Raising financing is tricky, stressful and for many involves navigating uncharted waters. It is an art and an important skill to master to ensure the future of your start-up. Whether your first investment comes when you simply have an idea scrawled on the back of a napkin, or once you already have a POC or product – the odds are that you will not have the experience to negotiate on equal grounds with sophisticated investors. Yet, many founders approach these first negotiations unprepared and unaware of the impact of their decisions. I want to equip you (the founder) with some requisite knowledge, to help you sidestep certain unhealthy choices.
It is popular for an early stage start-up to raise funds without fixing its valuation or issuing equity immediately. The trend started with convertible loan agreements (CLA) and more recently, the simple agreement for future equity (SAFE) has dominated the market. Nevertheless, although these finance instruments are simple, the lion’s share of founders are not spending enough time thinking through the impact of such SAFE (or CLA) on the cap table of their company.
The most problematic issue that is overlooked by founders, is the impact of issuing numerous SAFEs. Any issuance of new SAFE without converting the previous SAFE, can have a multiplier effect in the calculation of the conversion price of each SAFE, diluting the founders more than they anticipated.
So what can you do? Prior to negotiating, ask your legal advisors for a ‘real time’ cap table that reflects the holdings in the company prior to the issuance of the SAFE and following the full conversion of such instrument. Further, protect yourself by ensuring the definition of ‘Fully Diluted’ when calculating the conversion cap, excludes other outstanding CLAs/SAFEs or other debt instruments.
Too much dilution to the founders not only hurts the economic interest of the founders, but also the future of the company. Venture capitalists want to ensure the founders are economically vested and incentivized in the venture. If the founders look like they will be diluted too quickly as a result of the unfavorable conversion terms and the impact of future financing, VCs may get cold feet about investing.
Investors often ask, even in a pre-seed or a seed round, for a certain preference upon an exit event. However, before you agree, you should take a minute to understand the impact of the specific liquidation preference.
Investors previously used their leverage to demand a participating liquidation preference (PLP). According to a standard PLP, upon an exit, the investor will be entitled to receive its total investment back, prior to any distribution to other shareholders (often X times its investment), and then also participate in the distribution of the remaining proceeds in proportion to its percentage ownership of the company – what we (and Seinfeld) call “double dip”.
We still see investors trying to push for a PLP. However, it is highly recommended to steer clear from such provisions. PLPs create an imbalance with the other shareholders of the company and are toxic to the company in the long run. Why? It sets a precedent. Any future investor will demand at least the same terms as the initial investor (i.e. a PLP) and try to improve on it. After a few investment rounds you will look at the ‘waterfall’ of your start-up (the distribution of funds upon an exit) and realize that even in the event of a decent exit, you will meet an insignificant amount of cash.
As tech investors are acknowledging the drawbacks of PLPs and entrepreneurs are wielding more power, today, the more common liquidation preference is a non-participating liquidation preference (NPLP). The fairest NPLP mechanism, and the one you should fight for, is that in the event of an exit, the investor will receive the higher of (i) its investment; or (ii) its pro-rata portion of the proceeds.
This NPLP mitigates the gap between the parties and provides the investor with the comfort it needs, while allowing the founder to benefit more from an exit.
As investing in an early-stage startup is a high-risk investment, some investors seek to limit the risk by splitting their investment into installments based on performance milestones. Although every founder I met believes he or she can meet such milestones, we recommend not including a performance milestones mechanism in your early finance rounds.
Most startups start with a great idea that evolves. During the journey of a young startup, the founders learn their market and better understand the plan and their client. As a necessary result, you may change direction and redefine the product. It is possible your company’s targets will then also change (although not always a full pivot). As a result, previously agreed milestones may become irrelevant. Thus, in order to meet the money, you will need to renegotiate the investment terms, or worse, pursue a route that is not in the best interests of the company, purely for the sake of achieving the milestone.
An additional issue with investments based on milestones, is that typically the agreed milestones are too vague and then there is often a dispute as to whether they have been achieved or not.
Further, bear in mind that milestones give the investor a way out from its commitment. Perhaps the market or the investor’s cash flow changed and in order to avoid payment, it will simply claim that the company did not hit the relevant milestone (although not polite, I have seen this happen).
If you have no option, then make sure the milestone definition is crystal clear with no room for ambiguity, only issue the corresponding equity upon receipt of the relevant payment and you can include a penalty mechanism.
As following an investment, the investor will be a minority shareholder in the company, it may ask for negative control – the right to block various resolutions at the board and shareholders levels. Such rights are commonly known as “veto rights”, “protective provisions” or “restricted provisions”.
Although the best solution is not to grant veto rights, certain investors (mainly VCs) will insist on them.
Two main points you should bear in mind when you tackle this point:
- It is common to discuss, negotiate and narrow the scope of the requested veto rights;
- The number of veto rights is less important than their essence. It is critical to try to avoid vetoes on future investment rounds. This provision can appear in different shapes and form – beware!. It is also critical to try to avoid too much involvement in the day to day management of the venture.
Today, we are in a “founders market”. Most investors are looking for early stage startups in order to have a foot in the door in the “next best big thing”. The desire to invest in a strong team with a disrupting idea is strong – try to leverage it!
The issues above are only a small part of the provisions you should examine during investment negotiations. However, they can have a dramatic impact on the future of your company, so do not take them lightly.
If you have any queries, please contact Itay Gura. Itay specializes in commercial law, corporate law and mergers and acquisitions. Itay has also extensive experience in advising high-tech companies and start-ups from their initial stages through to their growth, acquisition, merger or sale. Itai also serves as a mentor at WeWork Labs in Haifa. In this framework, he provides participating startups with legal and commercial consulting in a variety of fields.