Is your startup ‘investor ready’? (Part 3/3): Structuring the deal terms

Introduction

Once an early stage company has achieved technical validation and consumer validation (detailed in my first blog in this series), and has addressed key corporate hygiene matters (detailed in my second blog in this series), it’s time to address the really hard stuff – structuring your deal terms.

Negotiating the legal terms upon which equity, debt or a hybrid security will be issued to new investors is one of the most important aspects of conducting a capital raise program. The deal terms ultimately determine how much equity, return and control you give away. Underestimating the implications of how the deal terms are drafted or structured can materially compromise the future value of your shareholding. Just ask the co-founder of facebook … now, what was his name?

Therefore, before approaching investors, it is important to understand how equity deal structuring works and the various deal terms that can have the greatest impact on the future value of your shareholding. This blog is an overview of the key issues.

The following paragraphs are not a substitute for legal advice.

Valuation

Valuation of early stage companies is an art rather than a science.

It is the product of a combination of factors including existing market traction, the size of the opportunity, the quality of the management team, the strength of the competition, the existence of barriers to entry (including protectable IP), relative values of comparable companies, the immediate value the incoming shareholder brings and the existence of one or more ultimate buyers or other likely exit strategies.

Generally, even where a start-up has early revenues they are rarely reliable enough to enable a discounted cash flow or similar valuation methodology to be used. In reality, investors will look at comparable transactions and take those valuations into account to determine a starting point for valuing your company. Then investors will typically adjust the comparable valuations to take into account the extent to which your business is stronger or weaker than the comparable businesses in areas such as technology, team and traction, and the extent to which the new shareholder can add immediate value to the business.

So before you risk alienating investors with unrealistic valuation expectations (which can also compromise the credibility of your management team), take the time to understand investor expectations and methodology around valuation.

Board representation

Depending on the size of the raise and the composition of the investors, incoming shareholders may require board representation or board observer rights.

The greater the proportion of total equity being acquired by the new shareholders, the higher the likelihood this will be required. Generally, the ideal start-up board composition is five directors – two founders, two investors and one independent.

Granting board representation rights can dramatically change the dynamic of a young company’s board. The extent to which this will be the case will depend on the size of the board, the ultimate voting power of the new board member, cultural fit and the skills and experience being brought to the board by new directors.

When formulating your deal terms, founding shareholders should consider if and when this right will be granted and whether any limitations should be placed on the right to ensure effective corporate governance.

Reserved matters & veto rights

Generally, the board is responsible for the decisions of a company. However, it is not unusual for investors to request some control over material financial, corporate and strategic decisions.

When considering what decisions should be reserved for shareholder approval or a higher threshold of director approval, a balance needs to be struck between operational efficiency and shareholder/investor protection.

Founders should understand the operational implications of requiring additional approval for key decisions and give consideration to the limitations that might be imposed on that reservation.

Preference rights

More often than not, venture capital investors will require preferential equity to be issued to them during an expansion stage fundraise. Angel investors may be more prepared to accept ordinary shares, but this is also the exception rather than the rule.

Preference shares can have both ‘debt’ and ‘equity’ characteristics, and those features need to be carefully balanced to ensure any preferential rights are reasonable taking into account the amount of capital being contributed and the valuation.

Preference share terms have the greatest potential to affect the future value of your shareholding, so they need to be well understood and negotiated carefully.

Whilst there are no standard terms of issue for preference shares, there are typical preference rights founders should look out for. These include the following:

Dividend rights

  • Should a dividend payable in preference to other shareholders?
  • If so, will the dividend be fixed or floating?
  • Should the dividend be cumulative or non-cumulative?

Conversion

  • What events should trigger a conversion?
  • What type of shares should the preference shares be converted into?
  • Should the company or the shareholder be able to unilaterally elect to convert?
  • What are the objectives of the conversion formula?
  • What dilution impact will conversion have on other shareholders, and how might it affect any future capital raise?

Liquidation

  • Should the shares confer a preferential return of capital on liquidation?
  • Should any preferential return be at a premium to the value of the capital contributed?
  • Should the shares have additional rights to participate in surplus assets?

Redemption

  • Should the shares be redeemable?
  • If so, what is the redemption price?
  • When may redemption be triggered and by whom?

Anti-dilution

  • Should preference shares have anti-dilution protection?
  • If so, in what circumstances should the protection be available?

Conclusion

There is no one size fits all approach to structuring deal terms. To ensure that founders maximise the future value of their shareholding when raising external capital, it is important to understand how equity deal structuring works and the various deal terms that can have the greatest impact on your equity, returns and control.

A successful capital raise program has the potential to secure not only capital for growth, but also attract strategic investors and partners who can help position your company for the opportunities that lie ahead. However, a poorly negotiated deal structure potentially compromises future value for founders and can lead to dysfunctional corporate dynamics. Trust me, I deal with the dramas every day!

So get yourself good legal advice upfront and save yourself the future drama.

Steven Maarbani

Acknowledgements: I’d like to thank Tank Stream Ventures, Reinventure, Blackbird, M.H.Carnegie & Co,VentureCrowd, Artesian Venture Partners, Telstra Ventures, Fishburners, SCALE,  Tyro Fintech Hub, NICTA, iAccelerate, & muru:D for their feedback and contributions to this series of blogs.

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