PDF Summary:Venture Deals, by Brad Feld and Jason Mendelson

In Venture Deals, venture capitalists (VCs) Brad Feld and Jason Mendelson offer a roadmap for entrepreneurs navigating the complex world of startup financing. Feld and Mendelson, co-founders of Foundry Group, a VC firm that invests in early-stage technology companies, have decades of experience in the startup world—as both founders and investors.In the book, they demystify the process of securing VC funding by breaking down legal and industry jargon, explain the key players in the venture ecosystem, and offer practical advice.

In this guide, we’ll explain what a term sheet is, explore the benefits and drawbacks of venture loans, and help you navigate the intricacies of selling your business once you’ve taken on VC investors. Throughout the guide, we’ll supplement and challenge the authors’ ideas with insights from other financial writers and analysts, bringing a balanced perspective on how to navigate VC.

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Governance Terms: Controlling the Board of Directors

In addition to finance terms, the term sheet includes governance terms that outline how VCs will influence your company's decision-making processes. If finance terms are about money, governance terms are about power and control.

According to the authors, the composition of the board of directors is a key governance term. The board is a governing body that oversees the management and direction of a company. It’s responsible for setting broad policies, hiring top executives, and safeguarding the interests of the shareholders.

VCs often seek to influence the board of directors in various ways—for example, by securing a board seat as part of their investment deal. Securing a seat gives them a say in the company's strategic decisions, which allows them to steer its direction to match their interests.

Protect Yourself From Investor Takeovers

Some writers note that handing over board seats to VCs can pose risks to founders. One of the challenges is that founders may find themselves ousted from their own companies, as happened to Elon Musk at PayPal, Travis Kalanik at Uber, and Jack Dorsey at Twitter (now X).

Founders can, however, take steps to protect themselves. One protective measure is maintaining a majority of voting shares in your company. If you hold onto more than 50% of the voting shares, it’s much harder for VCs or other investors to force decisions without your approval. In addition, you can make founder seats irrevocable, which guarantees your involvement in the company at some level even if you lose your board majority. Finally, you can implement term limits for board seats, which enables you to replace hostile or uncooperative board members once their terms expire.

Part 2: Venture Loans

So far in this guide, we’ve been exploring term sheet items and the different factors entrepreneurs need to consider when working with VCs and exchanging company equity for startup capital. But what if you want to raise money without sacrificing equity? This requires a distinct type of venture finance called venture loans, which we’ll explore in this section.

The authors explain that venture loans, also called venture debt, are specifically designed for startups and high-growth companies. Instead of borrowing from a bank and sacrificing equity, you get loans from specialized lenders who understand the unique risks and needs of the startup world. Next, we’ll explain the biggest benefit and some drawbacks of this type of funding.

The SVB Collapse and the Risk of Venture Debt

It’s worth noting that some specialized lenders may themselves rest on a shaky financial foundation—and if you don’t choose your lender carefully, you could be putting your business at risk.

In 2023, lender Silicon Valley Bank (SVB) collapsed due to a rise in interest rates during 2022-2023 that made the bank’s heavy investments in long-term bonds untenable. It started when SVB—at the time the largest holder of deposits in Silicon Valley—had a glut of cash deposits from its tech startup clients. But since those companies already had plenty of access to cash loans thanks to low interest rates, SVB had to find other ways to invest and make money. What they chose to invest in were long-term mortgage-backed securities—a type of bond.

SVB put 56% of its total assets into these bonds, far more than most banks do. Since bond prices fall when interest rates rise, if interest rates were to rise, the value of all these bonds SVB had bought would decline. In effect, the bank was taking a big gamble that interest rates wouldn’t rise.

Then, when the Federal Reserve began raising interest rates in 2022 to combat inflation, the value of SVB’s bond holdings plummeted. As word spread about the bank’s teetering financial position, depositors scrambled to pull out their money. To meet this depositor demand, the bank had to sell its already-discounted bonds at ever-greater losses—triggering even more panic among depositors and leading to a bank run that resulted in the second-biggest bank failure in US history.

Benefit: Greater Flexibility

According to the authors, the major benefit of venture loans is that venture debt can offer greater flexibility than equity financing. The terms of the loans are often negotiable and can be tailored to suit the specific needs of your business.

For instance, you might negotiate a flexible repayment schedule. This could mean making smaller repayments in the early stages when your startup is still finding its feet, with larger payments coming due once you're more established and generating higher revenue.

Alternatively, you might arrange for repayment conditions that align with your startup's growth trajectory. For example, if you expect a significant increase in revenue after launching a new product or entering a new market, you could structure the loan so that repayments increase proportionally with expected revenue growth.

Importantly, note the authors, unlike with VCs, you’re not tied down by investor expectations about where their money should go; instead, you have more freedom to allocate resources according to what's best for your business.

Sectoral Overreliance on a Single Lender

Although many lenders have industry-specific expertise that can suit your business, the relationship between lenders and clients can become problematic when a sector becomes too reliant on one lender. For example, Ampla is a VC-backed lender focused on small direct-to-consumer brands. The company carved out a niche by offering attractive terms to small companies that often struggled to secure traditional bank loans. However, it faced financial difficulties in 2024 and consequently pinched many clients’ credit lines.

In the fallout, many businesses in the sector now face a sudden credit crunch, forcing them to seek alternative funding sources quickly. These businesses have struggled to find funding, since the terms offered by Ampla have proven hard to match in the broader market. Because this impacts many businesses in the same sector, it’s had a ripple effect on an entire retail segment.

Drawbacks

The authors warn that while venture loans offer opportunities, they also come with significant risks for your startup. You need to carefully consider these potential drawbacks before taking on venture debt. Let’s explore two major drawbacks: high cost of capital and financial covenants.

High Cost of Capital

Feld and Mendelson note that venture debt typically carries higher interest rates and fees compared to traditional bank loans. Therefore, it increases your business’s overall cost of capital—that is, the total expense of securing financing. Since it’s a more expensive form of financing in the long run, venture debt can negatively impact your profitability and cash flow, limit your financial flexibility, and potentially hinder your ability to invest in growth opportunities.

(Shortform note: Despite the high cost of capital, one analysis shows that venture debt grew from 10% of the size of the VC market in 2017 to 14% in 2022, as startups were increasingly drawn to the idea of not diluting their equity stake through VC backing. The same analysis showed that the venture debt market will grow to 20% of the size of the VC market by 2027.)

Financial Covenants

The authors also warn that venture debt agreements often include financial covenants that your startup must adhere to. These might include maintaining certain financial ratios or performance metrics. Breaching these covenants could lead to default and other serious consequences, potentially putting your entire business at risk.

Imagine, for example, that you're the founder of a tech startup, and you've secured venture debt from a lender to fuel your growth. As part of the agreement, the lender includes financial covenants that require your company to maintain a minimum cash balance of $500,000 at all times. Now, suppose there's an unexpected downturn in the market, or perhaps a key customer fails to renew their contract. As a result, your revenue takes a hit and you burn through cash more quickly than anticipated while trying to keep operations running smoothly. By the end of quarter three, you fall short of the agreed upon $500,000 minimum cash balance.

In this scenario, you've breached your financial covenant, which could trigger serious consequences—like defaulting on your loan. If you defaulted on your loan, all outstanding debt would become immediately due, and your lenders might also be able to claim assets as repayment.

(Shortform note: One alternative to dealing with lenders’ sometimes onerous financial covenants and other requirements is to finance your new business with customer cash instead of lender cash. Customer-funded models allow you to support business growth while avoiding significant debt or equity dilution. Tactics include obtaining payments in advance for services, implementing subscription models that ensure regular income, and creating urgency through limited-time offers, all of which accelerate cash flow.)

Part 3: Managing an Acquisition

Feld and Mendelson explain that receiving an attractive acquisition offer is often the end goal for many startups and their investors once the company has achieved a certain level of financial success. However, they warn that acquisition is a complex process involving multiple parties—from the acquiring company to shareholders, board members, lawyers, and other stakeholders. In this section, we’ll cover two concepts you should understand when going through an acquisition: how letters of intent work and the differences between asset deals and stock deals.

Letter of Intent (LOI)

A letter of intent (LOI) signifies a potential buyer’s serious interest in acquiring your company, indicating that they’re ready to discuss terms more formally. It outlines the basic terms of an agreement before the actual deal is finalized, laying out key elements like purchase price, structure of the deal, due diligence process, and timeline. While it’s typically nonbinding, the LOI does set the stage for deeper discussions by clarifying initial expectations and priorities between you and the buyer.

LOIs Across Countries

LOIs may be interpreted differently across different business cultures. In Western business practice, an LOI typically represents a serious commitment and a significant step toward a formal agreement. However, one American VC says that in his experience, Chinese business culture views these documents with less binding authority. On the other hand, some legal experts report that countries like Germany and China may have more legal obligations associated with the LOI compared to other places. For instance, a Chinese court might find a company liable for damages if they’re accused of negotiating in bad faith.

This divergence in interpretation across countries seems to stem from both differences in contract law and cultural differences, indicating that it’s important to understand all obligations associated with the LOI based on where you’re doing business.

Exclusivity Clauses

The authors advise you to be aware of exclusivity clauses in LOIs—terms that prevent you from engaging with other potential buyers for a certain period. Exclusivity clauses can limit your options and hinder your ability to negotiate with other potential investors for a specified period of time after presenting your pitch. This might leave you in a vulnerable position if the initial VC decides not to invest or delays the process.

Legal Challenges to Exclusivity Clauses

While courts have generally found exclusivity clauses in contracts to be legal and enforceable, there have been instances where these clauses have been challenged on grounds of being anti-competitive or overly restrictive.

One potential challenge to exclusivity clauses falls within antitrust law. If an exclusivity clause is used to restrict competition, it might be deemed illegal. For example, if a VC firm used an exclusivity clause to prevent a startup from seeking other investments in order to maintain that VC’s market dominance, that clause could be challenged under antitrust laws.

One notable example of this kind of legal challenge (albeit in a non-VC context) involved Apple, which faced class action lawsuits over its exclusive agreement with AT&T for the iPhone service when the smartphone first launched in 2007. Critics argued this exclusivity agreement was anti-competitive and violated antitrust laws.The plaintiffs, who were iPhone users, argued that the exclusivity deal effectively locked them into a contract with AT&T without their knowledge and prevented them from switching to other carriers—even when better deals or services were available, thereby limiting consumer choice.

The Due Diligence Process

If you’re OK with the terms of the LOI, you can sign it to keep things moving forward. After signing, expect the buyer to conduct a thorough due diligence process, in which they verify the information you’ve provided and assess the financial and legal health of your business. The LOI should outline what this process looks like, including its scope and expected duration.

The authors explain that due diligence can be an intensive process. To uncover any potential risks or liabilities, buyers will want to scrutinize everything from your financial records and customer contracts to intellectual property rights.

For instance, the buyer may discover that your company is involved in a legal dispute. This could be a lawsuit from a former employee claiming wrongful termination or a patent infringement claim from a competitor. These kinds of legal issues represent potential financial and reputational risks that may discourage the buyer from proceeding with the acquisition. Similarly, if the buyer discovers that major customer contracts are about to expire without any guarantee of renewal, that would impact future revenue projections and, as such, may make them think twice about the deal.

Feld and Mendelson advise you to prepare for the due diligence process well in advance by keeping detailed records of all business activities. They also suggest working closely with your legal team during this phase to ensure all requests are handled properly. Most importantly, they caution against hiding or withholding information during due diligence, since any discrepancies found could lead to renegotiation or even termination of the deal.

Theranos Illustrates the Importance of Due Diligence

Buyers and investors both put companies through a rigorous due diligence process for good reason—failure to do so can have disastrous consequences. Yet corporate history is filled with examples of a supposedly groundbreaking company dazzling investors with promises of astronomical returns—and convincing those investors to forego due diligence.

In Bad Blood, journalist John Carreyrou explains how medical startup Theranos (whose blood-testing technology was later revealed to be a fraud perpetrated by founder Elizabeth Holmes) lured investors and partners like Walgreens by taking advantage of their short-sightedness.

These investors and partners failed to perform due diligence. Walgreens reasoned that if Theranos’s innovation was real, it couldn’t risk competitor CVS taking it—so it committed to partnering with Theranos. Walgreens started building out new clinics with Theranos’s technology and, in a classic sunk-cost fallacy, refused to pull out as concerns about the startup mounted, since pulling out would have been intensely embarrassing.

Another Theranos strategy was to land big-name investors—like former Secretaries of State George Shultz and Henry Kissinger, retired US Marine Corps General (and future Secretary of Defense) James Mattis, and former US Senator Sam Nunn. By reeling in these big fish, the company was able to boost its reputation and attract overly enthusiastic investors who failed to investigate the validity and viability of the company's technology.

Asset Deals vs. Stock Deals

Feld and Mendelson outline two main types of acquisitions: asset deals and stock deals. Below, we’ll explain the differences between the two, as well as their respective implications for both buyers and sellers.

Asset Deals

The authors note that, in an asset deal, the buyer purchases specific assets and liabilities from the target company rather than acquiring the company itself. This method allows the buyer to choose precisely which components of the business they want to take on, such as equipment, intellectual property, or customer contracts, along with any associated debts or obligations. Buyers often prefer this structure when they want to select only those assets and liabilities that align with their business objectives, effectively "cherry-picking" the components that offer them the most value. This approach helps a buyer avoid liabilities or non-essential assets that might come with a full company acquisition.

(Shortform note: Acquiring companies often prefer asset deals when buying distressed companies. However, buying distressed assets requires caution. Buyers need to protect themselves from risks like fraudulent transfer claims—legal challenges saying the company sold its assets for less than their fair value to avoid paying debts. If they sell assets at a price far below their worth and can't pay their creditors, those creditors could sue, claiming the sale was a trick to cheat them out of money they’re owed.)

The authors warn that asset deals may not be such a great deal for you as the seller. This is mainly because in an asset deal, the buyer acquires only the assets of the company—not its liabilities, which you could still be responsible for. (Shortform note: On the other hand, the “cherry-picking” principle mentioned earlier can also be an advantage for the seller in an asset deal. For example, you might opt to keep assets that provide more tax incentives or retain assets that allow you to keep running your core business.)

Stock Deals

In contrast, write the authors, the buyer acquires all outstanding shares of the target company's stock—so a stock deal gives the buyer ownership of the entire company, including all assets, liabilities, contracts, and obligations. As the seller, you relinquish your shares in exchange for the agreed purchase amount, resulting in a complete transfer of ownership and operational control. In this scenario, you exit the company entirely. This tends to be more favorable for you as the seller, since you get to transfer all your company's liabilities along with its assets, leaving you free from any obligations after the sale.

Stock-for-Stock Mergers

One variation of a stock deal is a stock-for-stock merger. Instead of paying cash (as is traditional in stock deals), the acquiring company uses its own shares as currency to purchase another company.

This merger structure offers several advantages for acquiring companies. For one, it allows buyers to keep cash reserves intact and avoid taking on debt. As a result, the acquisition process is faster and cheaper, which could benefit both the seller and buyer. It also provides flexibility, as deals can combine stock and cash components to meet specific needs.