As more and more start-ups launch, more entrepreneurs are fighting for their share of the venture capital pile. While this is great for VC firms--they celebrated increased returns across nearly all investment horizons through the summer--it's not so good for founders looking for the perfect deal.
Gary Schall, a lawyer at WilmerHale who advises tech entrepreneurs, writes in Xconomy about three sets of funding terms to avoid when you're trying to raise cash. Agree to one of these deals and you could be in for a surprise down the road.
Multiple Liquidation Preference
When you decide to sell your company, or it's otherwise liquidated, investors usually have the right to get their money back before the founders. But a multiple liquidation preference gives them much more--to the tune of 1.25 to 3 times their original investment.
"Under this scenario, the investor can realize a sizable return before the common shareholders receive anything," Schall writes. "In those situations, even where the company does reasonably well (but not great) the founders and early contributors may be left with little to nothing."
Full Participating Preferred
A full participating preferred deal means investors get their money back in the event of a sale, merger, or acquisition, plus a portion of the remaining proceeds. So that means you and other common stock holders get whatever is left after the investors get paid, which is likely not much. "Founders should be wary of participation features that are coupled with other terms (like a multiple liquidation preference) as they can be especially burdensome," Schall writes. He suggests you negociate for a non-participating preferred stock for investors. If this isn't possible, fight for a preference cap. He says that if the participation term is not included, the investor can only get his initial investment back first.
Extensive Protective Provisions
Schall says it's common for investors to request somewhere between five and 10 protective provisions. But anymore than that should raise red flags. "If the number of these provisions creeps too high, it should be cause for concern, particularly if the provisions turn over control of routine company operations to the investor, such as making cash disbursements or entering into a material contract."