“It is, of course, cleaner to just lower the price per share, but often there are reasons (e.g., a higher-priced friends and family round) not to do so,” he adds.

If the price per share in the friends and family round is high, issuing a lower price per share in the Series A round may significantly dilute the value and holdings of friends and family investors. Seasoned angels usually try their best, within reason, to keep entrepreneurs happy. No entrepreneur wants to tell his or her friends and family that their holdings have been diluted substantially.

Discounts

Photo Credit: dizznbonn

Receiving a discount means you get to purchase shares at a lower price than the price per share for that round.

Warrants

Warrants give you the right to purchase additional Series A shares within a specified time frame.

Purchasing additional shares allows you to increase ownership and enjoy the upside if the company does well.

In cases where the company issues new shares and dilution is inevitable, exercising your warrants would help protect your percentage of ownership up to a certain amount, which would help reduce the impact of dilution. [1]

Here’s the beauty of warrants: They provide you with potential upside and dilution protection (albeit limited), but you don’t have to pay up-front. You have a choice – you can exercise them within the agreed time period, or not.

For the company, issuing warrants allows it to sweeten the deal without reducing the company’s valuation, or price per share.

Even so, warrant does come with its own set of issues. (What doesn’t?) We’ll discuss those some other time.

Exercise Price

The “exercise price” is the price you pay to purchase the warrants. The exercise price is usually set at Series A price.

Warrant Coverage

The warrant coverage is expressed as a percentage. Twenty-five percent coverage for a $750,000 Series A investment would give you the right to purchase $750,000 x 25% = $187,500 worth of additional Series A shares.

Expiration

Most warrants can be exercised from a couple of years to 10 years after closing.

In the event of an acquisition or IPO, however, warrants typically expire immediately. [2]

“Acquirors do not want to assume warrants and generally demand that warrants be exercised prior to closing,” explains Yokum Taku, corporate and securities partner at Wilson Sonsini Goodrich & Rosati (WSGR).

And “many companies prefer to have warrants expire on an IPO to eliminate the share overhang associated with the warrants.”

Seasoned angel investors always make sure the clause that gives them the option to exercise their warrants immediately before these liquidity events (e.g. M&A and IPO) is included in the agreements.

References

The minimum threshold is sometimes required as a condition to the first closing because angels want to make sure the company has raised enough money to get to the milestone. This way, even if additional closings don’t occur (i.e., the company can’t raise additional funds), it will be less likely to run out of cash during development.

Photo by: jurvetson

For example, if the startup needs $500,000 to reach the milestone, but it can only raise $250,000, seasoned investors might refuse to close because by doing so they might put their investment in jeopardy — the funds might be spent, but the startup might only be halfway through the milestone. Both the startup and the investors are doomed if the company can’t raise follow-on money on time.

Example #1

The first closing will be for at least $500,000 and will close on [date].

Example #2

Closing: As soon as practicable following the Company’s acceptance of this Summary of Terms and satisfaction of the conditions described below under “Conditions to Closing” (the “Initial Closing”). Up to two (2) additional closings may occur at any time during the 90 day period following the Initial Closing.

Image by: Stefan Baudy

* This is not legal advice. Consult with your lawyer.

Antoine Brand asks -

What is a private placement memorandum? Should Angel Investors be concerned if the company doesn’t have one?

Since many an entrepreneur has asked the same question, why don’t we look at both sides of the table and examine the role it plays in an investment deal?

Say, an up-and-coming company called Yo!Woo is undergoing rapid growth and expansion. It needs money, and it’s planning to sell securities (debt, equity, or combination of both) to 2 angels: Annice, an accredited investor, and David, a non-accredited investor.

Under the Securities Act of 1933, any company wishing to offer and sell securities must register the offering with the Securities and Exchange Commission (SEC) — unless it meets an exemption.

Regulation D (Reg D)

You see, the registration process is anything but fun. It’s costly, complex, and time-consuming.

Luckily for Yo!Woo, Regulation D contains 3 rules that exempt fund-raising companies from registering their securities with the SEC — provided that certain conditions are met. These rules are: Rules 504, 505, and 506.

Each rule has different requirements, such as investor status (accredited or non-accredited); the maximum amount a company can raise; the number of people it can raise money from; and the type of information that must be disclosed to each type of investors.

Rule 504 allows Yo!Woo to raise up to US$1 million while Rule 505 up to US$5 million. With Rule 506, Yo!Woo can raise an unlimited amount of capital. Visit their respective links to learn more.

If Yo!Woo meets the criteria of the Rule it pursues, it can offer and sell securities to Annice and David without having to register with the SEC.

Private Placement Memorandum: What Is It?

A Private Placement Memorandum (PPM, Offering, or Offering Memorandum) is a disclosure document that details the risks, terms, and other aspects of the investment opportunity. It helps prospective investors understand the potential downfalls, and it makes it clear that the transaction is speculative in nature and only those who can afford to lose the entire investment should consider the opportunity.

Yo!Woo must include factual and realistic information about the deal in the PPM, such as a summary of offering terms and subscription procedures; a description of the company; information about the management team; risk factors and conflicts of interests; and any other information that’s considered “material” by a potential investor.

Whether a PPM is required would depend on the state laws and the specific Rule (under Regulation D) a company pursues.

If the company sells securities to non-accredited investors, “then a formal private placement memorandum, similar to that filed in a nonexempt filing, has to be provided to the investors, and the seller of the securities needs to show that the investors are ‘sophisticated,’” shares Scott Shane, author of Fool’s Gold.

Private Placement Memorandum: Subscription Agreement and Investor Questionnaire

The PPM also includes a Subscription Agreement and an Investor Questionnaire. The investors, Annice and David, will need to return a signed copy of these documents and send a check to the company if they decide to invest in the company.

The Subscription Agreement is a “sales contract” for purchasing (or subscribing) the securities at agreed terms and conditions. The Agreement also confirms that the investor has received and reviewed all documentations; is aware of the risks involved; and is either an accredited or sophisticated investor.

Just as the PPM discloses Yo!Woo’s information to Annice and David, the Investor Questionnaire discloses to the company the investors’ investing sophistication, such as background, employment, and business or investment experience evidencing their capability in evaluating an investment opportunity.

Together, these documents assure Yo!Woo that Annice and David are aware of the risks and that their wealth standard or investing sophistication meets the federal and state requirements.

Next:

• Why raise money from accredited investors
• Definition of accredited investors
• PPM vs. business plan
  
• Why using a business plan to raise money could haunt entrepreneurs and co-investors
  

Image by: striatic

This is Part 4 of an 8-part series on royalty or revenue-based investment. Please visit Part 1 for links to the entire series.

“Startup funding is hooked on exits,” says Thomas Thurston, president of Growth Science International.

Thurston is right. Equity investors are “exit junkies.” Exits are how they make money.

But in the aftermath of the financial crisis, some investors are no longer so fond of the exit-dependent investment approaches they’re using.

Shrinking net worth, depressing exit environment, expanding exit timeline – investors got a rude awakening.

A number of them decided not to wait any longer. They’re determined to see some returns on their investment by testing out an investment vehicle that doesn’t depend on exits.

And there comes royalty based investment (or “royalty based financing”).

You’ve seen an example of how royalty based investment works and reviewed the debt and equity components of the vehicle. Here, we’ll take a look at the repayment structures; breeze over some basic investment terms; and talk about the kind of companies that are suitable for royalty based investment.

Royalty Based Investment: Repayment Structures

Like all agreements, everything’s negotiable. According to law firm Foley & Lardner, royalty based deals can be structured in a number of ways to satisfy investor’s return requirements based on the company’s financial realities.

For example, you may receive (a) royalty payments and interest-only payments or (b) royalty payments over a fixed period.

Either case, returns are capped at an agreed-upon multiple (e.g 3x to 5x) of your original investment. That is, the payments will keep rolling in until you’ve received, say, 5 times of your original investment.

With repayment structure (a), you’d receive interest-only payments for, say, a year or two. Upon which, the company starts repaying the principal and interest on the loan based on a set amortization schedule, plus a percentage of the company’s revenue stream, over the same time as the set loan repayment.

Repayment structure (b) excludes the interest component so you’ll have to wait longer to see your full investment returns. Also, the royalties you receive will be more susceptible to revenue fluctuations.

On the other hand, repayment structure (b) would give the company more flexibility because it doesn’t have to adhere to making fixed payments on a strict schedule. The default risk is lower since the size of the payments isn’t fixed; it’s depended on the company’s revenues.

Royalty Based Investment: Terms

Approval Rights. Foley & Lardner suggests that you’d want some approval rights on major actions that could impact the repayment of investment, since you have no control through an equity stake.

Board Seats. “Because of the nature of the investment, board presence is less critical for the investors,” states Gordon Empey of Cooley. Whether to include board seats seems more driven by the companies. Some deals include them, some don’t.

Information Rights. Empey adds that investors most likely want information rights. After all, as an investor, you may want to know how the company’s doing and make sure the royalty payments would keep coming in.

Royalty Based Investment: Target Companies

Given the nature and structure, the royalty-based model works best on companies that have no clear exits and that are relatively established.

John Hamilton, managing director at Vested for Growth, comments (emphasis added):

Earlier this year we completed a $1.6 million investment into an M&A deal with 8 Angel investors who previously turned down the same deal as equity. They were right, it was a bad equity deal because there was no clear exit. But that did not mean that it was a bad deal. Our royalty terms resolved the issues so that the companies successfully merged and the investors are participating…so far the results are exceeding projections.

We have used royalty only for established companies and our due diligence focus is on sales pipeline, management team and cash flow. As such, we would not recommend applying royalty financing to a start up. We see it as an important tool to help get growth capital to established companies.

So, to qualify for royalty-based investment, the company should have

• a solid growth plan;
• an existing product and a proven demand for the product;
• an established revenue stream;
• substantial gross profit margins that are sufficient to pay royalties; and
• a reliable and reasonably predictable revenue stream.

For example, RevenueLoan invests between US$100,000 and US$500,000 in companies with at least 50% gross margins, and between US$1 and US$10 million in annual revenue.

Similarly, Arthur Fox, the god father of royalty based investment and the founder of Royalty Capital Management, invests in “emerging companies that are doing a few million dollars of revenue a year.”

Gregory T. Huang of Xconomy reports:

[Jeff Schrock, a VC at Intel Capital,] thinks the model makes sense for certain software, gaming, and IT companies (hardware, not so much).

Or even as a growth-capital tool for life sciences companies — especially those on the verge of gaining FDA approval of their product.

It also could work for venture-backed companies whose prospects no longer merit further equity investment. There might be hundreds of those companies in a given year, Schrock says.

Note: The royalty based approach appears safer, as the target companies are relatively established. “This does not, of course, eliminate the risk that the investment is simply bad,” states GigaOm columnist Brian McConnell.

Use of Proceeds

“Royalty-based financings can be an effective bridge to profitability for companies that have already brought a high-margin product to market and are seeking to expand their distribution,” comments Jeff Joseph of VenturePopulist.

Likewise, Rockwater Capital suggests that the company should use the funds to

• launch a broader marketing strategy,
• introduce new products to the market, or
• complete commercialization of a newly created product or service.

Coming Up

Next, we’ll discuss the benefits of royalty based investment for investors.

Alliott Cole

It’s no secret that investors fight head over heels for sizzling deals and promising entrepreneurs to increase odds of success and potential returns. But when demand for quality deals exceeds supply, you better come up with exclusive, creative, or effective ways to lure the Steve Jobses of tomorrow.

How to compete for hot deals? Are startup competitions a source of quality deal flow? What are the key terms to negotiate?

From deal sourcing and picking winners to negotiating terms, Alliott Cole of Octopus Ventures shares his perspectives with Venture Hype.

Alliott Cole and Octopus Ventures

Alliott Cole is an associate director at Octopus Ventures (@OctopusVentures) and a director at the British Business Angel Association (BBAA). He’s a broad member of several startups and he devotes his time advising and discovering promising entrepreneurs at the University of Oxford society Oxford Entrepreneurs.

Octopus Ventures is an award-winning early-stage investing firm in the United Kingdom. Its model is unique in that it prefers to back exceptional entrepreneurial teams rather than specific sectors, and co-invests with a private investor group, Octopus Venture Partners, in every investment. The group of private investors is made up of 110 scientists, entrepreneurs, businessmen, and leaders of commerce who can add value to the companies they back.

* Edited interview

Sourcing Deals

VH: How does Octopus Ventures source quality deals?

AC: Most entrepreneurs — around 4,000 companies each year — come to Octopus Ventures directly or are referred to us via the Octopus Venture Partners group. We also receive many introductions via corporate financiers and other venture capital houses.

In addition, I’ve been running monthly “Open Office” sessions in Oxford for undergraduate entrepreneurs and MBA students in the last 2 years. Similar sessions are also held periodically at our London office.

We also actively reach out to entrepreneurs through panels, conferences, and networking events.

VH: Competition is fierce for hot deals. How should investors position themselves as the most suitable/preferred investors for such deals?

AC: Not an easy question to answer!

At Octopus Ventures we look to build enduring relationships with entrepreneurs and to continually help their businesses in as many ways possible.

In competitive situations, we always ask the entrepreneur to do his or her own due diligence on Octopus. We encourage them to speak to the businesses we’ve partnered with in the past. We hope this will give a candid and accurate picture of Octopus and our modus operandi.

As to how should other investors position themselves as the most suitable investor for a deal, I think it comes down to building a strong, equal, and open relationship with the entrepreneur; communicating clearly at every stage of the negotiation; and demonstrating a proven ability to add value to growing businesses.

VH: You also judge startup competitions like the Innovate!100 competition held in March. What do you think of this type of deal flow?

AC: I love meeting entrepreneurs. Their enthusiasm and conviction is inspiring and infectious. If you add in the pressure and expectation of a pitching competition, you often witness something very special.

I’m always impressed by entrepreneurs who can thrive in this environment, articulating their proposition concisely and with force. I think these events provide a great source of deal flow for investors. I try to attend them as often as possible.

Picking Winners

VH: What do you look for in the businesses you invest in?

AC: For the most part, Octopus invests in companies that have revenues but may not be beyond breakeven.

We believe that the team is the single most important factor. We look for effective, inspiring individuals who can infect those around them with excitement and passion of their proposition.

Second to this, we look for companies that can scale quickly into big businesses addressing large markets.

Finally, these companies must resonate with the Octopus Venture Partners group.

To this end, the business must be simple to understand, has a product or service of value, with a clear route to market and a defined customer.

Negotiating Terms

VH: How does the negotiation process work?

AC: Octopus Ventures looks to build strong partnerships with entrepreneurs from the outset and the negotiation process is a critical element of this.

We provide detailed and lengthy heads of terms so that the entrepreneur can negotiate all of the critical terms of an investment at the same time — before committing his or her business.

Someone once described this process as moving in ever decreasing circles until both parties come together at an agreed focal point. We like to do this face to face and in an open and frank manner.

If the process becomes too difficult, we’ll agree to disagree and step away from the negotiation. It’s not in the interest of the entrepreneur or Octopus to force a partnership if either party isn’t directly aligned with the other.

VH: From an investor’s perspective, what are the key terms to negotiate? Why?

AC: The valuation of the business and structure of the investment are key terms.

It’s critical for all stakeholders in a business to negotiate terms that aren’t only fair and workable for the present but also for the future.

Early-stage companies often require several rounds of finance. Entrepreneurs and investors should be careful not to agree to terms that might make the business unattractive for follow-on investment (e.g. unrealistic first round valuations; complex distribution rights; ratchets and/or anti-dilution provisions) or misalign stakeholders when there are key strategic decisions to be agreed (e.g. on an exit).

It’s also important to strike the right balance on governance and ensure that nothing will prohibit efficient decision-making and action.

VH: Entrepreneurs and investors often disagree on valuation. How do you go about negotiating a realistic valuation with these entrepreneurs?

AC: Investment structures like ratchets and distribution preferences can be used to bridge these gaps, but they run the risk of misaligning the stakeholders in the business. And such structures may lead to bigger problems at a later stage.

With this in mind, a frank and fair agreement is always preferable but there’s no quick and easy route to arrive at this outcome.

The reader writes -

How do you prevent being washed out as you keep pro-rata and the numbers get increasingly bigger?

Suppose you invest $200k for 25%. The venture then raises $5m, so to keep pro rata you do $1.25m of that round. Then it raises $15m. Eventually it gets hard to follow you money and you get diluted down significantly.

We’ve covered dilution in an up round in Part 1 and examined dilution in a down round in Part 2. Here, we’ll go over some of measures you can take to lessen the impact and/or likelihood of getting burned by dilution. If this topic is new to you, you may want to read the basics in Part 1 and Part 2 before proceeding.

Note: Not all of the measures below can be taken simultaneously. Sometimes it’s either A or B, but not both. Talk with a lawyer who’s very experienced with startups and angel financing to gain a better understanding of the terms and deal structures.

Aligned Interest. Align your interests and objectives with the founders’. Paul Graham of Y Combinator writes:

Dilution is normal. What saves you from being mistreated in future rounds, usually, is that you’re in the same boat as the founders. They can’t dilute you without diluting themselves just as much. And they won’t dilute themselves unless they end up net ahead.

One way to do this is to offer entrepreneur-friendly terms, such as opting for common shares instead of preferred shares. The tradeoff is that common shares offer you very little protection.

Another way is to agree on an exit strategy early on. Basil Peters — an angel investor, prolific speaker, and author of Early Exits: Exit Strategies for Entrepreneurs and Angel Investors (But Maybe Not Venture Capitalists) — believes that “angels, and entrepreneurs, would have fewer dilution surprises if companies had good alignment on an exit strategy before the first investment went in.”

Angel-Only. Focus on angel-only deals to prevent follow-on financing from VCs (which can be very dilutive), notes Peters. The companies should require only US$0.5 million to US$3 million to prove its business model.

Early Exit. Big corps like Google are increasingly buying pre-revenue ventures as their growth strategy, says Peters. Help the company exit early (e.g. look for an attractive acquirer before it becomes sustainable or profitable) once it’s proven its business model. Exiting early allows you to cash out and helps avoid raising dilutive rounds.

Anti-Dilution Provision. Include anti-dilution provision in the term sheet, which allows you to re-price your stock if subsequent funding rounds are down rounds. In general, this comes in 2 forms, full ratchet and weighted average ratchet. More on anti-dilution protection in a future post.

Even if you’re protected by this provision, later investors can force you to waive or remove it. It’s really a matter of bargaining power. If the company needs the cash to survive, but potential investors refuse to invest if you don’t waive your right, then the company could die.

Board. “Negotiate for permanent board status or at least observer status,” advises Jeffrey Leavitt, partner of DLA Piper. This way, you can “learn of pending company activity that could affect [your] interests.”

But don’t take this as you-should-stick-your-nose-into-every-little-detail. Y Combinator, for example, interferes as little as possible. The seed firm realizes that independence is one of the reasons startups succeed. “Investors who try to control the companies they fund often end up destroying them.”

Though we should mention, the amount Y Combinator invests is relatively small — usually around US$11,000 + US$3,000 per founder. Which means US$17,000 for 2 founders, US$20,000 for 3, and etc.

Capital Efficient. Invest in companies that don’t need a lot of capital to reach breakeven or profitability. These companies have better odds to become self-sustainable; they’re less likely to be desperate for cash or funding from outside investors.

“[Capital efficient] means go-to-market (funding) is right around [US]$2 million, and maybe up to $4 million to get to cash-flow break-even and that’s got to be it,” stated James Geshwiler, managing director of Lexington’s CommonAngels and past chairman of the Angel Capital Association.

Deal Structure. Avoid unnecessary dilution by acquiring preferred shares or convertible debt, which converts to shares at a later date when the venture is properly valued by professional investors, Leavitt further suggests.

Follow-On. Reserve funds for follow-on investment. John Huston of Ohio Tech Angels Fund said, “The angels’ best protection against a ‘down round’ is to have adequate dry powder to preclude the need to seek new outside investors.”

Milestones. Before you invest, make sure the company has set, and will likely hit, milestones that will increase its valuation before raising the next round. Increasing valuation in the next round means there’ll be no down round. As mentioned in Part 2, down round can be very dilutive and can decrease the value of your holdings significantly.

One angel says, “[Significant milestones include] licensing of a critical piece of technology, completing a prototype, entering into an important partnership, entering beta testing, completion of FDA I testing, achieving first revenues, etc.”

Valuation. Value the company reasonably from the start. New angels frequently pay too much at the early stage, placing too high a value on the startup. Over valuation is more prone to down round if the company needs to raise more money from outside investors in order to get the business going. Again, down rounds can significantly dilute the value and size of your holdings.

Final Words

Dilution is inevitable in both good times and bad. When it comes down to it, you ought to be confident that the company’s valuation will exceed the impact of dilution before opening your checkbook; otherwise you may want to pass on the opportunity and look for one that has such potential.

Here’s the question:

How do you prevent being washed out as you keep pro-rata and the numbers get increasingly bigger?

Suppose you invest $200k for 25%. The venture then raises $5m, so to keep pro rata you do $1.25m of that round. Then it raises $15m. Eventually it gets hard to follow you money and you get diluted down significantly.

Dilution can be scarier than your in-laws. When the company is low on cash and has to raise money in a “down round,” outside investors get to purchase new shares at a price lower than what you’d initially paid. That is, they can buy more with less.

Let’s say the economy takes a nose dive after your investment. (No, we’re not saying you jinxed the company. Sh*t happens.) The company still has great potential but it’s hungry for cash. Existing investors can’t provide the funding it needs so it issues new shares at a price of $0.5 per share in order to attract outside investors.

Using our example in Part 1:

1st Round

• You invested $0.2m in exchange for 25% of the company
• This means the company is implicitly valued at $0.8m ($0.2m / 0.25 = $0.8m), post money
• Price per share = $1
• No. of shares you own: 200,000
• Total no. of shares outstanding: 800,000

2nd Round

• Each share is priced at $0.5
• This is called a down round since the valuation, or price per share, is lower than the previous round
• Venture raises $5m by issuing 10,000,000 new shares
• Total no. of shares outstanding: 800,000 + 10,000,000 = 10,800,000
• The no. of shares you own remains 200,000
• Pre-money valuation = $0.4m (800,000 shares from the 1st round x $0.5 per share)
• Post-money valuation = Pre-money + Investment = $0.4m + $5m = $5.4m
• Value of your investment: 200,000 shares x $0.5 per share = $0.1m
• Your percentage ownership: $0.1m / $5.4m = 1.85%

Do you see what just happened? In a down round, both the size and the value of your holdings are in the race to become The Biggest Loser, shedding pounds off left and right. Your percentage ownership has shrunk from 25% in the 1st round to 1.85% in the 2nd round. Not only that, the total value of your holdings has also dropped from $0.2m to $0.1m. Yikes.

Though you can’t prevent dilution if the company needs more money than planned, you can take measures to prevent it, or at least minimize its impact, before it occurs. We’ll look at exactly that in Part 3.

Delman is a professional angel investor and managing director of Golden Seeds New York, an angel network that invests in women-led ventures. In addition to Golden Seeds, Delman belongs to 2 other groups in the NY Metro area.

So far, he’s held equity positions in 11 companies and has had 1 positive exit. The rest of the companies in his portfolio have survived the tumult of 2009 and are still in business today. Delman expects some positive exits within 2 years.

* Edited interview

VH: How did you become an angel investor? What’s your story?

RD: In 2000 I sold my business, a 60+ year-old importer and distributor of branded tableware products, to a large public company. After staying on with the acquirer through 2003, I began looking for new opportunities. I looked at franchises and independent businesses for sale but couldn’t find one that “lit a spark.”

One day I read an interesting article about “angel investing” in the Wall Street Journal. I did some research and joined a group in NYC and began my career as a full-time, professional angel investor.

I love working with motivated and passionate entrepreneurs and helping them develop their business!

VH: What drove you to invest in women-led ventures? What makes investing in women entrepreneurs especially attractive?

RD: It goes to the old adage of men retreating to their caves. There’s no question that women make excellent leaders because they’re so collaborative in everything they do.

Joining Golden Seeds enabled me to be part of an organization that has a wonderful process for screening and evaluating deals and performing due diligence.

Over 90% of Golden Seeds members are women, so the entire process is very collaborative. Since the companies we invest in are run by women, we find that the organizations themselves are also run collaboratively with the CEOs being very transparent and open to new ideas as well as our input.

VH: Share with us an unpleasant experience you had throughout your angel investing career. What have you learned from it?

RD: One of the very first investments I made as an angel was in a tech company that was owned by a relative of my attorney. I invested out of obligation without really getting to know the CEO or perform significant due diligence. The lesson learned is to remove any sense of obligation or nepotism from an investment opportunity.

VH: A critical item you look for in a term sheet is?

RD: One overlooked item is often information rights. It’s critical that you make sure the term sheet calls for you to receive quarterly updates and financials. If your investment is substantial enough, you should also try to get board observer status even a board seat.

Next, Delman will share some due diligence tips with beginning angels. Stay tuned.

Link:

• Golden Seeds
  

Before you click away thinking that you got a lawyer and you don’t need to understand the terms, check out what Mark Suster of GRP Partners wrote:

Another big “gotcha” for me is that you expect lawyers to help you negotiate good deals.  What I found is that most lawyers will tell you what all the terms mean and sometimes will tell you what is commercially normal but they NEVER explain to you just how certain terms can be used to screw you in the future.  You cannot just say these clauses are “legalese” and I’ll let my lawyer figure them out.  You need to own your legal agreements.  You need to know how liquidations preferences work …

Suster’s post speaks to entrepreneurs but it’s every bit relevant to investors. Investors, especially new investors, did get screwed up because they didn’t really know what they were getting into.

Back to liquidation preference. Below is a simplest example of how the right can prevent founders from selling early on your dimes:

• You invested $1m in AppleSoft and own 33.33% of the company.
• Bill and Steve sold AppleSoft for $1m a week later.
• Without liquidation preference, you receive 33.33% of the proceeds, that is, $0.33m (33.33% ownership x $1m). You lost $0.67m ($1m – $0.33m), which ended up in the founders’ pockets.
• With 1x liquidation preference, you receive $1m (1 x original price paid per share), and the founders receive nothing.

As you can imagine, the founders are less inclined to sell the company at $1m if a liquidation preference is in place.

Multiple Funding Rounds

In Part 1, we assumed that the company needs only one round of funding and there are only 2 classes of stocks, Series A and Common. Life’s good when things are simple. In reality, a company might need multiple rounds. And the situation can get complicated when it builds up separate classes of preferred stocks.

Let’s look at this scenario:

• You pumped $3m into AppleSoft
• You’re a Series A preferred stockholder with 1x liquidation preference
• AppleSoft needs another round of funding
• A new investor, Larry Ventures (LV), invested $12m in the 2nd round
• LV is a Series B preferred shareholder with 1x liquidation preference
• Total preference amount = $3m + $12m = $15m
• For various reasons AppleSoft’s time’s up and it’s time to exit
• AppleSoft is liquidated at $10m, not enough to cover the total preference amount
• Assume there’s no debt and no other fees to pay

One of the two can occur:

A. Pari Passu: All preferred shareholders share the same rights and privileges. Available liquidation proceeds are distributed in proportion to each series’ share of preference.

Your portion of liquidation proceeds = $3m / $15m = 1/5 = 20%
LV’s portion = $12m / $15m = 4/5 = 80%

At $10m exit, you receive $10m x 20% = $2m
LV receives $10m x 80% = $8m

B. Senior Liquidation Preference: Later investors receive priority treatments over prior investors. For example, Series D’s preference is paid first, then Series C’s, then Series B’s, then Series A’s.

In this case, LV, a Series B preferred shareholder, gets paid before you, a Series A preferred shareholder.

Since the $10m exit isn’t enough to satisfy LV’s $12m preference, LV gobbles down the entire $10m and you receive nothing.

In other words, you won’t get any money back unless AppleSoft is liquidated at a value higher than $12m.

If there are more than 2 rounds of funding, with each later investor’s preference stacking on top of each prior investor’s, you can see how early rounds preferred shareholders might not see a penny unless the company’s liquidated at a fairly high valuation.

Negotiation

Early series favor pari passu while later series might want senior preference. How do you structure the preferred stock?

You can ask for pari passu in the Series A term sheet but whether later investors accept it or not would depend on each party’s relative bargaining power.

As Brad Feld of Foundry Group puts it, “Determining which approach to use is a black art.” It’s influenced by the

• relative negotiating power of the investors involved;
• ability of the company to go elsewhere for additional financing;
• economic dynamics of the existing capital structure; and
• phase of the moon

Now that you understand the basics, it might help you make faster decisions in the future and impress those who are easily impressed. Consult your lawyer before signing on the dotted line, but you also need to be detail-oriented and own your outcomes, Suster adds, “Lawyers are your support staff not your brain.”

I was asking my lawyer about liquidation preference and he bombarded me with legal jargon. Fifteen minutes later I still had not a clue what he had told me. So my question is what is liquidation preference? Some examples would be great.

Bravo. You obviously understand the benefits and convenience of understanding the term yourself or else you wouldn’t be asking your lawyer about it. Like Chris Dixon said, “you can’t outsource the understanding of key financing and other legal documents to lawyers.” It applies to both investors and entrepreneurs.

Of course, you still want to consult professional legal advice before you sign on the dotted line.

(For the purpose of this post, let’s assume only one funding round is required.)

A liquidation preference is a special right attached to preferred stocks that aims to provide some downside protection on your investment. Specifically, the liquidation preference is made up of 2 parts: Preference and Participation.

1. Preference determines the amount you’ll receive, plus any accrued and unpaid dividends, before common stockholders (typically founders and employees) receive anything in a liquidity event (e.g. when the company is sold or goes out of business/asset sale).

The amount is determined by a “preference multiple,” a multiple of what you’d initially paid for your shares. The multiple varies in different deals, ranging from 1x to as much as 10x (for some VCs back then!).

A “1x” liquidation preference (1 times the original price you paid for your shares) is the standard. Too onerous a preference and the founders and employees would lose motivation to take the company to the next level. Which does no help in jacking up the digits in your bank account.

2. Participation determines whether you can “double dip” in a liquidity event. With this right, you’ll

i. receive your Preference AND

ii. participate in the upside (share the remaining assets pro rata with common stockholders as if you held common shares).

Again for the purpose of this post let’s assume you won’t participate. We’ll discuss participation in another post.

The language for a non-participating preferred, 1x liquidation preference might look like this:

Liquidation preference: In the event of a liquidation, dissolution or winding up of the Company, the Preferred will have the right to receive the original purchase price prior to any distribution to the common stock. The remaining assets will be distributed pro rata to the holders of common stock. A sale of all or substantially all of the Company’s assets or a merger or consolidation of the Company with any other company will be treated as a liquidation of the Company.

An Example

• A group of investors, including you, invested $1m in AppleSoft
• All of you hold preferred shares with a 1x liquidation preference
• The founders, Bill and Steve, hold common shares
• Business isn’t doing great and there’s an opportunity for AppleSoft to exit now; otherwise it’ll die a slow, horrible death
• For simplicity’s sake, let’s say there’s no debt, no dividends, and no whatever that complicates matters

Scenario A: AppleSoft is sold for $2m

You guys got your money back. Some for common stockholders as well.

Scenario B: AppleSoft is sold for $1m

Just enough to satisfy your preference. Nothing left for common shareholders.

Scenario C: AppleSoft is sold for $0.5m

You guys are supposed to receive $1m but only $0.5m is available so you and other preferred shareholders will split the proceeds. You lost money on this investment but at least it’s not a total loss.

As you can see, the liquidation preference provides some downside protection on your investment when the exit is less than pretty.

Next, we’ll look at how the preference can prevent the founders from “ripping you off” and what’d happen in multiple funding rounds.