Company founders aren't the only ones with critical concerns when approaching financings. Investors have their worries too. It's important for both founders and investors that the risks underlying these opposing sets of concerns be allocated appropriately between the parties. So what do founders need to grasp to understand where investors are coming from?
Deals involve dozens of different types of issues. A typical termsheet will have provisions on everything from price, size of round and option pool, to composition of the board, rights of first refusal and co-sale, through liquidation preferences, anti-dilution protection, registration rights and information rights.
Although the list can be quite intimidating for less-experienced entrepreneurs, it does not need to be overwhelming. Making sense of it all requires understanding that all of the many different term sheet issues can be boiled down into four basic groups. Within those groups, the individual provisions of the termsheet (and deal documents) can be thought of as a subset of tools used to build a negotiated balancing or risk allocation between the concerns of the founders and the investors.
The four key areas of investor concern include:
(1) Basic Deal Economics
(2) Investor Rights & Protection
(3) Governance, Management & Control
(4) Exits & Liquidity
When you organize the termsheet concepts into these buckets, it becomes easier to wrap your head around the issues and keep them straight over time. So what investor concerns are behind these short-hand names?
How Investors Think About Deal Economics
First and foremost, investors need to make sure they have the ability to earn a big enough slice of the economic pie to make the investment worthwhile on a risk-adjusted basis. Investors also want to make sure they get paid back on a priority basis ahead of the founders and other common stockholders who have been taking value out all along in the form of salaries. Investors want to put some form of a time-clock on the founders to make sure there is adequate accounting for the time value of money. And investors want to make sure employee options are managed well and don't dilute them inappropriately.
How Investors Think About Investor Rights / Protection
Once an investor has come onboard, they have to pay attention to how their position may change over time. In simple terms, investors want to make sure no future financing deals contain terms which unduly diminish the value of their investment or lead to someone moving into a superior liquidity position without paying appropriately for that right. So investors insist on some say in how future financing rounds are structured.
Why Investors Focus on Governance, Management & Control
Your investors are making very long term investments. It is not uncommon for money to be tied up 7-10 years. Investors want to know what's going on in the company during that time. They want to have some input on very critical decisions. And investors want to protect against various founder behaviors that could be damaging to the company.
What Investors Mean by Exits & Liquidity
Investors go into deals wanting to make sure they maximize the chances that they will get their money back in all possible exit scenarios, even if they have to force such a situation to occur.
Harsh or Fair?
The investor perspective may strike an observer as greedy (or at least aggressive), but are they really? When you consider how equity investment deals work, investor goals may actually be fairer than they first appear. For example, unlike lenders, who have a legally-enforceable right to be repaid (often further secured by collateral or guarantees), investors purchase equity on no-recourse terms. This means that if a company fails, the equity is worthless. Absent fraud or misdeed, equity investors have absolutely no right to be repaid. Thus investors are fully assuming the risk of failure of the venture, proportional to the amount of money they put into it.
The only way investors get their money back is when two things happen in sequence:
1. The company makes progress and becomes more valuable; and
2. An opportunity arises in which investors can sell their stock in the company to a third party for more than their original purchase price.
In that sense, equity investment can be thought of like a totally unsecured loan that the acquirer of the company repays.
Once looked at through this lens, the many provisions of a term sheet begin to make more sense and might seem quite a bit more reasonable. They provide protections for many company development potholes and speed bumps investors' experience has taught them to expect.
The termsheet negotiation process is a collaborative effort to air and address the natural tension between founder and investor concerns. However, because negotiated terms are always a function of the market and investing dynamics around a particular company at a particular time, the question of whether a given term sheet represents a perfectly fair compromise can never be answered objectively. If both parties feel it is slightly imperfect, and they both sign anyway, that's a good indication it is probably a pretty fair deal in that particular circumstance.
Next up we'll look at how concerns are addressed in the actual deal documents. Stay tuned to this series for upcoming installments.