Founders’ guide to VC investment terms — Part 2
Raya Yunakova, Investor at LAUNCHub Ventures explains the main investment terms that every founder needs to know.
In the first part of this series we looked into some of the most important legal terms every founder needs to know before finalizing a venture deal with their investors. We covered Vesting, Option Pools, and Liquidation Preference (and valuation, but as I mentioned that one’s really not that important).
Below, you’ll find some more key venture deals terms. Many of these will serve as the basis for how your company operates post-investment, so be sure you understand what they mean and what implications they might have further down the line.
Pre-emption rights
Starting with one that is really important to your investors — pre-emption rights. Remember when we spoke about investors wanting to obtain a certain ownership in your company, which in the typical early-stage deals is roughly 12–15% (it can vary of course)? Well, we’d like to keep our ownership at that level or even increase it as the business grows.
Pre-emption rights give your investors the opportunity to acquire more of your company’s shares at future rounds. Typically this means that if your current investor holds for example 15% of your company, they get to acquire the pro-rata of the newly issues shares so that their holding remains at 15% after the dilution* of the round. Sometimes your investors can ask for the so called ‘super pro-rata’ or the right to buy more shares than what a normal pro-rata of their current ownership would allow them to.
Why is this important to understand? As you get new investors onboard you need to have in mind that your existing ones might want to buy additional shares, thus changing the financing structure of the round. This is usually a good problem to have but a problem nonetheless if there aren’t enough new shares to go around. This typically happens when the round is oversubscribed and you want to get more investors in for the same level of dilution. You will need to balance the situation here and you might be faced with some tough calls, especially as some of your early backers (angels) might not have pre-emption rights. My only advice is to act professionally and swiftly and not try to please everyone as you simply won’t be able to.
Another thing to be mindful of is the signalling effect of existing investors not exercising their pro-rata. There can be pretty valid reasons for that but on the face of it, it normally looks bad (if you’re doing well, why wouldn’t your investors want to maintain their ownership?). This usually puts new investors off as they know your existing shareholders have better information than themselves and makes them think there are underlying issues with the business. The good news is that good investors will follow on if you’re doing well. If the company isn’t doing well… you probably have other things to worry about than signalling.
* I will write a separate piece on dilution, how to calculate your pre- and post-money ownership, etc. as the topic is long and would bloat this article too much. Stay tuned.
Anti-dilution protection
This is a clause entirely for the protection of investors and I can’t say it even remotely benefits the company. It is usually non-negotiable whether to have it and it affects founder dilution, so it’s important to understand it.
Anti-dilution plays a role when your company raises money at a valuation lower than that of the current round or executes a so called ‘down round’. In that case, investors would like to offset the hit to the value they are holding by reducing the amount of dilution they are going to take with the new round. This can either be done by getting additional shares, or by agreeing a lower conversion price for the investors’ shares. This is a very long topic which deserves its own article, and thankfully Tom Wilson at Seedcamp already wrote a very good explanation of it. You can check it out here:
Consent Matters / Majority Reserved Matters
As the name suggests, these are actions you might want to take that require the consent of your investors. You may receive a summary of what those actions are in your term sheet, but the full list will be in the investment documents.
Don’t be scared of these, they are normally concerning major things and would not interfere with your day to day business. Things like transferring control of the company, selling or issuing new shares, making substantial expenses, settling legal disputes of substantial size, etc. The consent matters are there to protect minority shareholders so that no major event happens without their knowledge. Again, if you are running your business and making reasonable decisions, the consent will be a mere formality. If you decide to sell your shares to your distant cousin and swap places with him to spend 3 years of solitude at his house in the woods… you get my gist, you’d need to get an OK from your investors first.
Board of directors
The board of directors is essentially a group of key stakeholders who meet regularly to discuss strategic matters and make major decisions in the company. The board comprises of representative(s) of the founders and representative(s) of the investors, with each having a number of board seats respective to their shareholding. Each board seat then gets one vote. Your lead investors will normally require a board seat, typically representing all investors. Board meetings happen monthly or quarterly, and this is normally the place where the matters from the previous point are discussed, along with other important topics for the business.
There are a couple of crucial things to note about boards.
First and foremost, the purpose of the board is NOT reporting!
Its goal is to have a productive discussion on where the company wants to go and figure out ways to achieve that. That’s what good investors bring to the table, and that’s what you should look for when you assess the value add that all VCs love to talk about. Bad investors will use this as an opportunity to beat you up for the things that aren’t going well instead of understanding what the causes are and trying to find a solution together with the founders. Don’t get me wrong, if you’re consistently failing to deliver the results you’ve promised, you’re up for a tough conversation, but if your investor’s contribution extends to ‘Why don’t you just close more deals?’ that’s not adding value.
Secondly, and as a consequence to the previous point, be mindful of who you invite to your board. Board members should be people you can comfortably discuss both the ups and downs with, who can bring experience and contacts to the table and who are efficient in how they work. Don’t get board members for the sake of getting board members, or because you think that they would look good to others (your clients don’t care, so who else are you trying to impress?). You will see quite a lot of this person, so make sure you can work well with them. In the case of your investor, you won’t really have a choice on who takes the board seat, so this is also a good way to judge the investor — if you don’t want them on your board, you probably don’t want them on your cap table either.
Information rights
Investors will want to have an overview of the company’s (financial) status on an ongoing basis. We need to report this to our LPs so they know how we are performing… you get the power dynamic.
This is generally very straightforward and while it does create some additional overhead on your part, it shouldn’t be anything dramatic. Quarterly reporting is typically sufficient at the seed stage and you can handle this during board meetings if you decide to. Formal monthly reporting is rarely necessary and requiring this from seed founders is too much in my view. Unless the VC has some special LP requirements, it’s probably symptomatic of trust issues.
Is that all?
No :) There are a few more important terms coming in a Part 3 of this series. Bear with me, we’re nearly there.
Originally published at https://www.linkedin.com.
