In our new ‘Guide to Investing’ blog series, we lead you through seven steps of investing. In the second blog, we’re talking about deal-making. If you want to make a deal, you negotiate terms. That gives some people inspiration to be creative, but you probably shouldn’t be. Find out why!
When making deals, everyone wants an outcome that matches their own situation well. Professional investors may have responsibilities towards their own money sources. They may want to mitigate specific risks, or put themselves in control of some parts of the company. This means there is quite a lot of contract language they will normally want, including control rights, a liquidation preference, anti-dilution, etc. Generally, informal investors are investing their own money and will likely become normal shareholders. But they will build up a lot of influence as an informal advisor that has contact with the founders.
Generally, standard practices emerge in markets where there are a lot of deals happening all the time. Amongst VCs there are certainly standard practices for deal terms, and they often communicate amongst each other to make sure that standards are established. There are also standard practices for informal investor deals in most markets. In markets where startup investments are not as common, we see a lot of strange deals happen. Unusual deals are normally not a good idea: it means in future investment rounds the investors have to do more reading, and there is more going on that someone could object to. Market standard terms are almost always best, in whatever market you are in.
A common exotic deal structure is a milestone deal. In this kind of deal, the investor promises extra concessions, but only when certain milestones are met. At Leapfunder we have handled a lot of transactions of this type. So far no one ever met any of their milestones (please let us know if you had such a deal and the milestones were met: it would be our first). In practise the market, and the company, changes direction and when the milestone date comes you wind up having to re-negotiated. Often you can simply no longer figure out how to apply the milestone criteria because the metrics you use have changed. Let’s say an investor invests only part of the intended total cash up-front, but does receive the full share allocation, and promises to put the full cash only when the startup gets to a milestone. Well, then the startup may face a particularly harmful difficulty. Without the milestone, the startup doesn’t get the full cash, but all the shares were transferred and there might be no way of getting those back. Those deals can hurt. In general, we prefer deals that are as simple as possible: if shares are transferred today, then so is the cash. What we do in the future will have to be decided in the future, in both directions.
Generally, it is important to remember that any concessions that is made to an investor now, will affect future deals as well. For example, if there is an anti-dilution or a liquidation preference for an early investor then the next investor will likely want to bring that up in negotiation also. If the founders keep promising everyone an anti-dilution then the founders will risk losing a lot of shares if the anti-dilution is ever triggered in the future. That can be damaging if it means the founders just leave the company behind. A strong liquidation preference, that has been given to simply too many of the shareholders, may mean that the founders don’t benefit from an exit. In every funding round, the investors can be reminded that the founders need to benefit also, otherwise you no longer have a motivated team.
To learn more about investing stay tuned for more knowledge.