was the
founder of ARD and is usually referred to as “the father of venture capital”. His primary focus
was to search for ideas that would work as businesses and then give them skin and bones
through his financing and monitoring.4
In 1958 the United States’ government took action in order to boost the development of
a more organized and professional venture capital industry by introducing “the Small
Business Investment Act” in order to increase the possibility for young entrepreneur
businesses in the United States to receive financing.5 Despite the small success and
influence of the act, the following years, many venture capital companies were established
changing the route of history especially in the technological sector.
Arthur Rock, Pitch Johnson, Don Valentine, Tom Perkins, Bill Draper are only some of
the new venture capitalists at that time, who changed and transformed the venture capital
industry. Their ability to see opportunity where other people saw risk, led them to search for
good ideas and try to finance them in order to help them grow. Many great companies that
exist until now were built then, such as Intel, Cisco, Apple, Teledyne and Scientific Data
System. As Arthur Rock, who financed Intel Corp. in 1968, said “writing the check is easy”
1 Arun Rao and Pierro Scaruffi, A History Of Silicon Valley: : The Greatest Creation Of Wealth In The History
Of The Planet (Omniware 2012). Ch. 7 2 Paul Gompers, 'The Rise and Fall of Venture Capital' [1994] 23(2) Business and Economic History.5 3 Paul Gompers, 'The Rise and Fall of Venture Capital' [1994] 23(2) Business and Economic History. 6 4 Beattie, A. (2009). Georges Doriot And The Birth Of Venture Capital | Investopedia. [online] Investopedia.
Available at: http://www.investopedia.com/articles/financialcareers/10/georges-doriot-venture-capital.asp [Accessed 25 May 2016].
5 Anon, (2016). [online] Available at: https://en.wikipedia.org/wiki/Venture_capita [Accessed 25 May 2016].
7
but a venture capitalist is way more than that for a start-up company.6 As a venture capitalist
he was a board member, he was doing staff meetings, press releases, he interviewed with
key people and in general spent a lot of time and effort to support the portfolio company.7
The growth of venture capital industry after 1980s was also connected to two legislative
changes introduced by the US government. First of them was the “Revenue Act” that came
into force in 1978 which “decreased the percentage of tax on capital gains from 49.5% to
28%”8 and the change in “the prudent man rule” of ERISA, which let pension funds to invest
in venture capital funds, translated into a huge amount of capital available for investments.9
After 1980s the structure of the venture capital industry in the United States started to
change significantly. The large number of venture capital firms, their unsophisticated image
with the short term view and the poor managerial skills led to a decrease in the returns
compared to the past.10
The picture changed again after 1995, when the industry faced a boom period with
investments oriented to internet products and other computer technologies and the most
powerful venture capital firms welcomed huge returns through the rising IPO market until the
internet bubble in 2000 which reversed the image again.11
2.1.1 Venture Capital in Europe
Compared to the United States, the venture capital industry in Europe was not so
organized or developed, leaving the United States with the leading role in funding high-tech
start-up companies. Venture capital industry in Europe was formed at the early 1980s, when
the first firms were established. Some years later, in 1983, the European Private Equity and
Venture Capital Association (EVCA) and the British Venture Capital Association (BVCA) in
UK were established12 in order to boost financing for small enterprises and young
entrepreneurs. At that time, venture capitalists had to deal with the lack of possible exit
options, as the existing stock market could not be compared to the United States model and
Nasdaq that existed across the pond.13 Nevertheless, despite the poor performance of this
6 YouTube. (2016). Something Ventured. [online] Available at:
https://www.youtube.com/watch?v=Lq7JVThjHEA [Accessed 25 May 2016]. 7 YouTube. (2016). Something Ventured. [online] Available at:
https://www.youtube.com/watch?v=Lq7JVThjHEA [Accessed 25 May 2016]. 8 Paul Gompers, 'The Rise and Fall of Venture Capital' [1994] 23(2) Business and Economic History. 10 9 Ibid 10 10 Anon, (2016). [online] Available at: http://https: //en.wikipedia.org/wiki/Venture_capital [Accessed 25 May
2016]. 11 Ibid 12 Arundale K, Raising Venture Capital Finance In Europe. A Practical Guide For Business
Owners,Entrepreneurs And Investors (Kogan Page 2007). 13 Smarter Ventures: A Survivor's Guide to Venture Capital Through the New Cycle, Katharine Campbel,
Pearson Education Limited 2003. Part 1, p.54
8
time compared to its counterpart, the United States, the venture capital industry from the
1990s was significantly developed in Europe and governments recognized it as a tool for
economic growth and development generating numerous job positions.
2.2 The old-traditional model of venture capital
The role of venture capital industry in boosting innovation and technology through
financing promising young start-up companies was recognized after the success of many
venture backed companies in the past. For most start-up companies though, get funding from
other sources has been proven a difficult task. The option of a bank loan was discouraging
for several reasons. First of all, most start-up companies do not own any important assets
which they could use as collateral in order to secure a bank loan. Besides that, the lack of a
structured and professional business plan was a red flag for bankers who always wanted to
secure the payment of their money and interests. As a result, especially after the seed stages
where friends and family usually invest in start-up companies14, larger amounts of money
were needed to cover the costs of operation and expansion of the company.
Traditionally, venture capital firms used to invest in start-ups, which were at the early to
the expansion stage.15 The structure and the basic characteristics of venture capital firms
made them a popular investor for most companies seeking to raise capital after the seed
stages. Venture capital is usually called the risk capital provided by private investors or
financial institutions to the venture capital firms, which use the money to build high risk
portfolios and finance young companies in return for equity.16
As it was previously mentioned, venture capital firms traditionally used to invest in
companies being in the early stage, which means either in the early development or the
expansion of the company. They rarely invest at the seed stages, where the product has not
reached its final version or needed further research before the final production. The decision
to invest among other things, is linked to the evaluation of the business plan of the company-
one of the most important assets for a start-up company- and an extensive due diligence. The
characteristics of the market they want to operate or expand, the potential for growth and any
other risk factors were always considered and analyzed before the initial investment.
Close to the financial support to the young company, what distinguishes venture capital
firms is the overall support provided in every aspect of a young company’s growth. As it was
mentioned before, the investment is taking place in exchange for equity. The venture capital
14 Things are changing today, after the introduction of the online platforms and crowdfunding which is a relatively easy and direct way to raise capital at the seed and early stages.
15 Financing High-Growth Firms THE ROLE OF ANGEL INVESTORS.OECD p.22 16 'What Is Venture Capital? Definition And Meaning' (BusinessDictionary.com, 2016)
<http://www.businessdictionary.com/definition/venture-capital.html> accessed 27 May 2016
9
firm receives seats on the board of directors- usually analogous to the equity investment-
receives excessive control rights and usually preferred stock with advanced voting rights. In
exchange, the venture capital firm contributes to the start-up its managerial expertise, its
knowledge over the market and in general support the company on legal, structural or
operation related issues. A sophisticated and well reputed firm can add real value and help
the start-up into become a growth company, which will then be translated into higher returns
for the venture capital firm when the exit will occur.
2.2.1 The legal structure
The legal structure of a company defines important issues, such as taxes, liability, as well
as the way that all conflicting interests should be allocated in the firm. The most common legal
structure for venture capital firms is the Limited Partnership structure (hereinafter LP) that can
reduce the agency costs by regulating incentives for both inside and outside investors.
The legal structure of the LP has on the one side the general partner, a corporation that
is organized by the venture capital17 and carries full liability and on the other side the limited
partners as the outside investors who provide the money to the firm and are liable only until
the amount of their investment. There are several legal forms that are used by venture capital
funds throughout the years, such as “the small business investment companies (SBICs) the
financial venture capital funds, corporate venture capital funds and the venture capital limited
partnerships”.18 Although the LP structure is the most common both in the United States and
Europe and the reasons behind this could be found on some specific characteristics of this
legal form that serves better the purposes of private equity firms.
Regardless to the specific rules that exist in different jurisdictions, the LP vehicle
generally offers flexibility through the limited partnership agreement to the parties involved to
self-regulate the way that the relationships between them will be structured. In addition tax
benefits arising from this legal form, as well as the fixed duration of the partnership makes it
attractive to many venture capital firms.19
The general partner is most commonly compensated with a 2 to 2.5% fee of the total
amount invested and is responsible for the creation of the portfolio of the firm and the
alignment of risks among the investments.20 The importance of the freedom of the parties
17 Klausner M and Litvak K, 'What Economists Have Taught Us About Venture Capital Contracting' SSRN Electronic Journal. 13
18 McCahery, J. A., & Vermeulen, E. P. M. (2004). Limited partnership reform in the United Kingdom: A
competitive, venture capital oriented business form. (TILEC Discussion Paper; Vol. 2004-024). Tilburg: TILEC. 19 Sahlman W, 'The Structure And Governance Of Venture-Capital Organizations' (1990) 27
Journal of Financial Economics.490 20 'How VC Funds Work - Expenses And Management Fees | The Venture Alley' (The Venture
Alley, 2011) <https://www.theventurealley.com/2011/01/how-vc-funds-work-expenses-and-management-fees/> accessed 9 June 2016.
10
involved in the partnership to regulate their relationships explains the popularity of this legal
structure. Investors, as the limited partners, can through the appropriate covenants control to
an extent- depending on the clauses that apply in the LP agreement- the actions of the venture
capitalists serving as the general partners in order to ensure their investment. Typically they
have the right to vote for important issues “such as the amendment of the limited partnership
agreement, dissolution of the partnership before the termination date, extension of the fund’s
life, removal of any general partner, and valuation of the portfolio”.21
Source:22
The importance of exit options for investors, as it will be analyzed later in this chapter, is
also connected to the reason why the limited duration of the LP vehicle is an attractive feature
for the venture capital funds. The fixed duration of the firm (with possibilities of some
extension) provides the investors with a kind of security, as they know that there is an ultimate
time, at the dissolution of the fund, when they can cash their investment; at the same time
they can put some pressure on the managers of the fund to manage the investments in such
a way that until the dissolution of the company-usually at ten years- they should have created
the appropriate conditions for a successful exit.23
21 Ibid 490 22 Angel Investment, Private Equity And Venture Capital In Turkey - Corporate/Commercial Law -
Turkey' (Mondaq.com, 2016) <http://www.mondaq.com/turkey/x/295958/Corporate+Commercial+Law/Angel+Investment+Private+Equity+And+Venture+Capital+In+Turkey>
23 McCahery, J. A., & Vermeulen, E. P. M. (2004). Limited partnership reform in the United Kingdom: A
competitive, venture capital oriented business form. (TILEC Discussion Paper; Vol. 2004-024). Tilburg: TILEC p.14-15
11
2.3 The exit options
An investment can be characterized as successful, only if it is accompanied by a
successful exit. When the portfolio company has reached the point where it is mature for an
exit, venture capital funds can exit their investment either through an initial public offering (
IPO) or through the sale of the portfolio company to a larger organization (M&As and trade
sales).24 In this way the venture capital firm pays dividends to the investors and create the
conditions to continue funding other start-up companies in the future.25 Until recently there
were only these two options for investors to exit and get a return for their investments. As it
will be discussed in a following section, today there is a third exit option for investors, the
secondary market. The necessity for this was driven by the financial conditions in the venture
capital industry and the market in general.
2.3.1 The Initial Public Offering (IPO)
Initial Public Offering (hereinafter IPO) is the offering of securities of a private company
to the public in order to raise money and at this point the investors have the opportunity to sell
their interests in the company to exit and cash their investment. Typically though, investors of
the firm do not sell their securities at the moment of the IPO as this could give a negative
signal to the outside investors and could possibly affect its success.26 The investment bankers
set a predefined period-commonly 6 months- where no investor, including the venture
capitalists, can sell their shares in order to avoid a concept where inside investors are trying
immediately to cash their investment and thus protect the success of the IPO.27
The exit behavior in United States and Europe differs and it is related to the existence of
an active capital market which make it easier for investors in United States to exit through an
IPO in contrast to Europe where the M&As are the most common exit option.28
The importance of an active stock market is underlined by Black and Gilson(1998) who
state in their paper that the exit option for the venture capital firm is crucial for the relationships
between the venture capitalists and the start-up company as well as the relationships between
the venture capital fund and the capital providers.29 As it was mentioned before, the venture
capital firm provides the young company with its managerial expertise, with the close
24 (2016) <http://2014 National Venture Capital Association Yearbook by Thomas Reuters> accessed 26
May 2016. 71 25 Ibid 71 26 Gompers P and Lerner J, 'The Venture Capital Revolution' (2001) 15 Journal of Economic Perspectives.
161 27 Ibid 161 28 Susanne Espenlaub, Arif Khurshed and Abdulkadir Mohamed The Exit behavior of Venture Capital
firms.Manchester Accounting & Finance Group, Manchester Business School. 29 Black B and Gilson R, 'DOES VENTURE CAPITAL REQUIRE AN ACTIVE STOCK MARKET?' (1999) 11
Journal of Applied Corporate Finance. 11
12
monitoring of the firm as well as with the contribution of “reputational capital”. When combine
the financial and non-financial contributions, capital providers in the fund have the opportunity
to evaluate at the exit these elements simply by measuring the return on their investment.30
Through the exit it is also possible for the capital providers in the fund to evaluate the skills
and profitability of the managers in order to use this information for their future investments.31
It is clear then, that the exit through an IPO is possible when an active capital market
exists and thus the capital cycle is fully functioning. The contracting between the fund and the
entrepreneur firm also plays a crucial role in the alignment of the control rights and the IPO
process as it will be analyzed further in the next chapters.
2.3.2 Exit through M&As
The counterpart of the IPO option is the sale of the young company to another, bigger
organization. At this option the venture capitalists can get the return on their investment with
money from the transaction. As it was mentioned before this option is more popular in Europe
than the United States, which has a stronger and more active stock market.
Sometimes though, depending on the circumstances, this exit option might be more
suitable for some firms. Similar to the outsourcing of R&D that large corporations prefer in
order to boost innovation, a smaller firm might be better in innovation and combined with a
larger corporation with large production and marketing the benefits arising from these
synergies could add more value to a company than a public offering.32
2.3.3 The new exit option: The secondary market
Even if the IPO was the most desirable option for investors in order to get a return in their
investment, the numbers show that there is a significant drop in the number of venture-backed
companies going public (see the graph below for statistical information on the number of
venture-backed IPOs from 1995 to 2015). As a result the emergence of the new exit option,
the secondary market, was crucial in order to increase liquidity for investors who want to sell
their interests in company before a possible IPO or trade sale of the portfolio firm.
A strong advantage of this exit option for private companies is that it can avoid an
“investor capital lock-in”.33 As Darian M. Ibrahim argues in his paper related to the secondary
market, an “investor capital lock-in” differs from the situation of a “capital lock-in”; the investor
30 Ibid 11 31 Ibid 8-11 32 Ibid 12-13 33Ibrahim, Darian M., The New Exit in Venture Capital (October 7, 2010). Vanderbilt Law Review,
Vol. 65, 2012; University of Wisconsin Legal Studies Research Paper No. 1137. SSRN Electronic Journal. 6-8
13
of a pre-IPO company cannot turn to a ready market to sell its interests as investors of publicly
traded companies could do through NASDAQ and the New York Stock Exchange (NYSE).34
In this situation the investor is locked, along with the capital that is locked, as she cannot sell
any interests of the company to third parties. As a result, without the existence of an organized
secondary market, an investor who needs to liquidate her investment has to wait until the exit
of the company through an IPO or a trade sale. This in turn, leads to unwanted situations that
investors who want to exit their investment will put pressure on the company, even if it is not
mature enough, to go public or be part of a less successful M&A deal.
According to the above, the exit for the investor is closely linked to the exit of the portfolio
company.35 Combined with the fact that the IPO market has significantly dropped the need
for a strong secondary market is crucial now more than ever.
Graph Source: (2016) <http://: National Venture Capital Association Yearbook 2016 by Thomson
Reuters> accessed 26 May 2016
2.3.4 The advantages of a secondary market.
The existence of a strong secondary market could help reduce the liquidation gap in the
venture capital cycle.36 If there are no sufficient exit options for venture capitalists then they
will not contribute their time and money to support young companies, a situation which could
in turn threaten the smooth operation of the venture capital cycle.37 Close to this, new
investors would lose their appetite for new investments in the industry. This could be really
34 Ibid 7 35 Ibid 12 36 Mendoza J and Vermeulen E, 'The 'New' Venture Capital Cycle (Part I): The Importance Of
Private Secondary Market Liquidity' SSRN Electronic Journal. 11-12 37 Ibid 11-12
14
risky for the way the ecosystem works. The alignment of interests between the different
investors in a young company could be more difficult, if there is no exit option apart from those
that are linked to the exit of the portfolio company.
The conflicts arising between venture capitalists and entrepreneurs could be partly solved
through the secondary market. As it was mentioned before, different stage investors, different
interests and information asymmetries between the parties involved create negative situations
that can affect the start-up company in a way that each party will force things to achieve
individual goals.38 “Super angel” funds, the new type of investors which have entered into the
start-up ecosystem usually exit their investment within four years or even less, which means
that if there is no alternative exit option they will put pressure in order to sell or merge the
company with a larger corporation even if the startup is not mature enough for this step.39
Thus, an alternative exit option could let the disagreed party exit its investment earlier
through a private sale of its interests, letting the company to reach its full potential by avoiding
a premature exit.
2.4 The evolution of venture capital
From 1960s that the first venture capital firms appeared in Silicon Valley until today things
have changed for the industry. The traditional model of the venture capital firm transformed
through the years following the demands of the society as well as the financial conditions. A
determinant factor for this was also the severe financial crisis of 2008. Different types of
investors, such as super-angels, hedge funds that finance high-tech companies as well as
the reappearance of the corporate venturing have contributed to this evolution in the
traditional venture capital cycle.40
Another factor that has affected the model of venture capital is the profile of their portfolio
companies. In particular, nowadays starting a business is much cheaper and easier than it
was in the past. The amount of the investment to an early stage start-up firm is lower and this
in turn means that the experimentation cost for venture capital firms is lower too.41 Following
the lower cost of experimentation, venture capital firms have started to adopt a “spray and
pray” tactic which differs from the traditional investment strategy that venture capital firms
used in the past, when they had to provide young firms not only with money but also with their
38 Ibrahim, Darian M., The New Exit in Venture Capital (October 7, 2010). Vanderbilt Law Review, Vol. 65, 2012; University of Wisconsin Legal Studies Research Paper No. 1137. SSRN Electronic Journal. 27-29
39 Ibid 11-12 40 Dittmer J, McCahery J and Vermeulen E, 'The New Venture Capital Cycle And The Role Of
Governments: The Emergence Of Collaborative Funding Models And Platforms' SSRN Electronic Journal.11
41 Ewens M, Nanda R and Rhodes-Kropf M, 'Cost Of Experimentation And The Evolution Of
Venture Capital' SSRN Electronic Journal. 23
15
expertize.42 This “spray and pray” strategy is opposed to the traditional venture capital model,
where the involvement of the venture capital firm in the start-up company was the key
component for growth of the young company.
The evolution of the venture capital model and the new venture capital cycle indicate the
need for all the parties involved in the ecosystem (from entrepreneurs, to investors, regulators
and lawyers) to work together in order to adapt the appropriate behavior and create the
conditions to boost innovation and materialize good ideas into growth companies.
2.4.1 The new funding models
As the venture capital cycle is affected by the introduction and development of the new
funding models, a short reference on their most noticeable characteristics would be useful.
2.4.2 The evolution of Business angels -“the Super angel fund”
Business angels play a major role in the ecosystem and help the venture capital cycle
spin smoothly. In particular, business angels are private investors, who have gained during
their career wealth and want to invest their money and personal experience in startup
companies in order to help them grow and of course get a high return for their investment.43
Typically in the traditional financing cycle business angels used to invest in the early stage of
a company while the seed stages were usually financed by friends and family.44 Venture
capitalists as it was mentioned previously used to invest in the early to the expansion stage
of a start-up leaving business angel with the financial contribution of the seed stages.45
Consequently, the involvement of business angels in the start-up ecosystem is crucial as they
cover the financial gap that would otherwise exist in the early stage financing. Indeed, the
importance of business angels in the ecosystem became more obvious the latest years, when
the investment strategy of venture capital firms steadily moved to later stages and the
financing gap was partly covered by business angels.46 In addition, a key element to their
success is the fact that beyond their obvious financial incentives, their motivations are also
driven by their willingness to transfer the knowledge they have in the field to the new
generation of entrepreneurs.47
The evolution of the business angel model could be the so called “super angel funds” or
the micro venture capital funds that differ from the traditional model as they attract capital
from other sources as well, such as rich individuals, foundations or family companies who
42 Ibid 23 43 Veland Ramadani, 'Business Angels: Who They Really Are' (2009) 18 Strat. Change. 44 Financing High-Growth Firms The role of angel investors. OECD p.21-22 45 Ibid 22 46 Ibid 21 47 Veland Ramadani, 'Business Angels: Who They Really Are' (2009) 18 Strat. Change.
16
seek for innovative investment opportunities.48 As the traditional business angels, the “super
angel funds” invest huge amounts of money at the early stage of the company and due to the
experience and domain knowledge of their manager, they are more likely to find good
investment opportunities and attract in the future more traditional venture capital financing.49
As a result, the evolution of the venture capital model and the change in their investment
strategies is linked to the appearance of the super angel funds which provide startup
companies with professional guidance and financing in the early stages.
2.4.3 The corporate venture capital
The advantages of corporate venturing were known for large corporations as a way to
move from traditional R&D and outsource by investing in promising start-ups. Following the
dot com bubble the number of corporate venture capital firms was significantly decreased,
although the last years an increase in the number of corporate venture capital funds is
observed and in many occasions they even outperform compare to the traditional venture
capital firms.50
In addition, a number of collaborative venture capital models have arisen as venture
capitalists tend to work with large corporations in order to build partnerships and invest in
start-up companies.51 In these partnerships the managerial skills of the fund managers
combined with the actual support that a large corporation can provide to the start-up lead to
a win attitude and the development of a promising portfolio of companies52. The involvement
of the collaborative models in the start-up ecosystem was important given the evolution of the
traditional venture capital model and the need for more financing sources for early stage
companies.
2.4.4 The online platforms
Arguably, raising money through the internet is not something totally new, but
crowdfunding in return for equity in a start-up company seems to gain ground the last years.
The term equity crowdfunding defines an investment that is regulated under securities law, in
an early stage company through an online platform in exchange for stock in that company.53
48 Dittmer J, McCahery J and Vermeulen E, 'The New Venture Capital Cycle And The Role Of Governments: The Emergence Of Collaborative Funding Models And Platforms' SSRN Electronic Journal. 22
49 Ibid 22 50 'Corporate Venturing' (Harvard Business Review, 2013) <https://hbr.org/2013/10/corporate-
venturing> accessed 26 May 2016. 51 Dittmer J, McCahery J and Vermeulen E, 'The New Venture Capital Cycle And The Role Of
Governments: The Emergence Of Collaborative Funding Models And Platforms' SSRN Electronic Journal. 23-24
52 Ibid 24 53 Ibrahim D, 'Equity Crowdfunding: A Market For Lemons?' SSRN Electronic Journal.
17
The popularity of this way of financing for young companies, most commonly in the seed
stage, is based on the simple and fast way that it is used by matching investors with the young
businesses.54
Despite the hurdles, such as regulatory issues or the large number of investors who could
discourage future investments, crowdfunding is a famous alternative for startup companies in
the seed and early stage to raise capital and inevitably online platforms seem to have
established their role in the start-up ecosystem.
54 Dittmer J, McCahery J and Vermeulen E, 'The New Venture Capital Cycle And The Role Of Governments: The Emergence Of Collaborative Funding Models And Platforms' SSRN Electronic Journal.28
18
3 Information Asymmetries
3.1 The information asymmetry in entrepreneurship
The role and importance of information are highly acknowledged in all kind of businesses.
The individual who possesses the information can use it to create opportunities. It is generally
accepted that information advantages can drive entrepreneurship, as the possessor can use
it to explore new ideas or simply be aware of new opportunities.55
When an entrepreneur wants to raise capital from an outside investor, a principal-agent
relationship is established.56 In this relationship the entrepreneur acts as the agent who runs
the company using the capital provided by the investor; the latter acts as the principal and
their relationship is characterized by conflicts of interest regarding the management of the
company.57The information asymmetry problem that arises from this principal-agent
relationship is then expected, especially in technology market where the core idea of the
business is usually ambiguous or it is hard to access; similarly happens with those companies
that are mostly relied on R&D.58In particular, this principal-agent relationship triggers the
problems of adverse selection in the pre-contractual behavior of the parties and the moral
hazard problem addressing to the post-contractual behavior (Folta and Janney 2004).59In the
pre-contractual phase, the problem is focused on the information that the entrepreneur did
not reveal to the other party before its initial investment, thus putting the other party in a less
favored position. In the post contractual stage, the moral hazard problem is focused on the
fact that the entrepreneur may not reveal all the actions or the plans that he is willing to follow
regarding to the management of the company, making it difficult for the other party to evaluate
its progress.60
It is expected then, that adverse selection and moral hazard do not provide investors with
incentives to finance a firm when there is no certainty about the quality of their investment. As
a result, most venture capital firms will decide to either step back from a possible deal or
finance the start up for only a small amount compared to what they would have invested if
information asymmetries did not exist.
55. Dutta, S. and Folta, T. B. Information Asymmetry in Entrepreneurship. p.2 56 Folta, T. and Janney, J. (2004). Strategic benefits to firms issuing private equity placements.
Strat. Mgmt. J., 25(3), pp.223-242. 57 Klausner, M. and Litvak, K. (n.d.). What Economists Have Taught Us About Venture Capital
Contracting. SSRN Electronic Journal. 4 58 Gompers, P. and Lerner, J. (2001). The Venture Capital Revolution. Journal of Economic
Perspectives, 15(2), pp.145-168. 59 Folta, T. and Janney, J. (2004). Strategic benefits to firms issuing private equity
placements. Strat. Mgmt. J., 25(3), pp.223-242. 60 Ibid 225
19
This outcome would be really harmful for start-up companies and in general for
innovation, as information asymmetries would be an obstacle between the entrepreneurs and
the needed capital, which is necessary for the survival and expansion of the company.
Consequently, as it happens in every transaction, if entrepreneurs want to raise money they
should in some way provide the investors with a kind of certainty about their investment and
also create incentives for well reputed venture capital firms to invest money in their company.
Information asymmetry depending on the way that it is handled is also connected to the
success of the exit, with those companies that have managed to mitigate better the
asymmetries, achieving more successful exit results.61 In particular, especially for the IPO the
more information and transparency exist at the time of the public offering, the more possible
it is that the offering would be more successful. This is rational, since investors, in case of
information gaps at the time of the IPO, will either eschew from buying interests in the
company or will offer a lower price, affecting in both situations the success of the IPO. This is
more intense particularly in the high-tech industry, where the information asymmetry is
associated with the characteristics of the entrepreneurial firm increasing the costs for a
possible exit through an IPO and making an exit through a takeover a more possible option.62
The decision on the exit is important for both the entrepreneur and the venture capital firm,
depending of course on the contractual provisions at the time of the initial investment;
entrepreneurs will usually ask for a public offering instead of a takeover because the
possibilities for taking again the control of their company after the venture capital exit is more
possible with a public offering. As it will be analyzed later, control rights among the parties
have a huge influence over the possible exit, since while the parties have conflicting interests
regarding the exit the one with the contractual superiority will make the final decision.63 Taking
into account the fact that most of the times more than one firms have invested in the same
company, the importance of the contractual allocation of their power is obvious.
It is then clear that the idea of information asymmetry is dominant in the relationships
between the entrepreneur and the venture capital firm. This situation makes it difficult for the
parties to reach to a deal as typically the entrepreneur who possesses the information about
the company will be in superior position compared to the venture capital firm. Financing
though, is absolutely necessary for the young company, as the amount of money needed for
a start-up to expand and grow is difficult to be gathered without outside financing. As a result,
beyond any other practices used by investors to overcome asymmetries (some of them are
61 Cumming, D. and Johan, S. (2008). Information asymmetries, agency costs and venture capital exit outcomes. Venture Capital, 10(3), pp.197-231.
62 Ibid 7 63 Ibid 8
20
mentioned below), the entrepreneur has to sacrifice some control rights over the company
and offer incentives to the capital providers to invest.
3.1.1 Overcome the information asymmetries
Theory suggests that internal access to financial capital could solve the problem of
information asymmetries.64 This simply means that in order to avoid the asymmetry, the
entrepreneur should self-finance his company and as a result since the person who
possesses the information will be the same with the person who invests, no conflicts of
interests exist and no disclosure is necessary. Since there is no relationship with an outside
investor there is no information asymmetry and thus a need to mitigate any conflicts of
interest. Nevertheless, this is only possible if the entrepreneur can afford to finance the
company, which is not the case in most start-ups. The amount of money needed for
production and expansion of the company is usually difficult to be covered solely by the
entrepreneur and this option is rarely applicable in real life. Plus to this, it does not take into
account the non-financial contributions of venture capitalists in the young company, which is
of equal importance to the monetary participation.
Another way to reduce the conflicts arising from the information asymmetries is the social
capital.65 When the entrepreneur has some kind of social relationships with the capital
provider, it is accepted that information asymmetries could be easier mitigated. This is based
on two arguments; firstly, when there is a pre-existing social relationship between the parties
then the sense of trust and fairness that govern their relationship can moderate the conflicts
arising from the information asymmetries; it is then expected that the party who has the
information advantage will not use it to exploit opportunities at the expense of the other
party.66 Secondly, since social ties exist, typically the disclosure of information would be easier
as it will be based on a personal and not exclusively professional bond between the parties.67
Even though these two factors -the self-financing and the social ties- could mitigate
under some circumstances the information asymmetries, it is not always possible to have
either an entrepreneur that can afford to self-finance his company or an investor connected
to the entrepreneur with some kind of social ties.
64 Acs, Z. and Audretsch, D. (2010). Handbook of Entrepreneurship Research. New York, NY: Springer New York. 63
65 Ibid 64 66 Ibid 64 67 Ibid 64; and Gulati, R. and Gargiulo, M. (1999). Where Do Interorganizational Networks Come
From? 1.American Journal of Sociology, 104(5), pp.1439-1493.
21
3.1.2 Common practices to mitigate information asymmetries used by the
venture capitalists
Other practices often used by the venture capital firms in order to moderate the impact
of information asymmetries in the start-up financing are “the staged investments, the
monitoring of the firm, syndication of the investment as well as the incentives provided for a
successful exit”.68
In particular, the staged investments are a common practice for venture capital firms in
order to ensure their investment and reduce the risks associated with it. Having analyzed the
information asymmetry problem and the hurdles that it sets between the venture capital firm
and the entrepreneur, venture capitalists choose to release the capital provided not in once
at the time of the initial investment but periodically. This practice is often characterized as one
of the most efficient ways for venture capitalists to solve the problem of information
asymmetries.69The idea behind of the staging of capital provided to the start-up company is
that at the beginning of the investment where limited track records exist for the company only
a part of the funding is released. Before the next release, investors have the opportunity to
monitor the company and evaluate its progress. The risk then of the investment is significantly
reduced as the investor can actually control whether there is opportunistic behavior from the
entrepreneur. At the same time, the delays in the financing make the entrepreneur more
cautious on actions that could jeopardize the release of the next funding rounds.
Monitoring of the firm is a typical characteristic of venture capital investments. The idea
is that the venture capitalists will contribute their knowledge and experience in the young
company by keeping an eye to the running of the business; this also works the other way
around as the monitoring discourage any opportunistic behavior from the entrepreneur. The
screening of the firm is more regular when there are staged investments as typically, the
venture capital firm will closely monitor the company before the new round of investment.
However, it is argued (Gompers, Lerner 1999)70 that even with the staged investments and
the regular “check-up” of the business, it is difficult to preclude the moral hazard problem
caused by any “hidden actions” of the entrepreneur; as a result more measures from the
venture capitalists are usually necessary, such as the informal monitoring of the firm or
additional control regarding to the entrepreneur's compensation provisions.71
Close to the concept of the staging of investments in order to minimize the risk factor are
the syndicates of investors, meaning a situation where more than one venture capital firms
68 Gompers, P. and Lerner, J. (1999). The venture capital cycle. MIT Press.129 69 Bergemann, D. and Hege, U (2006). The financing of Innovation: Learning and stopping; Cowles
Foundation Paper No 1176; Cowles Foundation for Research in Economics; Yale University p.5 70 Gompers, P. and Lerner, J. (1999). The venture capital cycle. MIT Press.129 71 Ibid 129
22
invest in a start-up company even at the same round.72 In this way, since more than one firms
fund the start-up company, then the amount of money provided is analogically smaller for
each firm. The smaller the amount of investment, the smaller the risk taken by the firm. This
is closely connected to information asymmetry problem (Admati and Pfleiderer, 1994)73, as
the syndication of investments offers incentives to the venture capitalists to fund a company
despite the informational gaps, since the risk they take is smaller than investing on their own.
All these commonly used practices to mitigate information asymmetries between the
parties, address the importance of contracting in the venture capital financing. The general
idea behind the contracting solution is that since information asymmetries exist between the
parties involved in the deal, as well as conflicting interests, then the contractual provisions
that regulate this relationship could limit the opportunism from the entrepreneur’s side. The
assignment of control rights to the investor works as an equilibrium to the informational
advantage of the entrepreneur.74 Control over the company provides the investor with a kind
of certainty about the operation of the start-up, since she can monitor the running of the
business. Control also works as an incentive for venture capitalists since the risk of the
investment is lower when the investor has the power to affect the decisions in the company.
The alignment of control rights through contracting has always played a vital role in the
deals between the venture capital firms and the entrepreneurs. As it was aforementioned, if
venture capital firms had no power over the decision making of their portfolio companies, their
investments will be significantly less in number and will be shifted to the later stages of a
company in order to avoid the high risk associated with the early stages and the high
information asymmetries. Financial contracting can prevent unwanted situations by avoiding
future re-negotiations that can harm the holding rights of the parties and can also limit to an
extent the results of inefficient liquidation events, when the firm is cash-strapped.75
Despite the fact that all these practices and measures are addressed to reduce
opportunism from the entrepreneur’s side, it seems that sometimes they could promote
opportunism from the venture capitalists’ side. During the last years, the extensive contractual
constraints on the entrepreneur in order to balance the information asymmetries have put him
in a less favorable position compared to the venture capitalists. This idea will be further
72 Sorenson, O. and Stuart, T. (n.d.). Syndication Networks and the Spatial Distribution of Venture Capital Investments. SSRN Electronic Journal.
73 Admati, A. and Pfleiderer, P. (1991). Robust financial contracting and the role of venture capitalists. Stanford, Calif: Graduate School of Business, Stanford University.
74 Gompers, P. and Lerner, J. (2001). The Venture Capital Revolution. Journal of Economic Perspectives, 15(2), pp.145-168.
75 Berglof, E. and von Thadden, E. (1994). Short-Term versus Long-Term Interests: Capital
Structure with Multiple Investors. The Quarterly Journal of Economics, 109(4), pp.1055-1084.
23
discussed in the next chapters along with the general idea of how contracting between the
entrepreneur and the venture capital firm should evolve in order to better serve innovation.
3.2 Introduction to the term sheet
Among the most popular documents in venture capital deals with the entrepreneurs is
the term sheet. The term sheet defines the frame of the proposed terms of the deal and serves
two purposes; on the one hand it contains a large number of financial and legal terms that will
be part of the final deal and on the other hand it describes in detail the amount of capital
financing and the value of the deal.76 The parties negotiate over the terms which will be the
guide in order to draft all the legal documents that are necessary in order to complete the
transaction. Despite its importance, term sheet is legally non-binding except for the provisions
that are explicitly mentioned as legally binding.77 These are the provisions which usually
define confidentiality issues, provisions about exclusivity during the negotiation of the deal
and other fees, such as the legal expenses of the parties.78
The parties are generally expected to act in good faith during the negotiations over the
provisions of the term sheet, but especially in this type of deals trust is of high importance.
Taking into account the difficulties created by the information asymmetries, the parties have
to try harder in order to balance their interests. Plus to this, the venture capital investment is
not limited only to the financial contribution, but also to the non-financial. Hence, the
establishment of a trustful and reliable relationship is crucial for the future, in order to avoid
disagreements that could negatively affect the growth of the company.
In addition to this, the reputation of the venture capital firm which is the leader investor in
the deal can also play an important role to the extent that the provisions signed are binding
for the parties. Usually in practice, reputed firms after the negotiation part and the signing of
the term sheet, will base on the agreed terms and will try to follow the timetable in order to
finish the deal on time.79 Any breach of the agreed terms could hurt the relationships between
the parties and even cancel the deal. Indeed, for a young company, the termination of a
signed term sheet with a reputed firm could have a really negative impact, especially if the
termination was caused by a breach on its side as it could discourage future venture capital
firms to invest in the company.
76 Wilmerding Alex, Term Sheet and Valuations: An Inside Look at the Intricacies of Term Sheets & Valuations (Aspatore Books 2003) 7
77 Ibid 10 78 The British Business Angels Association and Eversheds LLP improving the Investment Process:
The standard legal documents and how to use them. (draft 2008).12 79 Ibid 10
24
3.2.1 The role of the term sheet
Someone could question the importance of the term sheet in the negotiation process
since, as it was mentioned above, it contains in its biggest part legally non-binding provisions.
However, used as an outline for the future relationships of the parties, it is easy to understand
its importance when the deal is still in the negotiation phase.
In business practice, when the parties have agreed upon some specific provisions on the
term sheet they are expected to work on this direction and complete the deal. They have a
“moral” duty to comply with the agreed terms and finish the deal.80 In addition to this, during
the negotiations over the term sheet some really important terms for the future of the company
are discussed and since they are agreed, they are considered as binding for the parties. One
of these is the pre-money valuation of the company. This is really crucial for the young firm,
since the amount of the real investment as well as the real stake that each party will hold in
the company is affected by the pre-money valuation. For instance the option pool, as every
company needs to attract and employee valuable individuals, can largely affect the equity
percentage of the entrepreneur in the company based on the pre-money valuation. It is then
understood why it is important to focus and work over the term sheet and even if it is legally
non-binding the parties have to stick to it in order to avoid future conflicts.
Another point that is really important and is defined during the negotiations of the term
sheet is the anti-dilution provisions for the investors. A detailed analysis will follow on the next
chapter, but is important to underline at this point its role in the future financing rounds.
Specifically, the anti-dilution provisions signed in the term sheet at the time of the initial
investment in the first round of financing can largely affect any future investment rounds in
the company. Additional financing in the future is vital for every young firm as additional capital
will be needed to cover the expansion expenses of the company. However, the success of
the future financing rounds is basically relied upon the terms agreed during the negotiation of
the term sheet with the first investors. For instance, if the initial investors have achieved to
get a full ratchet clause in the term sheet, then in a down round the equity stake of the
entrepreneur will be highly diluted and new investors might be discouraged to invest when a
that clause applies.
Therefore it becomes clear why the term sheet is an important document in the venture
capital deals as it affects not only the relationships between the entrepreneur and the initial
investor but also any future investments in the company. An overview of the most common
terms of a term sheet in venture capital deals will follow in the next chapter, before the analysis
80 The British Business Angels Association and Eversheds LLP improving the Investment Process: The standard legal documents and how to use them. (draft 2008).12
25
-in chapter 4- of what could help re-define the term sheet today that information is easily
spread and asymmetries are more limited than in the past.
26
4 The Term Sheet
An overview of the most common terms included in a term sheet will make it easier to
understand how the relationships between the parties in a venture capital deal are regulated.
The control rights will be aligned based on the provisions agreed in the term sheet. Generally,
when venture capital firms make an investment in a young firm, they will ask for power based
on two factors; economics and control.81 By economics they refer to the exit, meaning the
time when they will be able to liquidate and get a return on their investment.82 As discussed
before, a successful exit is the ultimate goal for every investor and all the issues related to
this are defined already at the time of the initial investment. Control refers to the rights that
investors will ask in order to ensure that they will have the power to affect the running of the
business or to veto decisions not complying with their interests.83
Based on this categorization, the analysis of the terms will be grouped into three
categories; economic provisions, control provisions and then an analysis of other provisions
not falling in any of these categories will follow.
4.1 THE ECONOMIC TERMS
4.1.1 The Price/Valuation of the deal
Among the most important parts of a deal which is a matter of negotiation between the
parties is its price and it is equal to the amount of financing received by the company; the
most common measure used is the “price per share” ratio that shows the analogy between
the amount of money invested to the equity received in respect; sometimes, though, the price
of the deal is also mentioned as the valuation of the company.84
Valuation is further categorized in pre-money and post-money valuation. As pre-money
is defined the valuation of the company before the investment. What make things more
complex, regarding to the valuation of the company before the investment, are the hidden
factors that could affect it. For instance, the option pool, that every company has in order to
attract and motivate valuable employees, is counted in the pre-money valuation, thus
lowering respectively the value of the company before the investment. The option pool is
usually 15% to 20%.85 Close to this are the warrants that investors usually ask when investing
in early stages. Warrant is a right for the investor to purchase a certain amount of stock
81 Feld Brad and Mendelson Jason, Venture Deals: Be smarter than your lawyer and venture capitalist (Wiley 2011) 32
82 Ibid 32 83 Ibid 32 84 Ibid 36 85 Ibid 37
27
options at a price that has already been defined for a certain period of time. Similar to the
option pool, warrants can lower the amount of pre-money valuation.
Usually in all term sheets there is a part called “Post Financing Capitalization” which
actually describes the capital allocation of the start-up following the investment.86 With this
section it is easy to find out precisely the valuation of the company before and after the
investment.
4.1.2 Liquidation Preference
A liquidation event is not necessarily a bad thing for the company as it could describe a
merger or acquisition or the change of control of the company, where investors get a return
in their investment.87 Liquidation preference is used as a mean from venture capitalists
wanting to ensure that in such an event, they will be treated more favorably than common
stockholders.88 The privileged position of the preferred stock is one aspect of the liquidation
preference. The other aspect, that can make the difference when the proceeds are shared,
is participation. Participation means that preferred shareholders will also participate in the
distribution of all the other assets of the company with the other common shareholders on a
predefined conversion ratio.89 What it is important here, is also the multiple for the
participation of the preferred shareholders. The multiple means that common shareholders
will receive the proceeds of the assets of the company only after shareholders with the
liquidation preference get x times their initial investment.90 For instance, when the preferred
stockholders have participation multiple 2x, this simply means that their participation in the
proceeds will finish only after they receive 2x their investment.
Liquidation preference can be a really challenging term, as depending on the participation
multiple, common shareholders can be left empty handed. For instance, if investors have
achieved to get participation multiple 3x, which means that they should receive three times
their initial investment before common shareholders, it is possible that no assets have left to
satisfy the latter. Especially in cases that the assets of the company are not enough, only
preferred stock will receive any returns. In addition to this, if Series A investors have a
liquidation preference, things are quite simple. However, in the next Series, when the new
investors will ask for liquidation preferences as well, the interaction of their rights can be a
86 Wilmerding Alex, Term Sheet and Valuations: An Inside Look at the Intricacies of Term Sheets & Valuations (Aspatore Books 2003) 37
87 Feld Brad and Mendelson Jason, Venture Deals: Be smarter than your lawyer and venture capitalist (Wiley 2011) 43
88 Wilmerding Alex, Term Sheet and Valuations: An Inside Look at the Intricacies of Term Sheets & Valuations (Aspatore Books 2003) 42
89 Feld Brad and Mendelson Jason, Venture Deals: Be smarter than your lawyer and venture
capitalist (Wiley 2011) 42 90 Ibid 42
28
really complex issue to deal with.91 The final decision is affected by many factors, such as the
negotiation power of the parties or the flexibility of the company to seek additional financing
from other sources.
4.1.3 Pay to Play
A Pay-to-Play provision was rarely used in the past until the dot-com bubble, when it
started to gain ground in most term sheets.92 This is a provision used when the company is
in a down round and needs additional financing. When a pay-to-play provision applies, the
investor agrees to participate in the future financing rounds of the company; otherwise all the
benefits associated with the preferred stock she possesses will be lost, as her stock will be
converted into common. Depending on the aggressiveness of the term, it is an encouraging
provision for the young company, as investors at the time of their initial investment agree to
support the company in a case of a down round financing in the future. However, the success
of this provision is also relied on the type of the investors that have agreed upon this term, as
less sophisticated investors usually will not have the money to support the company in a down
round.93
4.1.4 Vesting
It is important for a young company to have all the parties involved working devotedly
especially in the early stages. Based on this idea, vesting means that all stock in the company
will be vested for a four years period.94 If a stockholder wants to leave the company before
the first year is completed, then all of his stock will be vested with the company. From the
second year and until the fourth, one can vest the stock owned monthly. This means that she
can leave the company taking part of the stock owned, in respect with the vesting percentage
applicable at the moment.
Typically, the same vesting rules apply to all the parties of the company -founders and
employees- although, for the founders there might be some differences. For instance, when
the founders have started the company a year before the outside financing they can get a
“year vesting credit”95 and after that, balance the remaining stock for three years. Vesting
rules work both for the employees as well as the founders. For the employees they work as
compensation which will be available, not immediately, but progressively giving them
incentives to work harder and stay with the company. The same idea applies for the founders,
91 Ibid 45 92 Ibid 47-48 93 Ibid 49 94 Ibid 50 95 Ibid 51
29
as if there were no vesting provisions then a founder could leave taking all of his stock, while
the remaining founders in the company would have ended up with the same ownership.
4.1.5 Employee Option Plan/Option Pool
Attracting valuable employees is a key component that can drive the company to growth.
The option pool is actually the amount of common stock kept aside in order to be used in the
future to cover needs associated with the key employees of the company and can affect its
financing.96 Typically, investors want to make sure that enough money exists in the pool in
order to cover the needs arising from employee matters, such as the insurance for the key
management. Indeed, management issues really matter to investors as they want to ensure
that managers will not be able to cash out early leaving the company to search again for new
employees to hire; this is rational as the effort that they-employees and founder(s)- put in the
company is highly linked to its success.97
Another factor that makes this term important for both parties is the fact that it affects the
pre-money valuation of the company. As it was mentioned earlier, investors will ask for a
higher percentage of the pool option in the pre-money valuation in order to avoid the dilution
of their percentage post-money.98 How the option pool will be allocated is determined based
on the negotiation power of the parties and whether the entrepreneur will be able to persuade
the investors that enough money exist in the pool to cover any future needs.
4.1.6 Anti-Dilution clauses
One of the most negotiated and crucial provision in the term sheet are dilution clauses.
Additional financing rounds are crucial for the company, but depending on the valuation at
the moment the share’s price could be higher, lower or the same with the previous rounds. In
the last two cases, i.e. when there is a down round or a flat round respectively, investors want
to make sure that their investment will not be undervalued.
Anti-dilution provisions are always a highly negotiated part of the term sheet. There are
mainly two types of anti-dilution protection, the full ratchet clause and the weighted ratchet.
With a full ratchet clause investors can ensure their investment as all of their stock will be
repriced to the new price of the stock issued in the new round.99 Consequently, the
percentage of ownership of the common shareholders will be highly diluted.
96 Wilmerding Alex, Term Sheet and Valuations: An Inside Look at the Intricacies of Term Sheets & Valuations (Aspatore Books 2003) 74
97 Ibid 75 98 Feld Brad and Mendelson Jason, Venture Deals: Be smarter than your lawyer and venture
capitalist (Wiley 2011) 55 99 Ibid 56
30
Weighted ratchet clause offers a less aggressive protection to the investors than the full
ratchet. In this case, what changes in a down round is the conversion price for the preferred
stock which will be adjusted based on the calculating formula that the parties have agreed.100
This adjustment in the conversion price can balance somehow the interests of the common
and preferred stockholders. From the entrepreneur’s side a weighted ratchet clause is much
more efficient than a full ratchet, as it also affects the control of the company.
It is hard for an entrepreneur to avoid the use of anti-dilution provisions and since there
is one in the Series A, investors in the following financing rounds will ask for it as well. The
weighted scenario, though, can really help him retain his ownership and the control of the
company without endangering the additional financing rounds of the company.
4.2 THE CONTROL TERMS
4.2.1 Board Composition
The board is the main body that controls the running of the business. The majority of the
important decisions for the company are taken by the board and as a result control over the
board means control over the company. Investors will typically ask for a board representation
that will provide to the class of stockholders created after the investment, such as the
preferred stock, advanced representation.101
Typically, in an early stage company after the first round of financing there will be a five-
person board, where the founder, the CEO and the VCs will take four seats and one will be
covered by an outside board member.102 In this way, the scheme is more balanced and the
outside member can make less intense the conflicts arising in the board. A well-reputed firm,
with domain knowledge could help the company with its expertize on management issues
and strategic decisions so usually this mixed representation in the board is beneficial for the
company.
4.2.2 Protective Provisions
Control over important decisions in the company is usually exercised by the VCs with the
protective provisions. In simple words, this means that they are enabled to veto certain
decisions, if they do not comply with their interests. These decisions are mostly related to
100 Wilmerding Alex, Term Sheet and Valuations: An Inside Look at the Intricacies of Term Sheets
& Valuations (Aspatore Books 2003) 53 101 Ibid 59 102 Feld Brad and Mendelson Jason, Venture Deals: Be smarter than your lawyer and venture
capitalist (Wiley 2011) 63
31
actions that could affect the economic position of the investors, such as the issuance of new
stock, the sale of the company, external loans or paying dividends to the shareholders.103
There are several mechanisms used in order to minimize the vetoing power of VCs. One
of them is to apply a minimum threshold regarding to the amount of preferred stock owned,
that would allow the owner to exercise her veto power. Nevertheless, it is hard for the
entrepreneur to exclude completely any veto rights from the term sheet. What it is important
to do though, is try to have a single class of investors with veto rights in order to avoid conflicts
and delays in the future.104 If investors from next Series ask to have separate protective
provisions from the initial investors instead of creating a single class with them, then this could
set hurdles in the future.
4.2.3 Drag-Along Clause
A common clause that almost all VCs will ask to include in the term sheet is drag-along
agreement. By this agreement, the investors that hold the majority105 have the right to drag
the shareholders opposing to the sale of the company and complete the transaction. A typical
problem arising from this agreement is that usually the common stock will not get anything
from the transaction. This happens due to the liquidation preference of the preferred stock,
which will be satisfied completely before any other class receives money. In order to preclude
the possibility of a bad deal the entrepreneur should have that power in the board -
contractually or not- that could enable him to refuse the execution of a transaction, which will
not serve anyone but the preferred stock.106 Again here, a well reputed firm could minimize
the effects of a drag-along provision, as it will avoid any short term tactics, such as a bad deal
for the company, not to endanger its name in the venture capital industry.
4.2.4 Conversion-Automatic Conversion
Preferred stockholders, when a liquidation event, have the right to convert their shares
to common stock, if they feel that this return would be higher than keeping the benefits arising
from preferred stock and liquidation preference.107 This is most of the times a fix term in the
term sheet and no negotiation takes place over it. However, the automatic conversion has
more points to be discussed. In an event of an IPO, underwriters will ask for the conversion
103Ibid 64-65 104Ibid 66 105The majority can be either the majority of each class or the majority of the common stock based
on the conversion rate. For smaller shareholders having a majority of the total common stock instead of the preferred could be a better choice as their interests are served better along with the same class of investors.
106Ibid 69 107 Wilmerding Alex, Term Sheet and Valuations: An Inside Look at the Intricacies of Term Sheets
& Valuations (Aspatore Books 2003) 47
32
of all preferred stock to common in order to have only one class of shares when going
public.108 At this point, it is important for the entrepreneur to negotiate the power of the
preferred stock to veto a decision for a public offering if certain things are not fulfilled.109
4.3 OTHER PROVISIONS
4.3.1 Dividend Rights
Dividend rights most of the times are not a highly negotiated term in the term sheet.
Especially in early stage companies VCs do not pay that much attention, as the distribution
of dividends does not make such a difference to the investor’s returns at the moment.110
Indeed, the profits in an early stage company are not so high and most of the times they are
re-invested in the company. However, the nature of the paid dividends, whether they are in
stock or cash as well as whether they are cumulative or non-cumulative should always be
taken into consideration. Dividends paid in options, i.e. stock of the company, can have a
dilution effect.111 Plus to this, when investors have asked and signed for cumulative dividends,
this simply means that if one year the board will decide not to distribute dividends to the
shareholders, then this dividend owned for this year will be added to the dividend received in
the next distribution. Especially in a down round, the cumulative dividends can cause high
dilution and sometimes the investor, depending on the liquidation preference and
participation, could choose to receive the cumulative dividends instead, thus experiencing
higher returns.112 A favorable provision for the company regarding to the dividends’
distribution, could be to have the preferred stock receive dividends in as converted basis
along with the common stock and only when the board decides for the distribution.113
4.3.2 Redemption Rights
By redemption right, it is meant that in case that the company has not created a liquidation
event (IPO or acquisition) in a predefined time horizon, then it has the obligation to redeem
the investor’s interests in the company.114 The limited-fixed life of venture capital firms in
combination with the fact that companies could be partly successful, meaning that they are
108 Feld Brad and Mendelson Jason, Venture Deals: Be smarter than your lawyer and venture capitalist (Wiley 2011) 71
109 Ibid 74 110 Ibid 74 111 Walker, S. (2011). Demystifying the VC term sheet: Dividends. [online] VentureBeat. Available
at: http://venturebeat.com/2011/02/28/demystifying-the-vc-term-sheet-dividends/ 112 Feld Brad and Mendelson Jason, Venture Deals: Be smarter than your lawyer and venture
capitalist (Wiley 2011) 74-75 113 Walker, S. (2011). Demystifying the VC term sheet: Dividends. [online] VentureBeat. Available
at: http://venturebeat.com/2011/02/28/demystifying-the-vc-term-sheet-dividends/ 114 Wilmerding Alex, Term Sheet and Valuations: An Inside Look at the Intricacies of Term Sheets
& Valuations (Aspatore Books 2003) 44-45
33
not able to go public or be acquired, have created the need for this provision.115 However, if
a company is not capable of a public offering or an acquisition, it is of a doubt whether it is
possible to cash the investors’ interests.
Even though this provision is not so big a problem for the entrepreneur, what could
actually be a headache is the “adverse change redemption”.116 In this case, the investors can
ask for redemption when there is a material adverse change in the company. The indefinite
notion of the material event could create huge conflicts in the future and endanger the running
of the business.
4.3.3 Conditions Precedent
Investors before the closing of the deal will ask for several conditions to have been fulfilled
first. As the term sheet is in its most part a non-binding document investors want to make
sure that certain things are done before moving to the financing. Typically, conditions
precedent will include the successful completion of due diligence, the submission of all
necessary legal documents and the budget of the company for a certain time frame to be
approved by the investors.117 These conditions could set hurdles to the closing of the deal
causing uncertainty about the financing of the company. Legal fees of the other party, many
times are also included in the conditions precedent.
4.3.4 Information Rights
With the information rights is defined the frame under which the investors will have
access in documents of the company.118 Most of the times, these are financial documents
used by investors in order to check the condition of the company and consequently of their
investment. Most of the times, this term does not create any additional hurdles to the closing
of the deal or restricts the entrepreneur’s control over the company. Transparency is really
necessary for a company in order to attract new outside investors, so it should be able to
deliver these documents to the investors with no need for further negotiation.119
4.3.5 Registration Rights
Registration rights define at the time of the initial investment, how the securities hold by
the stockholders will be registered in a case of an IPO. Despite the long text that usually
115 Feld Brad and Mendelson Jason, Venture Deals: Be smarter than your lawyer and venture capitalist (Wiley 2011) 76
116 Ibid 76-77 117 Ibid 78 118 Wilmerding Alex, Term Sheet and Valuations: An Inside Look at the Intricacies of Term Sheets
& Valuations (Aspatore Books 2003) 62 119 Feld Brad and Mendelson Jason, Venture Deals: Be smarter than your lawyer and venture
capitalist (Wiley 2011) 79
34
covers the registration rights most of the times it is not a highly negotiated term as the text
used is fixed. In addition to this, registration rights will be defined clearly at the time of the
IPO, as usually underwriters will ask for different rights depending on the needs of the
company, leaving the early stage negotiation over the registration rights meaningless.120 Feld
and Mendelson humorously suggest not giving much attention to this term unless “you are
the one paying for the legal fees”.121
4.3.6 Right of first refusal/ Restriction on sales
With the right of first refusal investors have influence over the sale of shares of the
company; they can either buy these shares or deny the completion of the transaction.122 The
degree of investors’ influence could be controlled by certain minimum thresholds set, in order
to ensure that only investors with a bigger stake in the company have that right.123 It is a term,
difficult to be excluded from the term sheet, as investors want to make sure that they can
control the status of the company. Minimum thresholds along with the provision that the term
applies only to investors participating in future rounds could make the term less problematic
to the entrepreneur and the company.124
The restriction on sales is basically a right of first refusal for the sale of common stock in
a private placement.125 With the emergence of the secondary markets, in order to increase
liquidity for investors seeking to sell their securities, this provision gained more ground.126
Taking into account that the sales of securities can be somehow controlled with this provision,
the company can be more benefited rather than harmed when this provision applies in the
term sheet.
4.3.7 Co-Sales agreement
Close to the aforementioned two provisions the co-sale agreement gives the right to the
investor, when a founder sells a part of his shares in the company, then analogically she can
sell her interests too.127 It is hard for the entrepreneur to have this provision excluded from
120 Ibid 80-83 121 Ibid 82 122 Wilmerding Alex, Term Sheet and Valuations: An Inside Look at the Intricacies of Term Sheets
& Valuations (Aspatore Books 2003) 69-70 123 Feld Brad and Mendelson Jason, Venture Deals: Be smarter than your lawyer and venture
capitalist (Wiley 2011) 83-84 124 Ibid 83-84 125 Ibid 85 126 Ibid 85-86
127 Ibid 87
35
the term sheet, since typically investors want to ensure that they will be able to exit when the
founders are selling their interests in the company.128
4.3.8 Critical Overview
Having analyzed the most common terms included in a venture capital term sheet,
arguably venture capital firms ask for increased downside protection. Many terms included-
anti dilution, liquidation preference, participation and multipliers- are extensively investor
oriented, meaning that they try to secure the investor at the expense of the entrepreneur and
the company. In the first place, all these terms had as their primary purpose to enhance the
reduction of the entrepreneur’s opportunism and the mitigation of information asymmetries.
However, the aggressiveness of the terms and the catholic acceptance of investor’s favorable
provisions have turned things the other way around, leading to a reversed situation, the
investor’s opportunism. Over the years followed the dot-com bubble, the term sheet failed to
be a document balancing the information asymmetries and turned instead into a list of
provisions that makes the investor the power player. What is hard to be recognized in these
term sheets is the importance of the direct involvement of the entrepreneur in the company.
What gives life to a startup company, is the passion and enthusiasm of its founders. Focusing
only to the outside investors’ protection this valid for the company relationship was highly
undervalued.
Lately, following the evolution of the venture capital cycle, as well as the poor
performance of venture capital firms, the industry has started to redefine these relationships
and the importance of entrepreneurship in innovation and success. Social involvement as
well as a shift to the traditional venture capital model, the lean model, has triggered many
experts in the industry to ask for different terms and more flexible relationships that could
serve better innovation and growth.
The need for a re-definition of the term sheet -and proposals for this change- along with
the effects of the evolution of the venture capital cycle will be the central point of discuss of
the next chapter.
128 Ibid 87
36
5 Venture Capital 2.0
5.1 Venture Capital 2.0
Based on the information provided in the aforementioned chapters, it is obvious that
venture capital industry is changing. From the introduction of new funding models (super
angel funds, collaborative models, CVCs) to the shift of venture capital industry to its
traditional model, the transformation is apparent.
There are many reasons why things are changing. The lean model of venture capital
firms, which was introduced after the financial crisis, seems to gain ground and presents
promising returns on its investments. These new minimalist VCs try to adopt and develop the
traditional values of the venture capital model; focus not only to the expected returns, but also
work along with the entrepreneur, provide the company with their domain knowledge and not
be afraid to carry the risk associated with early stage companies.129 These smaller funds,
according to the latest data130, are demonstrated among the most active venture capital firms
in early stages, while more established firms tend to invest in later stages. When the venture
capital firm has a relatively small portfolio, then it can easier monitor its progress and
contribute its domain experience to the young company. Most of the times, serial
entrepreneurs run these smaller venture capital firms, thus it is easier for them to recognize
opportunities. At the same time, the young company can be benefited by their life experience
in the field and more quickly translate it into a higher potential for growth. The evolution of the
venture capital model has triggered changes in the contracting behavior of investors as well.
In particular the domination of the idea that there is no industry without the entrepreneurs has
caused a shift to more entrepreneurs’ friendly terms with less power over the company for
the investors. It seems that after decades of restraining contract provisions and enhanced
control and economic power for the investors, trust is restored.
Indeed, the meaning of trust in the relationships between venture capitalists and the
entrepreneur has a broad impact on the way that a deal will be closed and how the power will
be balanced among the parties. What is different now compared to the previous years is that
venture capitalists tend to be more socially extrovert; internet and social media, blogs and
online platforms have played a crucial role on this. It is interesting to see how the more active
social behavior of venture capitalists has affected the way that the industry works and how
129 McCahery, Joseph A. and Vermeulen, Erik P. M., Venture Capital 2.0: From Venturing to
Partnering (May 2, 2016). European Corporate Governance Institute (ECGI) - Law Working Paper No. 315/2016; Lex Research Topics in Corporate Law & Economics Working Paper No. 2016-2. Available at SSRN: http://ssrn.com/abstract=2773622 or http://dx.doi.org/10.2139/ssrn.277362236
130 Ibid 35 (Table that shows the performance of young and established venture capital firms
depending on the stage of the investment both in US and Europe).
37
the entrepreneurs have adapted to this new situation following the insights disclosed by the
venture capitalists. Information is no longer a privilege laid on one party’s hands, but it is
spread among the different players in the industry in order to educate and make the
entrepreneurs more aware of the opportunities given to them. Excessive control rights seem
to be replaced by the establishment of a trustful environment, where the venture capitalist
works along with the entrepreneur for a common goal.
5.2 The role of social media in entrepreneurship
The growing influence of social media in our lives is inevitable. According to a GWI
(Global Web Index) research on social media presented in the “Telegraph” “the average
person has five social media accounts and spends around 1 hour and 40 minutes browsing
these networks every day, accounting for 28pc of the total time spent on the internet”.131 The
same research indicates that YouTube is the most famous social platform with Facebook
following ahead.132 As you can see in table 1 among the category of social media Facebook
is the leader, with Instagram, twitter, snapchat and WhatsApp follow with respectively lower
percentages.
Table1
131 Davidson, L. (2015). Is your daily social media usage higher than average?. [online] Telegraph.co.uk. Available at :http://www.telegraph.co.uk/finance/newsbysector/mediatechnologyandtelecoms/11610959/Is-your-daily-social-media-usage-higher-than-average.html
132 Ibid
38
Source:Adler, E. (2016). Social Media Engagement: The Surprising Facts About How Much Time
People Spend On The Major Social Networks. [online] Business Insider. Available at:
http://www.businessinsider.com/social-media-engagement-statistics-2013-12?IR=T.
Based on these data, it is beyond doubt that the impact of social media and social
networking in people’s lives is tremendous. Following this trend, the venture capital industry
has started to adapt and venture capitalists are now more open and socially active on their
social media accounts, sharing information with their network and followers. This shift from
the introvert social behavior of the past years has created a more transparent environment
regarding the venture capital industry. Indeed, competition among venture capitalists is
enhanced in an effective way for the entrepreneurs as venture capitalists now are also
“judged” by their presence and saying in social media, thus building a stronger social and
more trustful network.
Venture capitalists use mostly blogging as well as twitter in order to express their
thoughts, comments and insights about the industry with some of them have created a really
powerful network with thousands of followers.
5.3 The evolution of VCs extrovert in social media
When first venture capitalist Fred Wilson, in September 2003, uploaded his initial blog
post on his personal AVC.com blog, then a whole new era for venture capital blogging has
just started. Progressively venture capital blogging became popular among the industry.
Many venture capitalists created their own blogs uploading on a regular basis more and more
posts related to the industry and entrepreneurship. Mark Suster, Bill Gurley, Ben Horowitz,
Brad Feld are only some of the active VCs that use their personal blogs to communicate with
their readers. What is interesting to underline is the fact that many of the active VC bloggers
are founders or managing partners of the most successful venture capital firms, such the
Atlas Venture, Andreessen Horowitz and 500 Start-ups.133 Thus, blogging in venture capital
industry is not just a trend followed by a small number of venture capitalists, but it is popular
among the top ranked VCs. This results to more professional and reliable posts that give
insights, comments and opinions over related to the industry issues.
Close to blogs, venture capitalists started to use twitter in order to share their thoughts
with their followers or comment on up to date issues. Twitter gives the opportunity to the
followers to watch the interaction of the VCs’ tweets, as it is easy to follow a live conversation
among top ranked VCs on a related issue and get a global view on it. Indeed, the impact of
the VCs’ tweets is linked to the number of followers they might have. Considering that for
133 Wikipedia. (2016). Medium (website). [online] Available at:
https://en.wikipedia.org/wiki/Medium_(website)
39
instance Jason Calacanis, venture capitalist who has invested in several promising start ups,
has more than 220k followers on twitter is easy to understand the impact a tweet might have
due to the size of his network.
Compared to the past, that all this information was only available to a small group of
people, today is completely different. Published articles on journals and magazines are widely
replaced by the online articles. Everyone with internet access has the potential to reach all
this information, which was only available to a limited number in the past. Thus,
entrepreneurs, among others, have a unique opportunity now to learn and educate
themselves based on the information revealed online by sophisticated and experienced
investors.
Following the large success and influence of social media, the last years there is a tension
to gather all this available information that exist in VCs’ blogs and their twitter accounts in one
platform so they will be more easily accessible to their followers. Indeed, if one wants to follow
the blog posts of several VCs, he has to visit their separate web pages. Twitter on the other
hand, offers a uniform platform, but tweets are strictly up to 140 characters, which means that
only small comments are available to the followers instead of full texts. A representative
example of this tension for larger online platforms, where all the information and articles will
be uploaded with no size limitations, is Medium.
Medium, is an online platform for publishing professional and nonprofessional articles
regarding several issues, not precluded to a specific field; it is a type of “social journalism”
which attracts an impressive number of readers daily.134 The power of this kind of platforms
is impressive, taking into account the number of the subscriptions and followers a person
might have as well as the free accessibility of all uploads instantly through the platform.
Information is no longer a privilege, but it is widely spread to anyone. Venture capitalists,
seem to have a particular interest on this platform as many have created accounts and upload
relevant articles, which otherwise were accessible only through their personal blogs. Indeed,
there is a shift from the personal blogging to medium and VCs tend to be more active in the
latter. The impact an article might have or not, among other things, is widely depending on
the number of people that will read it. This is exactly the point where Medium intervenes as
VCs who use it to upload their articles can have a big impact according to their followers, who
will then read their text. Taking into consideration that some VCs, like Gary Vaynerchuk have
more than 120k followers on Medium it is easier to understand its importance.
134Wikipedia. (2016). Medium (website). [online] Available at
:https://en.wikipedia.org/wiki/Medium_(website)
40
5.4 The impact of VC’s social extrovert in entrepreneurship
This analysis aims to address the importance of social media and social platforms in
entrepreneurship from an informational point of view. In chapter 2 of this paper, we analyzed
the problem of information asymmetries between venture capitalists and the entrepreneurs.
The whole idea behind the regulation of this relationship was entrepreneur’s opportunism and
the analogous demand for control from the investors. The structure of this relationship was
based on the suspicious environment, where business was difficult due to the ambiguous
relationships of the parties. Information was a privilege on the entrepreneur’s side and
investors were willing to take all kind of measures to protect them from this opportunism.
However, things are changing. Information now is spread and things seem to be more
transparent. Venture capitalists share their knowledge and experience more easily than in
the past. Entrepreneurs, who want to take their chances with venture capital financing, are
now more informed about the industry and how it works. Through social media, venture
capitalists educate entrepreneurs on related issues and give an insight on information that
was totally private among the venture capital firms in the past. The size of this influence is
somehow calculable based on the popularity of the VCs’ in social media. The biggest the
audience one addresses to, the biggest the impact she might has. Having in mind the time
that each person spends daily on social media, it is not hard to imagine that this impact is, in
all aspects quite impressive.
In addition to this, positive competition among VCs in terms of popularity, generally,
enhances the quality of the information provided. People are not only judged based on their
work, but also on what they publicly upload. In these platforms, where the interaction between
the VCs is instant, peer review is inevitable. VCs are judged on what they upload not only by
their followers, but also by other VCs. As a result the information is filtered and entrepreneurs
could also benefit from it. Credibility is a key issue and VCs with continuous presence on
social media will try to avoid any misstatement that could hurt their reputation.
This situation creates a more transparent and easily accessible environment for
entrepreneurs seeking financing. The vague idea behind venture capital industry of the past
is no longer exist. Entrepreneurs have the possibility, to adjust their businesses and behavior
based on this information for the benefit of their company. There is a restoration of the idea
that VCs work along with the entrepreneurs for the same goal. Both want the company to
succeed for their own reasons. But the result is the same; built through venture capital
financing a growth company generating higher returns for all stakeholders.
Consequently, VC’s social extrovert is a key point in venture capital 2.0. The
transformation of the industry, which resulted to the lean venture capital model, is highly
connected to fact that the new breed of VCs appear to be more active on social media. As a
41
result entrepreneurs can use all this information in order to enhance the possibilities of outside
financing, but also their possibilities for growth. This exchange of information could replace
progressively the extreme restrictions set in the past to regulate this relationship.
Compared to the previous years-especially after the dot-com bubble-, the relationships
of the parties are based on mutual trust, which is built by mitigating information asymmetries
through social media. Thus, entrepreneurs when come into discussions about a possible deal
with a VC have already in mind the way that they will try to set the deal and the steps that
should be followed. Based on the information disclosed and the advices published by the
social activate venture capitalists, entrepreneurs should be in a position to absorb this
information and adjust respectively. As a result a more transparent and trustful relationship
is established and the VCs will ask for less extensive control rights.
5.5 The impact of VC’s social extrovert on the Term Sheet
The core idea behind this analysis regarding the active VCs in social media is the
establishment of trust. The restrictive control and economic terms was a result of the trustless
environment where the venture capital financing was taking place due to the information
asymmetries. Having explained why trust nowadays is partly restored the negotiation of the
term sheet is moving to the same direction.
The industry seems to now understand that the ecosystem cannot work without the
entrepreneur. VCs through their posts have explained the confusing concept of some terms
that were usually put the entrepreneur in a less favored position. The latter is now more
informed and prepared for these negotiations, since he has understood the meaning of the
terms and what he is willing or not to accept. At the same time, venture capitalists, when
negotiate for a term sheet, are less aggressive and open for less strict provisions.
For instance when it comes to liquidation preferences, as it was mentioned in chapter 3,
it was common for VCs to ask for multipliers that could minimize common shareholders’
returns in favor of the preferred stock. Recently, due to the aforementioned changes investors
tend to avoid multipliers as a result of the lower information asymmetries, as they face less
risk on their investment. This results to more incentives for the entrepreneur, as he knows
that he has higher economic perspectives. Indeed, it seems that investors are now more
positive to accept more entrepreneur’s friendly terms in the term sheets.135 Of course, this
does not mean that VCs are not less interested to high returns rather that they believe that
135 McCahery, Joseph A. and Vermeulen, Erik P. M., Venture Capital 2.0: From Venturing to
Partnering (May 2, 2016). European Corporate Governance Institute (ECGI) - Law Working Paper No. 315/2016; Lex Research Topics in Corporate Law & Economics Working Paper No. 2016-2.38 (figure 22 shows the declining use of liquidation preferences in the term sheets).
42
the right way to achieve them is by establishing a more trustful relationship with the
entrepreneur and work together for a common goal.
Another term that is less aggressive now, is the anti-dilution protection. Fewer investors
ask for a full ratchet, which can highly dilute the ownership percentage of the entrepreneur in
the company in case of additional financing rounds. Instead of a full, a weighted ratchet is
more friendly to the rest stakeholders and the company itself as more investors would be
willing to invest in the future if a full ratchet clause does not apply. Investors are still protected
in case of a down round and the entrepreneur can retain a higher ownership percentage.
It is obvious now, that the concept of excessive control over the invested company is
changing. Entrepreneurs seem to have understood how and what investors ask for when
negotiate for a venture capital investment. VC’s social extrovert is the key matter on this, as
through their online “discloses” they educate entrepreneurs on relevant issues thus creating
an environment of trust. The need for increased control is declining and the entrepreneur
benefits from this, as he can keep a bigger stake and control in the company. Of course, the
beneficial for the company contributions of VCs remain, but the opportunism on their side is
then reduced. Preferred stock retains some of the benefits associated with it, but not to an
extent that it excludes common stock from any returns. Relationships are balanced and
finally now venture capital seems to regain its role in the venture capital cycle, as the early
stage investor, close to the traditional model of the past.
43
6 Conclusion
Closing this analysis, it is obvious that venture capital industry is changing. The new
breed of VCs and the lean model they introduced seem to outperform compared to its older
counterparts and there are many reasons for this. The introduction of the new funding models
affected the venture capital cycle and retained the capital flow for early stage companies,
while at the same time the venture capital industry was moving to what is called Venture
Capital 2.0. Venture capital industry tried to come closer to its traditional model and the basic
values it reflects, as the funder and supporter of start-up companies with high potential for
growth.
In this transformation, social media and VCs’ extroversion are key points. Having
analyzed the structure of a VC deal and the extensive economic and control rights applied at
the expense of the entrepreneur in the term sheet, it seems that now trust is restored. In a
trustful environment, information asymmetries broaden and investments are more likely to
occur. As it is described in the previous chapter VCs through the increasing use and
disclosure in social media educate entrepreneurs on previously complex concepts and as a
result facilitate the future investments, since entrepreneurs are now more aware of and
prepared for the financing deal. Along with trust, the idea that the industry cannot exist without
the entrepreneur has changed the way that the deals are structured. This trend is also visible
in the term sheet as now VCs ask for less intensive control provisions and economic rights
working along with the entrepreneur to build high growth potentials for young companies.
It will be interesting to see in the future how this tension will continue and how the
extrovert behavior of venture capitalists will affect venture capital deals in general. At the
same time the idea of an open and more transparent industry will enable more entrepreneurs
to follow ahead and be more social active on their accounts getting precious and direct
feedback. If venture capital industry will manage through valuable disclosures mitigate
information asymmetries on the basis of positive competition among the parties involved
regarding to the reliability and truthiness of their uploads, then the transparency created
would attract more investors in the future. Of course this idea also addresses to the
relationship of the venture capital fund with its capital providers, but it is really important for
the start-up ecosystem to have more skin in the game, which will then pass to the portfolio
companies. The idea of trust is not limited to the relationship of VC with the entrepreneur, but
also applies to the relationship with the limited partners of the fund. A more transparent and
reliable industry could benefit both portfolio companies and investors. If this will be achieved,
then regulation will be less needed, since the industry will have found a way to protect
investors and at the same time boost the economic growth through the financing of young
firms.
44
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