This article highlights the potential pitfalls that can result in a founder unwittingly losing control and liquidity in their business during their negotiations when seeking funding for their company.
Here are some of the basics to review:
No. 1: Is the Term Sheet Legally Binding? Generally, no, except for legal liability in the area of confidentiality, exclusivity and costs. The intent here is to define the terms and determine if the deal has the legs to get closed between the parties.
No. 2: Valuation of Your Business: Realistically value your company’s value based on benchmarks against similar companies. A high valuation may look good on paper, but it will also raise the bar for your performance level if you want to get a future round of funding.
No. 3: Due Diligence: It’s important that the founder complete a thorough due diligence with whom they will be doing business with. One of the big concerns from venture capital and private equity sources is the founder does not take the time to complete their own due diligence on their long-term partner. Be detailed on how your investors will help your company besides just funding.
No. 4: Financial Instrument: There are generally two kinds of equity - stocks including preferred stocks and common stocks. Convertible debt notes are increasingly being used.
- Stock Classification- Preferred stock is where the investors can have unique terms and conditions that don’t apply to other classed shareholders and where voting rights tend to be unevenly distributed among common shares. Preferred stockholders benefit by having their money returned before other shareholders. It also pays a fixed dividend, is callable at any given time and can be converted to common stock at the election of the shareholder. Common stocks do not have these privileges.
- Convertible Notes- Convertible notes have become increasingly popular over a straight stock equity structure. Fundamental difference is that the convertible note is a debt instrument with provisions to convert into equity later. Convertible notes avoid valuation discussion, are cheaper and faster to negotiate than straight equity. Be aware of the CAP rate, lower discount, interest rate and when the note converts into equity and/or liquidity. These will have impact when the note is converted.
No. 5: Partner Participation Rights: There are three types, ranging in terms of their economic upside potential to investors.
- Non-Participating – Most owner friendly option. The investor must choose between straight liquidation preference or a pro-rata share of all proceeds.
- Capped Participation – As the Full (see below), but the total return from liquidation and participation rights is capped at a defined multiple.
- Full Participation - Most investor friendly. The investor first receives their liquidation preference and then a pro-rata share of any remaining proceeds.
Determine voting rights for all three types of investors.
No. 6: Pro-rata Rights: Pro-rata rights provide an option (the right, but not an obligation) for initial investors to invest in future rounds in order to maintain their ownership, which would be diluted otherwise.
No. 7: Liquidation Preference: Liquidation preferences determine the hierarchy of payout upon a liquidation event, such as a sale or merger of the company. Liquidation preferences allow investors to define the initial amount and breadth that they are guaranteed as a payout.
No. 8: Anti-dilution Provisions: This right protects an investor from equity dilution resulting from future issues of stock if the stock is sold at a lower price that what the original investor paid in. This also adjusts relative ownership percentages to prevent new stock lowering oft the investors’ stake.
No. 9: Protective Provisions: Protective Provisions grants investors veto rights that they otherwise would be unable to exercise at the board level, due to their percentage stake does not constitute a majority vote. These may include forced discussion such as a company sale, stock issuance to expenses, hiring sign-offs.
No. 11: Drag Along Rights: This clause allows investors to compel other classes of stock to agree with their voting demands for a liquidation event such as a sale, merger or dissolution.
No. 12: Right of First Refusal/Right of Co-Sale: Notifies all investors on stocks available to purchase by other investors and requires board approval of all transfers of ownership to help prevent secretive transfers of stock from happening.
No. 13: Guarantees: If the founder is required to be a guarantor, include specific language as to when and how the guarantor will be taken off the note.
No. 14: Vesting Schedule: Vesting refers to the process by which shares/equity are earned in a business over time (typically four years or fewer.) A sudden departure of a founder with vested stock leaves dead-equity on the cap table. This event could have important implications on the effects of the remaining founders and funders.
No. 15: Liquidation Preference: Liquidation preferences allow investors to define the initial amount that they are guaranteed as a payout.
No. 16: Confidentiality and Non-Compete: These prevent conflicts of interest that could arise when investors try to leverage their portfolio by sharing information or possibly investing in competing businesses. The period of this cover ranges from 2 years to 20 years (as seen in oil and gas deals.) Further, the founder wants the investor to be fully focused on ensuring their business is successful.
No. 17 Mediation/Arbitration: Unfortunately, some deals do go south. Disputes arise requiring a third party to intercede. Should this action be needed, make sure this course of action is handled in a jurisdiction most convenient to you. For example - In cases where the opposing party is out of state, you want your case reviewed in your county and state.
Marsha L. Powers is a finance and strategic development professional, author, entrepreneur and investor and the founder of Powers Advisors and Shale Capital Resources. She has been a contributing writer on Finance for Crain’s Cleveland Business for nine years. Her management consulting areas of expertise includes finance – ranging from senior debt, government finance programs to private equity, market strategy, operations, marketing communications and economic development. She’s a recognized award-winning leader with proven strategic direction and leadership to over 1500 companies, from early stage to Fortune 50 companies. You can reach Marsha at (216)965-3633, email@example.com to learn more about how she can help your company succeed.