What's reasonable when translating founder concerns and investor concerns into actual deal terms? If the goal is to allocate them appropriately between the parties, what does that actually look like? This article outlines some reasonable compromises to look for using the categories discussed previously. For a refresher on any of the terms see the previous article in the series.
Category 1: Negotiating Deal Economics
Company valuation is a fundamental deal term I have discussed separately at length. It is critical to collect opinions from different investors in your local market - all deal terms are local. Try to take the long view--an undiluted 100% ownership of an unfinanced business is worth less than a smaller percentage of a business with financing from quality investors.
Directly related to valuation is the size of the option pool. Investors generally want founders to set aside a larger pool. The hiring plan the key factor in building an options budget. For example, if you are raising 12 months of runway, budget the options needed for planned hires (including any directors or advisors) and add a little cushion. 10-15% of fully-diluted pre-money capitalization is a fairly typical range.
Liquidation preferences in excess of 1X are thankfully rare in mainstream financings because of the negative downstream consequences. Absent unique deals, I advise avoiding them completely. Some view participating preferred as similar to a multiple liquidation preference, however investors favor participation because, in mediocre outcomes, it provides a slight return for the significant risk undertaken. Compromises to explore include capping the maximum return at which participation can occur or automatically sun-setting participation after an up-round.
Although many deals do not include dividends on preferred stock, some investors use them to keep a time clock on an entrepreneur and ensure some compensation for the passage of time. Because interest can really add up, if you can't avoid dividends, try to keep them in the low single digit range rather than the 6-8% range commonly used.
Category 2: Investor Rights/Protection Provisions
Anti-dilution is the biggest concern and virtually impossible to negotiate away (for good reason). Its impact can be made as fair as possible by insisting that it is first calculated on weighted-average basis to reflect accurately the relative magnitude of any down-round, and second by using a very broad-based calculation of the total capitalization (including options and convertible debt) as the denominator.
Approval rights defy generalization because they are all over the map. The main consideration should be to build a good balanced board (two founders, two investors and an industry expert is an excellent formula), and to create approval mechanisms that favor consensus and collaboration rather than confrontation. Requiring super-majorities and allowing for too many single director vetoes can lead to unnecessary tension and difficult governance.
There isn't great variation in deal terms relating to transactions in the company's stock. Investors will always insist on the right to approve of (and usually participate in) any future financings. And they will pair this with a right of first refusal and a co-sale right. The best a founder can generally do is to keep the election notification windows tight and look for reasonable exemptions for hardship or estate planning. In very hot markets and later stage deals founders may be able to reserve the right to sell a little stock for personal gain, but those deals are typically negotiated as one-off arrangements.
Category 3: Governance, Management & Control Provisions
Investors consider governance provisions essential, so there is little negotiation room. Again, focus on building a good balanced board and be thoughtful about the use of veto rights, super-majorities, shareholder approval requirements and committees. It is in everyone's interest to avoid overly-cumbersome processes.
Conversely, information rights offer a rare win-win situation. Investors want regular company communication (whether it's good, bad or boring news) and it is in the company's interest to keep investors updated. Investors react very badly if the only thing they hear in a year is "I need more money." A good practice is to trade formality for frequency. During the critical early years, short informal monthly updates are more useful than formal quarterly or annual updates. Aim to agree on provisions that provide format and frequency flexibility such as quarterly, but in practice try to provide monthly updates monthly.
Founder Vesting is always a difficult issue. The damage caused by an angry founder leaving with a big chunk of stock is so undeniably great that investors will want some protection. Rather than trying to fight it, consider asking to have only a portion of your stock covered, or to have the vesting occur over a shorter amount of time. Founders can also seek relief for termination without cause situations. Also explore whether the company might be willing to purchase the stock at a price that gives you a little bit of compensation per share (though don't expect much since start-ups are chronically short on cash.)
Investors will likely not provide much flexibility with founder and employee agreements preventing use of confidential information, solicitation of customers, poaching of employees, (or, in some jurisdictions, competition). Basic agreements of this nature are another area where everyone's interests align--it is good company management.
Category 4: Exits & Liquidity Provisions
Drag-along rights are relatively non-controversial in that they protect the majority wishes from a small minority. Founders are as likely to be in the majority as not. You should be fine as long as you are careful about what constitutes a majority, and you make sure there is alignment on the acceptable exit options when choosing investors.
Redemption rights are a whole other kettle of fish, and founders would be wise to hold firm on this. Later on, many VCs genuinely need them, so the focus in those cases should be on minimizing the impact or the likelihood of a cash crunch. Try to push redemption farther into the future and establish a longer time window to pay the redemption off in installments if possible. A sale or major re-financing may still be the preferred route, but it is nice to have leeway.
Given the current rarity of IPOs, to save costs and time, registration rights in early stage financings are often as simple as "we get them if others do." If registration rights are in your deal, make sure founders are included in the registration and that the lock-ups are not unduly long. If possible, add the right to sell some founder shares in the offering, but you may not get it since it makes finding an underwriting bank harder down the road.
Negotiating reasonable terms requires sorting through a myriad of complex issues. Additionally, many of the subtleties will come out only after the term sheet is signed and attention turns to creating definitive documents. However, if you arm yourself with some reasonable compromises, and select good counsel with a lot of deal term experience, negotiating win-win terms should be far easier. This is a case where ignorance is definitely not bliss.
Stay tuned to this series for upcoming installments. Next up: tips for getting your deal over the finish line to closing.