Updated: Jul 4, 2022
Day 1: You start as sole owner of the company and cash every dollar possible.
Day 365: You still own the production line and other decisions, but now since you have scaled up you may need funds from external investors.
SO, WHAT NEXT?
Funding Day: Investors like to own a slice of your company and you lose control to that extent, but you get the required funds to stay afloat.
Isn't there a middle ground to these negotiations? Could we somehow manage funds to continue operations without dilution of stake?
We summarize the key tradeoffs that arise in negotiations between investors and founders by focusing on the term sheet process. We primarily focus on the negotiations tips and tricks to be used in the initial phases of the funding rounds.
VC vs Founder Trade Off
Average loss rate for VCs range from 25% to 33%. VCs need to find ways to minimize their downside risk by placing controls on founder behavior and giving themselves an option to abandon future commitments. On the other side, founders need capital and domain network and management expertise that respectable VCs can bring along with their money. The top 2 motivations of founders are to build wealth and maintain control. The term sheets negotiated in the early stages are used as blueprints for any future rounds of funding.
Now some interesting yet unfortunate data points about the consequences of funding terms: By the time ventures turn 4 years old, 50% of the founders were no longer CEOs, moreover 80% of the replaced founder CEOs were forced to step down.
Often founders aren’t even aware the implications of subtle terms that have the potential to turn the investment against their favor. So here we uncover some of the major elements in the term sheet.
Rich- The higher the valuation the more equity the founder retains and thus the more valuable the founder’s equity as the firm grows.
Control – He should be willing to give up the higher valuations for higher share in the decisions.
2. Option Pool:
Companies must retain the ability to offer some stock options to attract new talent. Option pool is that bunch of shares set side for the employees. So, now this would affect the dilution of stake for the investors and founder. The decision to set aside this pool before or after the investment affects the economics of the funding round. Before: Founder suffer the dilution, After: Founder + Investors suffer the dilution.
Rich- This affects the percentage held by the founders, thus is extremely important for the founders to negotiate the terms properly.
Control- Equally important as this term would affect his control stake as well.
3. Liquidation Preference:
This is negotiated in 2 parts:
i. In an event of any M&A, whether investors recoup 100% of their investment or multiple, before founders receive any proceed?
ii. Whether new shares are ‘participating’, this implied whether investors would participate in the payouts, when the proceeds from the exit are divided among the common shareholders.
Rich- This term indicates how big a slice investor would take at the time of any potential merger or exit.
Control- Not that important for them.
4. Anti- Dilution Protection:
When is it used: In subsequent rounds of financing, if there is a lower price per share- lower than that originally paid by the investor? In such an event this clause will adjust the conversion rate from the preferred stock to the common stock, to preserve the original value for the company.
Eg- If the price per share is cut in half in the next round of funding, preferred stick converts to common stock at the rate of 2 to1, effectively giving investors double the voting rights.
Rich- This term becomes important only in cases when the round of funding is at a value less than the prior value. Wealth motivated founders should emphasize on removing the anti dilution provisions.
Control- This is not that important.
5. Dividend rights:
Preferred stock to accrue dividends before any other stock receives dividend.
Rich- Founders should try to push for the exclusion of all dividend rights.
Control- Not that important for them.
6. Board Composition:
Boards normally comprise of Founders, Investors, and other experts brought in for expertise. This term would define the board representation.
Rich- Not that important as they are interested in exiting with more wealth than having control over decisions.
Control- One of the most important terms to be carefully evaluated and negotiated.
7. Protective Provision:
It entails a variety of extra voting rights enjoyed by the VCs. Investors can veto certain actions and can influence decisions even without majority board representation.
Rich- Not that important.
Control- They should ideally push for no protective provision. They should negotiate terms like, if the ownership falls below certain threshold, eg- 10%, then the protective provisions stand null and void and similarly, if the ownership stake goes beyond a particular threshold, they have exhausted their limit of voting rights.
8. Drag Along Rights:
So, let’s say, a venture gets a third party interest notification, now who calls the shots here? Is it investors, or founders or some other neutral party? Furthermore, who defines that what portion of the company is open for offer, and how much do the existing investors buy in?
So, the answer is simple and binary, its either the existing investors or the founders? But then how do we decide between them?
To address these problems, this term in the term sheet defines certain thresholds that the investors should meet to be able to call the shots on matters like above.
What is to be negotiated? - It is perhaps the minimum ownership stake investors need to have to be entitled to the Drag Along Rights. Founders should ideally try for as high a threshold as possible.
IMPORTANCE CHART OF TERMS FOR CONTROL VS RICH
This article is a part of the May'21 edition of our Startup Newsletter. Here's the complete publication: