This article was co-authored by Maynard Cooper & Gale, a prominent national law firm with a well-established startup, emerging company, venture capital, and institutional funding practice. Their team, comprised of more than 300 dedicated attorneys, work from a position of strength and efficiency throughout the U.S., with offices in leading markets including San Francisco, Los Angeles, Miami, New York, Dallas, andNashville.
They are currently working with successful startup businesses, founders, and prominent venture capital firms and their partners across the country, delivering legal counsel and advice on all facets of their business.
It’s a tough (but rewarding) time to be a venture capitalist.
If you’re at all familiar with the venture capital industry, you know it can be hard for VC's to maintain hyper-awareness of the early-stage startup scene. By the time a promising startup has come on the radar, chances are that they have already received funding and closed a substantive round.
So how does a VC stay at the top of their game? Enter venture scouts.
This post discusses in detail what aScout Program is, why it’s gaining traction in startup communities across the country, and further summarizes the key parameters if you’re considering developing your own Scout program.
What is a Scout Program?
First, we need to explore what being a scout really means. There are a variety of possibilities when it comes to how to organize scouting activity.
Venture Scouts are individuals, who are able to identify promising startups at the early stage and pass on deal flow to venture firms.They are empowered to invest small check sizes ($25K – $50K) in very early-stage companies.
In the vast majority of cases, Scouts are either highly networked entrepreneurs or known angels used by a VC firm tomaintain and scale deal flow, and gain an edge at the earlier stages of the investments lifecycle.
Some describe venture scouting as the intersection of angel investing and traditional venture capital. How it will actually lookin practice however, will depend on the VC firm.
Some funds choose to internalize scouting as part of their platform and deal flow strategy. This type of scout works as a full-time team member inside an actual fund.
These internal Scouts will lead deal flow generation by focusing quasi-exclusively on seizing every occasion to link to the ecosystem and meet as many entrepreneurs as possible.
Some funds also encourage later-stage portfolio founders to engage in scout programs as a side project, giving them an opportunity to kickstart their angel investing career.
Some VC funds may have already started to use Scouts sporadically, and in this case it’s a great opportunity to leapfrog and intensify their program. The external scout model on the other hand, has some interesting variants.
These folks are usually compensated by a portion of the carried interest (proceeds going to the general partners managing the fund upon an exit) to align scouts’ incentives with the funds.
How do Scout Programs work?
When a person signs up to be a scout, they enter into a Scout Agreement with the VC firm that outlines their duties as a scout, the investment criteria, protocol for pitching the investment to the VC, and how the scout will ultimately get paid.
While there are various ways to structure a Scout Program to be compliant with federal securities and other laws, this is an example of a common market-compliant scheme.
The scout has a duty to use the their efforts to present the VC firm with opportunities to invest in early-stage companies. The agreement may specify a target for the number of opportunities the scout should be sourcing for the VC firm.
The agreement also requires the scout to build and maintain a strong professional network throughout their timeserving as a scout. A strong network is one of the main reasons a VC firm will be interested in a particular scout in the first place. Ensuring these contacts are maintained increases the likelihood that the scout will be successful.
Finally, once the VC firm decides to invest in a particular company, the scout may have a continuing duty to advise and assist the VC firm over the lifetime of the investment.
Scouts should be mindful of how they present their authority and relationship with the VC firm to target companies. While the scout should make it clear that the potential investment is coming from the VC firm and not the scout personally, the scout also should avoid acting in a way that implies the scout is speaking on behalf of the VC firm.
Scouts should also consider what resources of the VC firm are available to help them be successful, such as training programs. Oftentimes the agreement will specify the resources and materials that the VC firm must provide to the scout to support their efforts.
The Scout agreement will provide guidelines for the type of investment the VC firm expects the scout to source.If the scout becomes aware of an opportunity that meets those guidelines, the agreement may require the scout to present the opportunity to the VC firm.
In the agreement, this obligation is referred to as the VC firm’s “right of first opportunity.”
Some agreements may even allow the scout to present the opportunity to another fund or invest on a personal basis if the VC firm does not invest within a specified time period, the right expires. However, this does vary from program to program and depends on the fund.
The investment criteria set by the VC firm includes categories such as the type of offering (e.g., pre-seed, seed,Series A), target industries, restricted industries, and investment vehicles(e.g., equity, convertible notes). This criteria sets the framework for what types of investments the VC firm will consider.
The agreement will set for the expectations for how the VC firm wants the scout to vet and present investment opportunities. The first step is typically preparing a short deal summary, which the VC firm will use to determine whether they are interested in thescout continuing to investigate the deal.
Once the scout receives the green light, the diligence process begins. The scout may conduct this process alone, with the assistance of the VC firm, or even with a “supporting scout.” The process results in an investment memorandum that will be evaluated by the VC firm’s Investment Committee and used to make a final decision on whether to invest.
If the VC firm decides to invest, a separate Compensation Agreement will be executed between the scout and the VC firm to set out the compensation terms for the deal.
While the original Scout Agreement entitles the scout to equity compensation for any deal the VC firm invests in that was sourced by the scout, the deal-specific Compensation Agreement contains the percentage interest that the scout is entitled to.
The compensation the scout receives is in the form of a profits interest, which is an equity stake in the future profits of the company (also known as carried interest).
This compensation is received upon an “exit event” by the company, which includes events such as a change in control, initial public offering, or sale of “all or substantially all” of the company’s assets.
The scout’s profits interest is typically framed as a percentage of the VC firm’s profits interest and ranges from 10% to 20% of that interest. For example, imagine a deal where total profits on an investment is equal to $100,000, the VC firm is entitled to a profits interest of 20%, and the scout is entitled to a profits interest of$10%. Upon a sale of the company or other exit event, the scout is entitled to receive 10% of the VC firm’s $20,000 allocation, which amounts to $2,000 for the scout.
VC firms should be careful to specify whether the scout is eligible for a portion of the profits from follow-on investment rounds. Most arrangements only make scouts eligible for a portion of the profits from the first-round investment.
Scouts should be aware that the profits interest is commonly the only form of compensation they are entitled to. Whether the scout is compensated at all depends entirely upon the success of the companies the scout sources.
The scout should also keep in mind that they are likely not entitled to any employee benefits or other protections available to employees.
Other Legal Issues
The agreement will also address other matters that are commonly included in employment agreements such as confidentiality rules to protect the VC firm’s trade secrets and intellectual property, rules to protect the VC firm from lawsuits arising from the scout’s conduct, and rules regarding how the relationship between the scout and the VC firm can be terminated.
Typically, the scouting arrangement is at-will, meaning the scout or the VC firm can terminate the relationship at anytime. However, the scout will still be eligible for any equity compensation owed under a Compensation Agreement even after termination.
Future of Scouting
Scouting is a trend that is on the rise in startup communities across the United States, as VC firms are eager to tap into the vast networks and on-the-ground intel scouts have on early-stage companies. While founders of successful startups were among the first scouts, the opportunity is becoming increasingly accessible to those wanting to get afoot into the VC world.
VC firms are also realizing that scout programs are a great way to bring more diverse and underrepresented groups into the industry.
Scouting is a unique structure with the opportunity for a significant win-win for both sides. The VC firm gets access to investment opportunities it otherwise would not have known about, and only has to pay for the scout if an investment is successful.
The scout is rewarded with not only the potential for a lucrative investment opportunity, but also a seat at the prestigious VC table.
For more updates on the startup investing world, join the more than 10,000 people who subscribe to the GoingVC Newsletter!