Structuring The Deal: Equity
When a venture deal is structured as a sale of equity (normally in the form of preferred stock), investors and founders must agree to the amount that your company is worth. Determining valuation in the early stages, especially pre-revenue, generally becomes a negotiation game based more on market norms than anything else. It is in the founder’s best interest for the company to receive a higher valuation, while a lower valuation is in the investor’s best interest. However, the goal for a founder is to show consistent growth in valuation over time and between financing rounds so it is important to realize that an overinflated value in an early round can be detrimental in the long run.
Although market norms are very important to understand, you should also gather the following information in preparation for meeting with a potential investor:
- Value of physical assets (if any)
- A listing of intellectual property (particularly patents)
- Attributes of founders and employees that help set your company apart from the competition
- Current customers, contracts and revenue (or your strategy for customer acquisition and revenue generation)
- Information on similar companies who have recently received funding
- Details on market size and growth projections
- Competitor research
Although the valuation of the Company is important, founders will do well to accept funds from investors based on several other factors. Taking the check is the beginning of a long relationship and it is important to build that relationship with the right investors.
Investors are inherently accepting a measure of risk when supplying capital and protective provisions give them a level of control over the company in exchange. These provisions grant investors the right to block or veto certain actions, providing them protection from getting dragged along by majority stockholders.
Investors can negotiate for consent rights as they see fit, but some of the most common protective provisions are aimed at changes to the charter and/or bylaws, sales of the company or its assets, executive compensation, increasing or decreasing the number of directors, creating and selling shares that have “better” rights than the investors have, borrowing money (or maybe a threshold).
Liquidation preference comes into play when a company is sold. Preferred stockholders receive payment before common stockholders. Many deals include a 1x liquidation preference, meaning the owner will receive the return of the original purchase price of the preferred stock, plus any declared but unpaid dividends. 2x, 5x or greater liquidation preferences are also possible, where the owner would receive 2 times or 5 times their original investment before common stockholders receive anything. However, 1x liquidation preferences are the most common.
Participating vs. Non-Participating Preferred Stock
There are two forms of preferred stock: participating and non-participating. Holders of participating preferred stock, after receiving their liquidation preference, will “participate” in the distribution of assets to the common stockholders that follows. In essence, holders of participating preferred stock get to have their cake and eat it too. If the preferred stock is non-participating, then the investor receives their liquidation preference and nothing more.
You may be wondering, “Why would anyone choose non-participating preferred stock if they just get their money back?” Which brings us to “conversion.” Almost all non-participating preferred stockholders have a right to conversion, meaning they may choose to convert their preferred stock to common stock if it works in their favor. In this case the owner may wait to see what the company is sold for, then opt to keep his/her liquidation preference OR give up the liquidation preference and convert the preferred stock into common stock (normally on a 1:1 ratio).
Now that you understand the basic financing structure, it’s important to consider your options for anti-dilution provisions. These price protection provisions are created to ensure your investor’s shares do not become overly diluted by future investor deals.When a venture capitalist invests in your company they will request assurance that you will not sell future shares at a lower price, diluting the value of their shares. Price protection provisions can be complicated and difficult to decipher, but understanding these two main variations will help you proceed.
Full Ratchet Price Protection
Full ratchet price protection means that if even one share is sold to a future investor at a lower price, the shares sold in the earlier round are essentially re-priced to the share price used in the current financing, which changes the conversion ratio. While full ratchet is relatively easy to understand, it can is very harmful to founders and is uncommon in my experience. It can also be risky for investors because it can make future fundraising more difficult.
Weighted Average Price Protection
While weighted average price protection may be complex, it is the most common and oftentimes best option. Weighted average price protection takes into consideration the number of later-sold, lower-priced shares and offers proportional protection. Most people in the venture community agree that weighted average anti-dilution protection is more appropriate than full ratchet, and you’ll rarely see full ratchet protection (at least until we start seeing more down-rounds).
Representation on the Board of Directors is a point of negotiation, depending on the investor and company preferences. In general, earlier stage investors may or may not want a board seat, while later stage deals will almost always include board representation. Depending on the size of your Board and the number of investors, investors may control a majority of the Board. The benefits of having an investor hold a Board seat can include greater access to expertise, strategic connections and industry knowledge.
Pre-emptive rights act as another form of anti-dilution protection for investors. This protection gives investors the right to participate in the company’s next issuance of securities. Normally these rights are “pro-rata”. There are variations but at the end of the day investors typically get the right to purchase whatever number of shares they need to buy to retain their ownership percentage prior to the next financing. Pre-emptive rights provide an opportunity to purchase later issuances, but does not include an obligation.