“Ask the Business Attorney”: What Are the Most Common Mistakes Startups Make Dealing with VC’s?

by Scott Edward Walker on July 28th, 2010

Introduction

This post was originally part of my “Ask the Attorney” series which I am writing for VentureBeat; below is a longer, more comprehensive version.  Please feel free to call me directly if you have any questions (415-979-9998).  Thanks, Scott

Question

My co-founder and I are crushing it, and we’re getting ready to approach VC’s for some cash.  We’re both first-time entrepreneurs, and we don’t want to make any rookie mistakes.  What are some of the common mistakes that you’ve seen guys like us make dealing with VC’s?

Answer

Obviously, that’s a pretty broad question.  Here are five quick ones:

1) Cold Calls.  One of the classic rookie mistakes is cold-calling or emailing a VC you don’t know personally; in short, you’re wasting your time.  The only way you will get a meeting with a VC is through a “warm” introduction – that is, an introductory phone call or email from a middleman (or woman) whom the VC trusts and respects.

The ideal middleman is a successful entrepreneur whom the VC has backed; investors can be good middlemen; and lawyers, accountants or recruiters may also be helpful.  As the guys at Venture Hacks so aptly put it in their book Pitching Hacks: “Getting an introduction is a test of your entrepreneurial skills.”

2) Not Doing Your Homework.  Startups often make the mistake of not doing their homework regarding the different VC firms.  Prior to approaching middlemen to make introductions, you first need to do some research and figure-out which VC firms are a good fit for your startup based on a number of different factors, including (i) their space/industry focus, (ii) their investment criteria, (iii) their fund size, (iv) their geographic focus, (v) their “sweet spot” and (vi) their track record.

You also need to do your homework (including speaking to other founders) with respect to the particular partners with whom you are interested in working, including determining their reputation, domain expertise and capacity to take-on a new deal.  (See paragraph #3 of my post “Angel Financings: Legal Tips for Entrepreneurs – Part 1.”)

3) Requesting an NDA.  Another classic rookie mistake is asking a VC to sign a Non-Disclosure Agreement (“NDA”); it ain’t going to happen.  VC’s are inundated with business plans and executive summaries and are constantly talking to entrepreneurs whose ideas may be similar to yours.  Indeed, there is no way a VC is going to risk getting sued as a result of funding a startup with a similar idea or business plan to yours.   Moreover, they would need to hire a lawyer to review and negotiate NDA’s – which from their perspective is a waste of time and money.

To the extent you have any “secret sauce” or proprietary technology that you’re concerned about disclosing, you should just not share it with the VC.  (I discuss NDA’s in detail in my post “Ask the Business Attorney: Non-Disclosure Agreements.”)

4) Obsessing Over Valuation.  Another common mistake startups make is focusing too much on valuation.  Obviously, the pre-money valuation (or “pre” as it is commonly referred to) of the company is an important deal term; however, inexperienced startups make the mistake of obsessing over pre – and will often a sign a term sheet with the VC firm that gives them the highest pre.

This is the wrong approach for two significant reasons: first, there are other important terms that affect the economics of a financing, including the size of the option pool and the liquidation preference; and second, a top-notch VC firm (like a Sequoia) can add extraordinary value to a venture.  Thus, even if they come in with a lower pre than another VC firm, a smaller piece of a huge pie is better than a bigger piece of a little pie.

As Alan Salzman and John Doerr note in Chapter 7 of the book, Startup and Emerging Companies: “Unfortunately, those actively involved with start-up companies encounter numerous instances in which the focus on [valuation] is somewhat out of balance and tends to prejudice the discussions with venture capitalists.”

5) Not Retaining Strong Counsel.  Finally, rookies often make the mistake of trying to negotiate VC term sheets (or some of the key investment terms) without having spent the time to fully understand them and/or retaining strong, experienced counsel.  Needless to say, term sheets are complex and a potential minefield for first-time entrepreneurs.  Moreover, the VC guys (and gals) spend their careers negotiating term sheets and know every term (including every nuance) inside out.

Accordingly, startups need to be smart (and demonstrate a certain level of credibility with the VC’s) by getting a good corporate lawyer involved early on, among other things, to coach and prepare them for their preliminary negotiations with the VC’s.  As I note in the comments to Mark Suster’s post, “Want to Know How VC’s Calculate Valuation Differently from Founders?”: a good corporate lawyer will also run spreadsheets/models to show the founders how the purchase price will be disbursed (i.e., the waterfall) in different M&A exit scenarios.

Conclusion

I hope the foregoing is helpful; and if you’re interested, Sachin Agarwal, co-founder of Posterous, wrote an excellent post regarding the “personal side” of dealing with VC’s: “If you can’t buy your investor a beer, don’t take their money.”  You should check it out.

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2 Responses to ““Ask the Business Attorney”: What Are the Most Common Mistakes Startups Make Dealing with VC’s?”

  1. Basic points that are often over looked! It is easy to get caught up in developing your business and over look the major points you just mentioned above.  Most also seem to be in to big of a hurry and need to slow down and do it right the first time.  Will take a look at the other articles you recommended.  

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