4 terms to understand before you raise funding
We've had a lot of experience over the years of working with first-time founders raising their first rounds of institutional capital (meaning from professional investors like a venture-capitalist). Unfortunately in these circumstances there is a natural information advantage on the part of the investor that can often leave founders feeling uneasy about the process. Our goal at StartFast is to the lift the vail on theses discussions to help founders understand what's actually going on, on the other side of the table.
If you are simply looking for more information on what various investment terms mean, I recommend looking at Brad Feld & Jason Mendelson's book "Venture Deals" or if you prefer online resources there are any number of quality legal blogs that can provide insight such as Cooley.go or StartupLawyer. Our focus is instead on helping entrepreneurs understand why these terms exist, why investors put them in place, and how often times they are more about aligning incentives than they are simply investors trying to get the upper hand.
Before we dive in on a term by term basis there is something more fundamental for first time venture backed founders to appreciate. Before you take any funding, you and your co-founders have free reign (within legal limits) to govern how you want. If you want the CEO to have veto power you can do that. If you want to allow one of your co-founders to work part-time on the business you can do that too. You call the shots and calculate the trade-offs of any decision yourself.
When professional investors come on-board, corporate governance becomes much more formalized. The focus steers away from purely what's in the best interest of the founders (as the founders see it) and towards what's in the best interest of maximizing the value of the company (and returns during an exit event). There are a number of ways that those two perspectives can clash and most investment terms are really more of a way of insuring they remain aligned than a way for greedy investors to increase their slice of the pie.
So let's go over four important investment terms every founder should understand before they raise capital.
Option Pool: I know sometimes this may look like a double hit, "first I face some dilution (loss in % ownership) from the new investors and now they want to dilute me further for my employees?" How much equity % you own as a founder is important but more important is the value of that equity. Owning 10% of a company worth $100M is a lot better than owning 50% of a company worth $2M. While you need to be conscious of how you distribute equity in the company, the most important thing to keep your eye on is how the value of your company is growing in comparison because that will ultimately determine how much your equity is worth. Early employees will be fundamental to your ability to grow the company post raise. The option pool aligns their incentives and makes sure you're hiring the right type of person for that early role. Corporate types that are more interested in their 401k and vacation time are not going to have the same sense of ownership necessary from an early-employee to be successful in the role.
Liquidation Preference: There's little getting around the fact that a liquidation preference is essentially a downside protection for investors. It allows them to be the first money out when the company exits at a lower than expected valuation. In most cases anything greater than a 1X liquidation preference is something to question. Because terms like these are rarely disclosed in public information sources it can be tough to figure out what is "market standard" for your circumstance. Find a trusted source (like an advisor with investment experience in venture deals) and seek their insight. At the end of the day, so long as the company is hitting the valuation targets everyone is looking for then the liquidation preference is usually less of a concern.
Vesting: This can be a difficult subject because it is very easy to misinterpret what vesting actually is and what implications vesting actually has. Often times first-time founder's initial reaction to vesting is that it is making them "earn their equity back". That is not what vesting is. Vesting exists for one simple reason, the founders are crucial to the success of the company at an early-stage, and at this point they often still own a large majority of the company. If a founder were to leave the company for whatever reason, they could potentially walk away with as much as 40% of the company's stock! That puts all of the remaining shareholders (*including the other founders that are still involved in the company*) at a HUGE disadvantage. Not only is 40% of the stock not being used to increase the company's value (via an incentive for the founder holding those shares) but now the remaining shareholders only have 60% of the company left from which they can give away a piece to the next person they need to hire to replace the founder that left!
So let me run a scenario by you. Founders A & B each own 40% of their company and just raised a seed round where the new investors control 20%. Founder B may decide to quit, or they pass away unexpectedly, or maybe they have a horrible accident become permanently disabled and can no longer work for the company. In any of the above cases, Founder A is still left behind to run the company and still has the same growth targets they are trying to meet. The difference is, 40% of the company's stock is now owned by someone who (often times through no fault of their own) is nevertheless not contributing towards increasing the company's value anymore. Let's further assume this company was valued at $4M during their seed deal and has the potential to be valued at $100M during an exit. Yes Founder B's contribution towards building the company into something worth $4M should not go without reward (thus why they would keep any vested shares). But if they left the company at $4M and it ends up being sold for $100M 5 years later, is it right for Founder B to get the same payday as Founder A even though Founder B wasn't around to contribute toward $96M of the company's value? Vesting exists to keep everyone's incentives aligned not to short change the founders.
Anti-dilution: So long as the anti-dilution applies only to financings under a relatively small threshold (say $250,000) then anti-dilution is more about aligning incentives than investors putting their interests above the founders'. This may seem counterintuitive because anti dilution essentially insures that investors maintain the same equity percentage when the company raises small amounts of money even though the founders' equity percentage would decrease (get diluted). While that is true, the reason some early-stage investors request this is actually to provide an incentive for the founder's to keep growing the company and raise larger rounds of capital. If a company instead keeps raising small rounds of money, chances are the valuation hasn't increased much which is not in anyone's best interest. As long as the company is growing and raising larger sums of money at higher valuations, then the anti-dilution clause doesn't apply.
For first-time founders raising money, the process can be nerve-racking. Just like any other negotiation, find experienced mentors that can help to guide you, and try put yourself on the other side of table before you start reacting to proposals.
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