You did it! You received your first term sheet from a venture capital firm. Your great idea, product or service is about ready to get funded. Congratulations! Now what!?
Most company founders have not stopped working on their vision for long enough to think through the most critical factors that will make sure their business remains viable following an outside investment. Any entrepreneur worth their salt should feel no shame in admitting this. It means that you have the courage of your conviction and the perseverance to achieve your goal. It also means you might be susceptible to some dirty tricks that can sneak into investment agreements and hurt you financially when you exit.
It’s exciting to know that someone else wants to be a part of what you are building, and that they are going to give you money to build your vision. Sure, you would take the money, right? Well, not so fast…you need to be nimble enough to dodge the landmines an investor will put in your way. I do not believe that they create obstacles on purpose for you. Perhaps I shouldn’t be so generous to think that most people have good intentions, but a wolf is always going to be a wolf — it’s their nature. Most private company investors tend to be so focused on not losing their money, that they over-engineer the investment agreements and voting rights. This practice can often lead to worse than expected outcomes for the founders.
Common VC Pitfall: Unreasonably high multiples on preference at a liquidity event
Any company founder would jump for joy at the notion of a high valuation, right? Less dilution is better for everyone. Except when the expectations from an investor are so high that it creates a scenario that an investor receives multiples on preference if you don’t achieve your forecast. Investors prey on some founders’ belief that they have the only product ever created that could sell itself. As a result they will offer a high company valuation on the term sheet, and then hide a clause in the agreement that gives them escalating preference if your results are lower than expected. This is a common trick that investors can use to increase their net earnings upon exit, and it can hurt the founders severely. In the meantime, most company founders are content knowing that they are not being diluted as much on their cap table — later discovering at exit that the investor put coal into their Christmas stocking.
Here’s how it works:
In earlier years, or shall we say more “civilized” years — a typical investor would seek 1x preference on their investment, and then take part in the distribution of funds thereafter, once the company exits. For example, a founder receives an investment of $1,000 with 1x preference, at a pre-money valuation of $4,000. This means that on a post-money valuation basis, the investor would own 20% of the company. Post-money valuation = pre-money value + investment ($5,000 in this case). $1,000/$5,000 = 20% ownership.
Three years later, if the company sells for $9,000, the investor would receive their initial $1,000 investment off the top (that is the 1x preference), and then participate in the remaining $8,000 at a rate of 20%, based on their ownership percentage — or $1,600. 0In this case the investor will receive $2,600 for a $1,000 investment, and $6,400 remains for founders. Seems fair, right? After all, you did all the hard work.
In today’s venture market, it’s not uncommon to see multiples as high as 4x. In the example above, the investor receives 4 x $1,000, or $4,000, at sale. The remaining $5,000 is then awarded by percentage ownership, and the investor receives 20%, or an extra $1,000. The founders receive $4,000 from the $9,000 sale. A simple contractual change from 1x preference to 4x preference, results in the founders receiving less than 50% of the net proceeds from the company’s sale — despite the investor owning a mere 20% of the company.
The moral of the story is that the cap table can be misleading, and hidden easter eggs in an investment agreement can create inequity upon exit. It would be easy to recommend not working with investors who would do this to a founder, but the decision is not that clear. Sometimes you just need the money. But you also need to be aware of your own risks in the future.
Action Item for Founders: Always run an exit scenario model using every key contractual assumption included in the term sheet. By modeling scenarios for the sale price of your company, you can follow the money trail. Be honest with yourself about your expectations on sales and expenses. If your results are linked with your share of the pie when you exit the company, go into an investment agreement with the full knowledge that you may be giving away a lot of money later. If you aren’t good atcreating financial models, you should find someone to help you who understands investment agreements and can illustrate for you how the math works. Your bank account will thank you later.