Priced rounds offer better alignment with investors. But that alignment is not perfect - no arm's length bargain offers perfect alignment. In all investment rounds there are still key areas where risks need to be allocated between the founders and the investors. And the founders and investors approach these areas with very different perspectives. Let's start by looking at the key concerns entrepreneurs are generally thinking about.
Loss of Control
Any founder bringing investors into her company worries about loss of control, and rightly so. Investors expect a fair measure of control because they are providing money on a no-fault basis--if the company fails, the CEO has no obligation to pay them back. The equity is worthless and the investor absorbs the loss and moves on. That is why when investors approach a termsheet, they seek ways to ensure they have some control over the company's direction. And founders naturally look to limit, or at least balance, that investor control. We'll go into detail in future installments of this series, but typical tools investors utilize include board seats, protective provisions about what has to be approved by classes of stock, information rights, and potentially founder vesting provisions which allow the company to claw a founder's stock back if the founder leaves the company.
Founders also fear the dilution which comes from giving up big chunks of their company to investors. If you bring investors in, you really cannot avoid shrinking your stake in percentage terms. However if you can get the valuation right, bring great investors in, and you execute well, you should be able increase the value of your stake, even if your percentage ownership is smaller. This is really about the difference between arithmetic dilution and economic dilution. Your focus should be on trying to get the valuation where it should be, and executing well enough to achieve new value-creating milestones for each tranche of money you raise. Given that investors are always going to want significant control, worrying too much about your absolute percentage ownership is a waste of time--focus instead on growing the value of your stake.
Running Out of Money
More capital always equates to more safety and more speed. There is an art to raising just the right amounts of money at just the right times, but being unable to raise when you absolutely have to is every entrepreneur's worst nightmare. Entrepreneurs can mitigate this risk by working with investors who have a demonstrated track record of doing follow-on investments as needed, are very clear about the key milestones necessary for follow on, and are willing to help the team achieve those milestones.
Risk of Losing Stock Ownership if Fired
If a founder works hard for a couple years, but ultimately isn't a fit or is unsuccessful in his role, what happens to his stock? Allowing a departing founder to walk away with a huge chunk of stock is very dilutive to the company and its investors because the stock no longer represents value being contributed, and because it will take a big chunk of new stock to replace the founder. But being forced to give up everything you worked hard for due to reasons not fully in your control is not fair either. So the compromise that is usually struck is time-based--the longer a founder stays, the more stock he can keep when he leaves. To ensure a fair outcome, when setting up the terms of these arrangements, pay attention to the definitions used, particularly termination for "cause."
Risk of Losing Freedom Upon Departure
Founders often view markets (and careers) in pretty fluid terms. It is not uncommon for a founder to leave a company to pursue another opportunity which they discovered as a result of work for the first start-up. Issues arise when the new opportunity is competitive with the original startup. Many people think outright non-competes are too strong, too unfair, and bad for the economy (notably, the State of California which generally will not enforce them). But investors have legitimate concerns about founders stripping knowledge and value out of a funded company and then leaving to compete directly. The compromise usually lies in setting strict limits on the use of the original company's confidential information, and prohibitions against poaching employees for a certain period of time.
Security Interests and Personal Guarantees
There is more than enough risk to go around with any start-up, but founders assume some of the largest risks. In addition to investing their own money (as investors do), founders also risk their reputation and absorb the opportunity cost of foregoing other career options. However, a founder can balance these risks to a level that can be absorbed when they use equity investment to access capital because it allows them to share in the upside with limited economic exposure on the downside. In contrast, borrowing money from a lender on a non-convertible basis requires them to underwrite the downside risk with a repayment obligation. The risks are even greater if the lender wants a security interest in corporate or personal assets or a personal guarantee backed up by collateral such as the founder's house. Most founders would be wise to stay far away from giving security interests and personal guarantees--if you cannot raise money on more attractive terms than that, perhaps the idea needs more work.
Fit and Value-Add of Investors
A nearly universal concern for all founders is centered on the fit and value-add from investors. Founders are right to ask "will I like working with this investor, and will they add value beyond just money?" A related question is "will they add, um, too much value?" These are valid concerns that need to be researched carefully. Mitigate these concerns by spending time with prospective investors and checking references from other founders who have worked with them. Read up on the topic. Here are some thoughts on things to watch out for when choosing investors, working with investor groups to help you sort and find your true supporters, networking to find great investors, and working with mentors as a way of meeting potential investors.
Now that we've outlined the key concerns for founders, we can begin to tackle the investor perspective, and walk though the key deal terms used to strike the balance. Stay tuned to this series for upcoming installments.