Not all investors, bankers, and lawyers realize it, but the entrepreneur is the center of the entrepreneurial universe. Without entrepreneurs there would be no term sheets and no startup ecosystem.
Throughout this book we use the terms entrepreneur and founder interchangeably. While some companies have only one founder, many have two, three, or even more. Sometimes these cofounders are equals; other times they aren’t. Regardless of the number, they each have a key role in the formation of the company and any financing that occurs.
The founders can’t and shouldn’t outsource their involvement in a financing to their lawyers. There are many issues in a financing negotiation that only the entrepreneurs can resolve. Even if you hire a fantastic lawyer who knows everything, don’t forget that if your lawyer and your future investors don’t get along, you will have larger issues to deal with, since the way your lawyer represents themselves will directly reflect on you. If you are the entrepreneur, make sure you direct and control the process.
The relationship between cofounders at the beginning of the life of a company is almost always good. If it’s not, the term sheet and corresponding financing are probably the least of the founders’ worries. However, as time passes, the relationship between cofounders often frays. This could be due to many different factors: the stress of the business, competence, personality, or even changing life priorities like a new spouse or children.
When this happens, one or more founders will often leave the business. This can happen on good terms or not, and experienced investors know that it’s best to anticipate these kinds of issues up front and will try to structure terms that predefine how things will work in these situations. The investors are often trying to protect the founders from each other by making sure things can be cleanly resolved without disrupting the company more than the departure of a founder already does.
We cover this dynamic in terms like vesting, drag-along rights, and co-sale rights. When we do, we discuss both the investor perspective and the entrepreneur perspective. You’ll see throughout the book that we’ve walked in both the investor’s and the entrepreneur’s shoes, and we try hard to take a balanced approach to our commentary. We have witnessed a lot of bad behavior on both sides of the table and will try to be clear about these difficult issues.
The Venture Capitalist
The venture capitalist (VC) is the next character in the term sheet play. VCs come in many shapes, sizes, and experience levels. While most (but not all) profess to be entrepreneur friendly, many fall far short of their aspirations and marketing campaigns. The first sign of this often appears during the term sheet negotiation.
Venture capital firms have their own hierarchies that are important for an entrepreneur to understand. Later in the book we’ll dive into all the deep, dark secrets about how VCs are motivated, how they are paid, and what their incentives can be. For now, we’ll consider VCs as humans and talk about the people.
The most senior person in the firm is usually called a managing director (MD) or a general partner (GP). In some cases, these titles have an additional prefix such as executive managing director or founding general partner to signify even more seniority over the other managing directors or general partners. These VCs make the final investment decisions and sit on the boards of directors of the companies they invest in.
Partners can be but often are not what their title says they are. Many VCs these days carry business cards with a “partner” title but are not actually partners in the firm. Instead, they are often junior deal professionals (also referred to as principals or directors) or are involved in specific aspects of the investing process, such as deal sourcing or due diligence. In some firms, which are described as full-stack VC firms, these partners help companies across a variety of dimensions, including recruiting, operations, technology, sales, and marketing, but are not decision makers in the investment process. Some firms give everyone a “partner” title regardless of whether they have decision-making authority. This is an old investment-banking trick (where everyone is at least a vice president) to try to blur the lines between GPs and non-GPs so that entrepreneurs don’t really know the seniority level of the person they are interacting with. In the case of our firm, Foundry Group, we got tired of the pomp and circumstance of the MD and GP designations and now simply call each of the decision makers “partner.”
Clear as mud? Good. As a founder, you should do your own due diligence into whom you are speaking to at any given firm. Figure out if the people you are spending time with have the authority to actually get your company the investment you are seeking. And, while we generally use the terms “managing director” and “general partner” throughout this book as the most senior partners in a firm, understand that their titles in real life could be as simple as partner. Or not.
Principals, or directors, are usually next in line. These are junior deal professionals working their way up the ladder to managing director. Principals usually have some deal responsibility, but they almost always require support from a managing director to move a deal through the VC firm. While a principal has some power, she probably can’t make a final decision.
Associates are typically not deal partners, those who can lead an investment process inside a venture fund and effectively get a company funded. Instead, associates work directly for one or more deal partners, usually a managing director. Associates do a wide variety of things, including scouting for new deals, helping with due diligence on existing deals, and writing up endless internal memos about prospective investments. They are also likely to be the person in the firm who spends the most time with the capitalization table (also known as a cap table), which is the spreadsheet that defines the economics of the deal. Many firms have an associate program, usually lasting two years, after which time the associate leaves the firm to work for a portfolio company, attend business school, or start their own company. Occasionally, star associates become principals.
Analysts are at the bottom of the ladder. These are very junior people, usually recently graduated from college, who sit in a room with no windows down the hall from everyone else, crunch numbers, and write memos. In some firms, analysts and associates play similar roles and have similar functions; in others, the associates are more deal-centric. Regardless, analysts are generally smart people who are usually very limited in power and responsibility.
Some firms, especially larger ones, have a variety of venture partners or operating partners. These are usually experienced entrepreneurs who have a part-time relationship with the VC firm. While they have the ability to advocate for a deal, they often need explicit support of one of the MDs, just as a principal would, in order to get a deal done. In some firms, operating partners don’t sponsor deals, but take an active role in managing the investment as a chairman or board member.
Entrepreneurs in residence (EIRs) are another type of part-time member of the VC firm. EIRs are experienced entrepreneurs who park themselves at a VC firm, usually for up to a year, while they are working on figuring out their next company. They often help the VC with introductions, due diligence, and networking during the period that they are an EIR. Some VCs pay their EIRs; others simply provide them with free office space and an implicit agreement to invest in their next company.
In small firms, you might be dealing with only MDs. For example, in our firm, Foundry Group, we have a total of six partners (previously called managing directors), each of whom has the same responsibility, authority, and power. In large firms, you’ll be dealing with a wide array of MDs, principals, associates, analysts, venture partners, operating partners, EIRs, and other titles. Since we wrote the first edition of this book in 2011, there has been a huge amount of title inflation among VC firms: a person who was called an associate back then might now be referred to as a partner.
Entrepreneurs should do their research on the firms they are negotiating with, in order to understand who they are talking to, what decision-making power that person has, and what process they have to go through to get an investment approved. The best source for this kind of information is other entrepreneurs who have worked with the VC firm in the past, although you’d also be surprised how much of this you can piece together just by looking at how the VC firm presents itself on its website. If all else fails, you can always ask the VC how things work, although the further down the hierarchy of the firm the person is, the less likely you are to get completely accurate information.
The Entrepreneur’s Perspective
Managing directors or general partners have the mojo inside venture capital firms. If you have anyone else prospecting you or working on the deal with you (associate, senior associate, principal, venture partner, or EIR), treat her with an enormous amount of respect, but insist on developing a direct relationship with an MD or a GP as well. Anyone other than an MD or a GP is unlikely to be at the firm for the long haul. The MDs and GPs are the ones who matter and who will make decisions about your company.