Five Things Entrepreneurs Must Know About an Investment Contract
So you’ve found an investor who wants to invest in your start-up. Let’s assume that this is an excellent investor who understands your company well, and has the power and know-how to help the company grow. Let’s also assume there is chemistry between you, and that you will enjoy working together over time. Why is it necessary that you pay close attention to the investment documents? What aspects should you be cautious of? As someone who has spent time on both ends of the table, I have some advice in mind.
In every investment agreement, the entrepreneurs tend to give most of their attention to the investment amount and the company valuation. Other details receive less attention, but can be more important in the long run, and can even have a significant impact on the distribution of funds when the company is sold or goes public. Some matters deserve greater focus, and some less.
Here’s a quick overview of the points you’ll see in most investment agreements:
1) Liquidation Preference
This section determines how cash will be distributed when there is a liquidity event, such as a merger, acquisition, or IPO. In certain situations (mainly exits with a relatively low price tag), the wording in this section can hold greater significance than the valuation of the company or its holding structure. The investors’ line of thought is that, in the case of a very small exit, since they risked a great amount of money, they need to get their investment back before the entrepreneurs get a piece. I must say, this is a logical argument in my opinion (I do not think the situation would be fair if reversed — if the entrepreneurs make millions while the investors lose money).
On the other hand, there are investors who ask for a large minimum repayment (such as double their investment) before the entrepreneurs receive any compensation. This structure is less common today, and I would not take it into account unless there are large gaps in the valuation of the company or the company is a high risk investment.
In general, there are two types of distribution preferences:
Participating Preferred – A situation in which the investor receives the minimum agreed upon payout, and the remainder is divided according to the amount of shares held by each partner.
Non-Participating Preferred – The investor receives the larger of either an agreed upon minimum payout, or an amount proportional to their share of the company.
My recommendation: Non-participating preferred is largely accepted today and is used by most of the leading funds in first round investments. This seems fair and appropriate to both sides.
What happens if the company’s valuation in one of the following rounds is lower than the valuation of the company today? Most investors will seek protection from such a situation. In other words, they say to the entrepreneurs: “Today you’re valuing the company at X, and we accept it, but if in a year or two the share price is lower, we want our investment to be re-calculated as if we entered at the lower value.” This condition makes sense, but it can also be destructive to the entrepreneurs and the company, especially in companies that have raised a significant amount of capital. In such a case, in the event of a Down Round, all previous investors will receive additional shares — diluting the entrepreneur’s share of the company.
The accepted solution today is known as a “broad-based weighted average,” which does not correct the full damage incurred from the decline in valuation, but it grants the investor partial compensation based on a formula that accounts for the number of shares prior to the funding round.
The real solution to the danger associated with this matter is to be careful in raising large sums of money, and to raise money only when you are convinced that it’s the right amount and valuation for the company.
3) Board of Directors Structure
Who will sit on the board? What’s the division of the board between the entrepreneurs and investors? Naturally, entrepreneurs typically have more weight on the boards of young companies, and as the company progresses and raises more funds, investors are usually added to the board.
I have come across very few situations in which resolutions are decided by a majority vote of the board, so I think the importance of this clause is less than what one tends to think. On the other hand, the personalities of those on the board, the chemistry between them, and each member’s ability to help (or disturb…) the company, is very important to me. A bad board can certainly spoil an excellent company, and vice versa.
My recommendation: It all depends on the chemistry and trust between the partners. If you get an investment from an excellent investor who adds value to the company, there is no disadvantage in having them join the board. If it’s not a good investor, simply do not accept the investment.
4) Veto Rights
Professional investors will usually require special veto rights for strategic decisions in the company and/or decisions that can change their rights. From the entrepreneur’s point of view, veto rights are likely to be perceived as aggressive. From the investor’s point of view, they certainly make sense — at the end of the day, the investors in the initial stages hold a minority stake in the company, and the company is managed daily by the entrepreneurs, so without veto rights, investors have little to no control over what happens in the company. How else can a reasonable investor avoid unilateral/unusual moves made by the company’s management?
Giving investors certain veto rights — limited to matters that are critical to the life of the company (such as changing direction or strategy, selling the company, etc.) — is an acceptable and fair solution in my opinion. With this right, a balance is struck between the company leaders’ desire to manage the day-to-day operations without disturbance, and the investors’ need for assurance that with significant issues, their opinion will be considered.
Note for further rounds: In more advanced rounds, as there are more investors around the table, make sure that veto rights are given to most investors rather than to select groups of investors. A situation in which different groups of investors have veto rights at the same time can make it very difficult for the company to function.
The meaning of this clause is that the entrepreneur’s shares will not be available to them if they leave the company soon after the date of the investment. I must admit that when I first saw this clause as an entrepreneur, I was very angry — why should my shares not belong to me in any situation? Over the years I understood the logic of the clause. In my opinion, it protects not only the investors, but largely the company’s managers as well. In the event that one of the entrepreneurs leaves the company in the first few years after the investment, the damage to the company can be fatal. The company will need to find a strong replacement that will take over the role of the departing entrepreneur, a process that is neither simple nor easy. The company will have to grant the new leader quite a few shares — what makes more sense than taking shares from the retiring entrepreneur and giving them to the one who stepped into their shoes? Moreover, how will an entrepreneur who stayed feel, knowing that their former partner, after leaving early on, holds the same stake in the company? Another issue that arises in the case of the departure of one of the entrepreneurs: If the one leaving continues to have a large holding in the ownership structure of the company, a new investor who enters the company will try to understand what happened — why did the entrepreneur leave? What does this say about the business? What does this say about and mean for the remaining entrepreneurs? From my experience, such a departure can weigh heavily on decisions made in further rounds.
My recommendation: Assuming that you, as an entrepreneur, do not plan to leave, it would behoove you to include such a clause. Try to construct a clause that will be fair to the partner who leaves, while still minimizing the harm caused to the company in the case of a departure.
This section is more important if the group of entrepreneurs is larger and/or in the event that the entrepreneurs’ did not spend a lot of time together in the past.
And finally, a word about the amount of funding raised and the valuation: It is commonly believed that it is always better to raise as much money as possible, for as high a valuation as possible. I will not go too deep into this (more on this subject in some of my earlier posts), other than to say that I don’t see this to be true. In my opinion, an entrepreneur must think of the money they raised as if they must return at least three or four times the amount to the investor. Raising too much severely limits the entrepreneur’s ability to enjoy a future exit. Even a very high valuation can be an obstacle. Think about it this way: Each round must be worth significantly more than the previous round. If it is not likely for a next round to happen in 2-3 multiples of the post money of the current round, you are putting yourself at risk.
My recommendation: Raise the amount you need, at a valuation you truly believe is fair. This will prevent trouble down the line.
I’m always happy to see an entrepreneur/investor who knows how to stand on their own, while continuing to consider the other side’s needs; who understands what is important to the other side, and knows when to compromise on their own wishes. I try to do it myself, and at the same time, evaluate whoever stands before me: Are they doing the same?
Have an easy and pleasant funding round!