It often takes money to start a company—much more than what people tend to have on hand. In the grand scheme of things, very few potential founders opt to fundraise through venture capital. However, when it comes to "tough tech" startups, like those that are "spun out" of MIT's labs, that need lots of money to get going, the venture capital route makes a lot of sense.
This is a half-semester class about venture capital for current and future entrepreneurs with science and engineering backgrounds. In fact, only 30% of the class can be business students. The course is listed as a graduate course, but there are usually several undergraduates enrolled.
Venture capital firms focus on different stages of a startup's life. The earliest fundraising rounds are called pre-seed and seed, followed by Series A, B, C, and so on. These are equity rounds, meaning that investors put money into the company in exchange for equity, or ownership. (There are ways to raise money in small batches as you go without assembling a round, e.g. by issuing convertible notes, a form of debt that later converts into equity).
Liquidity events (merger, selling the company, initial public offering) are also important parts of a company's timeline. For someone like me, who's not econ-savvy, it's worth explaining that liquidation involves ownership equity becoming liquid/cash. Since the payout of money is involved, VC deals often include negotiating who gets paid how much and in what order.
The term sheet is the document that defines the deal. In any equity financing round, there's a lead investor, who takes on the role of keeping the round's other investors on the same page and and offering their term sheet template.
The term sheet is pretty short (5-6 pages) and is not a Legal Document(TM) (although, when a term sheet is signed, the deal will most likely close, unless a dealbreaker or major issue is revealed). Nowadays, there are lots of example term sheets on the interwebs.
The terms on the term sheet affect: 1) economics, and 2) control. How much money is the company worth, and how much money is being invested? In a liquidation event, who gets paid, how much, and in what order? Who owns what portion of the company? Who sits on the board of directors? How much equity do founders and employees receive, and over what timeline does it become accessible to them? These are just some of the questions that the term sheet answers.
Valuation is how much money the company is estimated to be worth. In early stage startups without metrics like revenue, this number depends on the team, market size, etc. There's the pre-money and post-money valuation, the latter of which is how much the company is valued at after the investment.
The phrase "5 on 10", for example, means that the VC is investing $5 million into a company with a pre-money valuation of $10 million. The post-money valuation will be $15 million, and the investor will own 33% of the company. This information can be represented in a capitalization table, or cap table.
Insert cap table, no cap
The option pool is what percentage of stocks will be set aside as incentives for future employees. The size of the option pool is a point of negotiation, and depends on the hires you plan to make. There are standards for how much equity to set aside, based on the roles/seniority of potential future hires.
Employee options are common stock and come out of the founders' share of the company after the investors' ownership percentage is determined. Another phrase for this fact is that the option pool is determined post-dilution (?). An implication of having a higher option pool size is that it lowers your company's effective valuation.
Vesting is the schedule at which employees, including the founders, receive(?) their stock. For example, an employee might get no stock until one year (this would be a one-year cliff), at which point they receive a fraction of it every month/quarter/year. Everyone should be on a vesting schedule: it provides incentive to stay and work, and it keeps things fair when people have to/decide to leave—they can't cash in a significant chunk of ownership a few months after getting hired.
In a negotiation, founders who've been working on the company for a while already might want credit for that work. As a result, a vesting schedule can include an upfront: stocks/ownership(?) that founders receive immediately. Vesting schedules can also be accelerated, usually by combinations of two liquidation events (double trigger). This makes sense because IPOs and selling the company are often incentivized.
Liquidation preference: participating, non-participating
Protective provisions are voting rights that exist to give preferred shareholders more control of the company even if they don't own a majority of the stocks.
Postpone discussion of valuation until later
Note valuation cap
In addition to knowing the definitions of all these terms, it's crucial to understand
Unlike a mere decade or two ago, resources for learning about venture capital abound. Although Venture Deals by Brad Feld and Jason Mendelson was the main reading for this course, I initially found it hard to grasp, so I looked for other content and found the following to be valuable: