DUISENBERG SCHOOL OF FINANCE

MEMORANDUM VENTURE LAW &

FINANCE
LEGAL ADVICE TO BRUNO FRANCOIS

Sahin, C (140499)
3/20/2015

Legal advice concerning the following questions: How to choose the right Venture Capitalist for your
company?; What are the alternatives to the Venture Capitalist?; and What is the best exit strategy for
your company?
0

Dear Bruno Francois,

As we have discussed earlier, here I sent you the legal advice concerning your company.
The advice consists of four (4) parts. The first part provides a general background on your preferences
and the features of your product(s). Based on these analyses the second part provides you the
investment strategy you should take into consideration when you are choosing your investment
partner. The last part of this advice provides you the exit strategy.
Every section has a recommendation and my main recommendation is that you dont give too much
equity away and dont accept money you dont need. You can keep control over your company as long
as you have financial independency.
Please feel free to contact me if you have any questions, comments and/or need clarifications of any
part of the advice.
Kind regards,
Cigdem Sahin

PART I: BACKGROUND INFORMATION

Concerning the valuation you have said you were willing to give up some of the equity for future
investments. In the Shark Tank show you have said you needed an amount of $90k and was willing to
give up 5% of the equity. You got several offers where the best offer was the $500k for 15% of the
equity in your company which gave you a free $320k.
Your product, Cycloramic, is a great product and during the exposure it gained in Shark Tank
Cycloramic was downloaded about 100.000x which lead to a $200k income. Currently the product has
been downloaded more than eight (8) million times [$1.99/1.99 per download] from App Store which
is 12x more than before the show.
Before you decide whether you are going to operate independently or not, you need to know the reach
and the potential of your product and/or start-up. Questions you might consider answering could be:
Has Cycloramic already reached its potential?; Are there comparable products?; Can the application
also used for other phones than iPhone (5/6)?; What is the time horizon?; Could the product
technology used by other companies?; Will Cycloramic lead to other innovative products?; and Will
you invent more innovative products like Cycloramic - which also have the same success?
In cases there is potential to be reached, such as the technology can be used by other companies; the
product will lead to other products or you will invent more products like Cycloramic, you might want
to consider a Venture Capitalist (VC) for the growth of your company. You said that you are
developing an iPhone platform where the Cycloramic technology is used and has a high probability of
success.
Before you accept a deal from a VC, my first recommendation for you is to consider having a mentor
which will help you build your company. Mentors are people who have been helped with their startup. You would like to have a strong relationship with your mentor and work closely with them. You
can compensate them by granting a small - performance based - equity for serving on the board or
acting as your personal advisor. You will retain the control over the compensation and only reward
your mentor if he/she delivers. You can also consider having a super angel investor as your mentor.
These kind of investors have micro capital funds and contribute a significant amount of their wealth
into the fund. They can monitor through the very early start-up phases which increase the probability
of being successful. Having a super angel investor would mean that you have combined your investor
and your mentor which could be very efficient and useful. You might find an angel on the AngelList
which is an online platform that matches start-ups with investors.
Note that when you are selecting your mentor, VC(s), and/or CVC(s), they have experience in
investing in start-ups in the seed and/or early stage.

PART II: INVESTMENT STRATEGY

In this part the possibilities for choosing the right investment strategy will be discussed. First,
choosing the right VC will be discussed followed by choosing the right CVC. Both of the investors
have their upside and their downside. Read these sections carefully, it will provide you an overview of
both types of investors which enables you to choose among the proposals/term sheets you have
received.
II. A. VENTURE CAPITALIST
VCs are not homogeneous and you would like to have a VC matching your needs. After the Shark
Tank show you have received a lot of offers and you want to select the best one(s). The selection
criteria is divided into: i) tangibles and ii) intangibles. Please take all parts into consideration when
you are selecting your VC(s). Also, make sure that you develop a direct relationship with the General
Partner (GP) or Managing Director (MD), because they are the ones who make the decisions
concerning your company.
I Tangibles
This part provides information about indicators reflecting the past performance of VCs. It is useful to
have an overview of what the VCs have done until present which could be a prediction of what they
will do in the future. Note that transparency is a key requirement to have access to these kinds of
information.
Reputation
The most valuable asset of a VC is its reputation which increases the added value to the invested
companies. These VCs needs to maintain their reputation and needs to returns to their investors which
enables them to raise funds more easier. VCs with a high reputation will have his term sheets accepted
and will pay less than those with low reputation. They take an average stake of 15% within their
portfolio companies. They often require a carried interest of 25% to 30% which you can use as an
indicator to find the VCs with good reputation.
Fund performance
VCs have multiple funds and will have a track record of their performance. To be able to predict the
performance of the VC it is useful to check the performance of other funds. The best VCs will have
typically multiple star funds (min. $50m in committed capital plus a value multiple of five or greater)
and a strong track records. These VCs have good relationships with their investors. Also, it is
important that the funds you are checking is consistent with the sector your company is operating.
Fund performance could be affected when a VC firm is facing a significant personnel turnover which
means that the track record might not be a good measure to predict the future performance.
Syndicate
It is common that VCs will syndicate their investment(s) amongst other investors. Here, it is important
that you insist to have a lead investor or (two) co-lead investors who are able to speak for the whole
syndicate. It is important that you select the lead investor based on their experience, know-how and
the rolodex they have regarding the sector your business is operating. They will be able to value your
product and/or company more accurate than others who dont possesses these characteristics. Also, it
is useful to choose a VC who is experienced having the lead. Having the right lead VC, helps you to
have a fair negotiation on the deal terms.
Note that communicating with your other investors will lead to broaden your network which could be
useful for other future investments.
II Intangibles
This section discusses the importance of monitoring by the VC(s) and how you will know which
VC(s) is likely to outperform other VC(s) in the future.

Monitoring
Important for you is that the VC you select will help you to find your way within the business world.
VCs monitoring your company could be a true partner. Note that VCs requiring a higher carried
interest will need more time to raise funds which leads to having less time to monitor. The value added
goes through monitoring activities: i) board membership, ii) corporate governance, iii) human
resources, iv) matchmaking and v) strategy.
Monitoring
Board Member
VC spends a
fraction of his
time as a board
member where
he
could
influence and is
aware of many
aspects of the
company.

Corporate
Governance
VC
backed
companies have
better corporate
governance
which
adds
value to the
company.

Human
Resources
VCs
evaluate
the skills of the
board
and
replace
underperformer.
Replaced CEOs
stay within the
company while
a
more
experienced
CEO

Matchmaking
VCs often use
their
network
and reputation
to make the
right
connections
which leads to
new
partnerships,
customers and
suppliers.

Strategy
VCs operating
as
advisors
within
your
companys
sector could be
wisely
used
which leads to
better decision
making.

Indications of future success

There are three key characteristics which enlarges the future success of the VCs investment: i) risk
appetite, ii) leadership and iii) exit performance.
Characteristics
Risk appetite concerns the
seeds and/or early stage
investment over the last five
years.

Leadership refers to VCs

who have actively sourcing
the deal and being the lead
investors.

Exit performance reflects

experience of the VC(s).

These characteristics can be indicated by i) visibility, ii) hyperactivity (angel investments), iii) disruptive
leanings.
Indications
Visibility takes (partially)
care of the transparency
problem and also creates an
entrepreneur-friendliness
and trust. Channels used for
this is blogging, tweeting
and other social media.
Through these media you
can understand whether the
VCs incentives aligns with
that of yours, e.g. a blog
where the downside of a
financial
instrument
(convertible
note)
is
explained.

Hyperactivity refers to VCs

who are also angel investors.
Being an angel investors
shows they are willing to
take some of the risk,
because they truly belief in
the business and try to help
the
business.
Their
incentives are aligned with
yours and creates trust
within the relationship. The
more angel investments they
do, the better. Note that the
amount they invest should
be sufficient.

Disruptive leanings refer to

becoming
more
entrepreneur-friendly which
is visible in the term sheets.
Term sheet provisions will
be discussed in part III of
this advice.

III Recommendation
I strongly recommend you to make a list of the investor(s) interested in your company and/or you are
considering to approach. Take the social media they use into consideration and categorize them in
groups where you have the leaders and followers.
You should find a lead (co-)lead investor(s) who are familiar within the sector you are operating, have
a sufficient understanding of your product, have an objective valuation for your company and where
you can built a strong relationship with. The (co-)lead investor(s) will determine the term sheet and
will be your most active investor.
II. B. CORPORATE VENTURE CAPITALIST
As an alternative to the VC you might be interested in selecting a Corporate Venture Capitalist
(CVC). The following section will give you an overview about CVCs.
I Objectives
While some large corporations seek for growth through acquisitions, some seek to generate organic
growth by obtaining innovation. The main purpose for CVCs for investing in start-ups is for strategic
reasons - where VCs invests purely for financial returns. These considerations are relative to be able
to obtain new technologies from new companies. CVCs are willing to provide the resources in return
of having a minority equity stake which provides them the window to the new technology. This
enables them to innovate and to have real options on technologies and/or business models. Thus,
CVCs are willing to build relationships with the new companies and learn about the new technology
and/or business directions which gives them the opportunity to make better investments leading to be
more competitive.
II CVCs versus CVs
There are three (3) ways where CVCs differ from VCs. Firstly; they are a subsidiary of corporations
and have one (corporate) investor whereas VCs are independent market participants. The subsidiary
will be off the balance sheet of the parent company. Secondly, CVCs investment horizon is typical
shorter than the typically 10 year horizon VCs have. Third, the 2-20 Rule which regulates the
compensation of VCs is not applicable here. CVCs managers have a fixed salary and the regular
bonus structures which lead to less incentive obtaining financial returns. The effort they put in your
company could be less than the potential what could be reached. Fourth, the parent company of the
CVCs has specialized know-how and experience of the industry. They are typically less diversified
and the managers have less freedom making decisions regarding their investments. They invest based
on a real-option model and obtain control through drag-along provisions and/or redemption rights.
This means for you that you have no control about the exit strategy they are targeting and you will not
choose you preferred exit.
III Exit strategy
To clarify the exit strategy CVCs choose for are as following: i) project is cancelled, ii) project is
incorporated in the core business of the parent company, iii) the start-up is spun-out where the parent
company maintains its connection through shareholding, or iv) start-up is spin-off where the parent
company is the main shareholder of the new company. The latter is the strategy practiced by CVCs
which means that you will hold a minority stake within your company.
IV. Dealing with the downside
CVCs may be connected to the government via a collaborative VC model where the main role of
government is to align the incentives between parties in order to stimulate corporate venturing.
Governments wants to stimulate job creation and economic growth in the country. They invests in
funds where the funds consists of a combination of financial (VCs) and strategic investors (CVCs).
The participation of the government decreases the probabilities of the downsides and increases the

probability of the upsides being realized. If you know that CVCs are participating via a governmentsponsored fund, you might want to have a look at their offer.
V Pros versus Cons
Advantages
CVCs could create value for start-ups in two
ways.

Disadvantages
There are some complications when it comes
to CVC.

Firstly, CVCs invest significantly more in

younger and riskier companies involving
pioneering technologies. These companies are
able to grow and mature with the funding
received by the CVCs.

Having a CVC invested in your company

could lead to liquidation of the funds when
there is a management change, because the
new CEO might decide that it is not worth
investing in your company.

Secondly, CVCs have an important role in

signaling the true value of firms by having
VC(s) to co-invest prior to the IPO, allowing
the start-ups accessing to various financial
market players (underwriters, institutional
investors, analysts etc.) in an earlier stage and
allowing IPO investors to obtain these
valuations of the start-ups.

Managers are less incentivized to maximize

financial returns, are independent and will try
to maintain control about the exit-strategy.

CVCs are changing their investment strategy

from venturing towards partnering which
means that their intention is to help start-ups
and create a long run relationship.

Also, these kinds of funds are the first to be

liquidated when the parent company is
underperforming. CVCs have a short term lifecycle and are lasting only for one year which
might be due to herd behavior, lack of interest,
less incentivized managers, lack of internal
know-how, internal politics, disappointed
performance, ineffective governance structures
and regulatory issues (e.g. taxation).
In addition, it is argued that CVCs are strategic
investors which might also lead to acquiring or
liquidating your company.

VI Recommendation
It seems to be difficult to have a strong relationship build upon trust with CVCs due to the strategic
objectives and the low incentivized compensation structure of the managers of CVCs.
When you have an offer from a CVC and the funding is structured via a subsidiary, I recommend you
not to accept it. The main objection for this is that there is no reputation risk for the parent company.
When the CVC is participating via a government-sponsored fund and there is reputation risk involved,
the offer might be attractive to be considered. Be aware of the rights they are claiming within the term
sheet and take also the exit strategy they are targeting into consideration.
Make sure that their targeted strategy fits yours and do remember the downsides of having a CVC as
an investor/partner.

PART III: TERM SHEET

When an investor, a VC or CVC, sees (some) potential in your company he/she will offer you a term
sheet. They will say that the term sheet is not binding, but your signature on this document is crucial.
By signing you have approved the investor(s) to do a due diligence. The key provisions set in the term
sheet are very important and set a ceiling for you not to negotiate for more favourable terms when the
real financing agreement will be closed. The aftermath of the due diligence will provide the investor(s)
to deviate from the proposed term sheet when their valuation is less than before the due diligence. The
investor will request a set of documents concerning your company. Be prepared for this. In addition,
some investor(s) may use plain English term sheets, others not. Where the simple term sheets are easy,
the plain English will be difficult to understand. However, the content may be the same and the most
important provisions you should be aware of will be discussed below.
I Valuation
The valuation concerns the price the investor(s) are willing to pay for the stake they will hold in your
company. A higher price for a share is always better than a lower one. However, there are cases to
accept a lower share price value if other terms are more founder favourable. A second capital raising
will affect the valuation of your company. Earlier investors will have protection through anti-dilution
provisions whereas you will not have such protection which means that you will be diluted.
II Liquidation Preference
Be careful with the provision concerning the liquidation preference. This provision defines the
division between the common stock which you are holding and the type of stock the investor(s) are
holding. Mostly investor(s) choose to be a preferred shareholder. The liquidation preference will be a
multiple of the amount invested. If this number is large and unrealistic you probably will have nothing
when the investor(s) will exit your company. Keep in mind that the lower the liquidation preference,
the better for you.
III Financial instruments
The term sheet will propose a financial instrument which the investor(s) will hold during their
investment.
The term sheet could propose that the investor(s) will have a participating preferred stock which
provides them to have their liquidation preference and based on their ownership they will participate
as a common stockholder. If you are confronted with this type of instrument and you dont have
another option, propose a cap which puts a ceiling to the amount they will get. The entrepreneurfriendly investor will not propose for this financial instrument.
It is better to have a proposal of a non-participating preferred stock. In this case the investor(s) have
to choose either getting the liquidation preference or participating pro-rate with the common stock
holders (after converting into common).
The preferred stock provision could also contain terms like cumulative dividends. Be aware that this
means that the investor(s) will have rights to dividends accumulated during the investment they have
made. They will get their proportion of the profits before anything is distributed to you. The
entrepreneur-friendly investor will not include such provision.
Convertible notes are short term debt which converts into equity upon closing of Series A financing.
investor(s) might argue that the valuation of the company at that moment is unnecessary and it is the
cheapest and fastest way to finance. At the moment of conversion investor(s) will minimize the
valuation of the company whereas you want to maximize it. To align the incentives you might
consider proposing a cap. The investor will negotiate that the cap is set at his/hers valuation for your
company and will negotiate for a discount when Series A comes in. However, these capped
convertible notes have a full-ratchet affect which means that it is not in favour of your company.

IV Control rights
There are two key considerations when it comes to provisions concerning the control rights. The
entrepreneur friendly investor will elect a board member who does not have a voting right. The right to
appoint the majority of the board is not an option. Also, be careful with voting rights which exceed the
50% of approval of the preferred shares.
V Super pro rata rights
The term sheet might give super pro rata rights to the investor which enables them to determine if a
new investor will participate in the next financing round. If you need an investor who has a certain
expertise, you will not able to benefit from this expertise without the consent of the earlier investor(s).
VI Redemption
It could be that the term sheets contains a provision where the investor has the rights to redeem the
investors stake at a specified time in the future. The entrepreneur-friendly investor would not include
such provision in the term sheet.
VII Drag-along
The term sheet may also have a drag-along provision which secures the investor(s) the exit they seek
for. The intention here is that they could exit your company even if the sale price is below the true
value of the company. In such a case you have to vote in favour of the sale, merger or other deemed
liquidation of your company.
VIII Anti-dilution
The investor(s) may have included protective provision called as full ratchet or weighted average
(narrow based). These provisions are in favour of the investor(s), but will have a significant effect on
your stake within the company. You will have a significantly diluted. When they propose such
provision propose the weighted average broad base or secure yourself an amount when they exit their
investment in your company.
IX Recommendation
When it comes to signing the term sheet dont rush. Take your time to understand the provisions and
where possible make a counteroffer. You can obtain the true intention of the investor(s) by looking at
those term sheet provisions.
Much usage of the prior explained provisions should ring a bell. Investor(s) using more founder
favourable provisions are the good investor(s) and those are the ones you want to have as your
investor(s).
The best favourable deal for you is that the investor(s) would require obtaining their initial investment
(1x liquidation preference) and a conversion right to common stock. This proposal would incentivize
them to work for the upside and that would be aligned with that of yours. However, do keep in mind
that these kinds of investors are hard to find and that you might have to settle a deal which is more
investor favourable relative to their expertise.

IV. EXIT STRATEGY

This section provides you an overview of the possible exit strategies you might consider at the end of
the investment cycle with your investors. The investors will think about exiting your company before
they invest in you, because they need to be sure of their financial returns before their investment
period expires.
I Initial public offering
You might have targeted an IPO as your exit strategy which is common for high-tech entrepreneurs.
To do an IPO your company should be big enough. If you are company is growing in the upcoming
years to such a stage like Twitter, Facebook or Groupon, there is potential to do an IPO and with that
IPO you will be able to regain control again.
In general, going and being IPO is very costly. However, it is possible to qualify your company as an
emerging growth company (EGC) under the JOBS-Act which imposes less stricter compliance rules
and is less costly. To guarantee yourself a successful IPO, you can use the testing-the-waters
provisions which enables you to communicate with professional investors and obtain their interest in
your company. Once you have done your IPO, you are able to have relieved regulatory obligations
(SOX Section 404b). An upside of an IPO is that it deals with the liquidity gap you might face in a
later stage of your company.
When you are considering the IPO, do remember that in this process there are several issues you
should take into consideration: i) timing of the IPO, ii) which stock exchange, iii) the underwriter (and
costs), iv) underpricing and V) signaling.
Normally, IPOs are done based on market timing meaning that the market needs to be (over)optimistic
(high market to book ratio). The place you do an IPO is important relative to the liquidity that
particular stock exchange could provide. The more active the stock market, the higher the chance to
convince the VCs to do an IPO. Some markets have a low trading volume, require a lot of regulatory
obligations, have high underwriter costs, have a higher underpricing and/or affected by country/sector
specific events at that moment. To signal that your company is a good one you need to take care of the
information asymmetry which means that your investors needs to be locked-up for a certain period.
Locking-up your investors will decrease the underpricing by provide trustworthiness towards the
(public) investors.
The lock-up will lead to a low median free float and is not the favorable option for the VCs. Their
objective is to exit their investment in order to maximize their financial returns. Thus, an IPO is not
the primary exit strategy of investors who want to exit your company after the investment horizon.
Note that if the investor(s) is not willing to do an IPO and proposes an qualified public offering
(QPO), they will probably, also, propose having a participating preferred share. If such case
negotiate that the participating preferred share is capped and/or propose to have a mandatory
conversion provision.
As an alternative to the IPO you might want to consider to list your company on an AIM secondary
market (AIM). These markets are self-regulated and principle based which allows you to tailor the
regulatory requirements upon your business needs. By allowing the sale of equity you can measure the
liquidity without affecting your future exit strategy.
II Trade sale
It could be the case that your company, even though it is successful, could not go public and thus have
to rely on other exit strategies, such as the trade sale. Compared to the IPO the trade sale is a more
universal exit channel and investors will prefer to have a trade sale instead of an IPO, because they can
immediately exit and arent hold up through lock-ups. They will get their liquidation preference and
can focus on other/new investments. Further, a trade sale is much more cheaper than doing an IPO.

There is no SEC registration required. Be aware that in this case you will become an employee in the
company and you will lose control.
For the trade sale the geographical location of your firm is important. Local VCs who have a network
will effectuate trade sales. In addition, a syndicate will enlarge the probability to have a trade sale,
because you have more VCs and thus a broader network.
III Remain private
You could also remain private and keep the control over your company. This option is the best way to
go if you are able to develop your company and remain financially independent. At the end of the
investment horizon you should be able to compensate your investors.
IV Recommendation
Based on the fact that you already have gained the financial independency, I recommend you to get an
investor in who can truly help you to build your company as much as possible. You will be able to
reach the potential your company has and at the end of the investment period you will know what exit
strategy is the most favourable one. You might be able to build more and high potential technologies
which can be applied on all kind of phones and your new products can have also a lot of success. If
you manage to grow like Facebook, Twitter or Groupon you will be able to do an IPO.
Key thing here is: Dont give too much equity away and dont accept money you dont need. You can
keep control over your exit strategy as long as you have financial independency.