The Three Terms You Must Have In A Venture Investmemt
Many years ago, when I was still in my 20s, the managing partner of my first venture firm, Milt Pappas, told me that he felt there were three terms that really mattered in a venture deal (other than price of course). They are:
1) The liquidation preference
2) The right to participate pro-rata in future rounds
3) The right to a board seat
I listened intently and have been practicing what Milt preached ever since. In recent years, I've gotten comfortable doing a few deals without the board seat in very specific circumstances. But I've mostly followed Milt's advice to me and I have been well served by it.
There are many other provisions in venture term sheets that can, at times, come in handy. There are the protective provisions, the blocking rights, the rights of first refusal and co-sale, the anti-dilution protections, redemption rights, etc, etc
I've seen some of these provisions invoked and they have been useful to have. But there are several typical venture terms that I have never seen invoked in almost 23 years in this business. That doesn't mean they aren't useful or even best practices to have them. But it does mean that some things matter more than others.
And in a negotiation, it is critical to know what you must have, what you should have, and what you can live without.
When it comes to venture terms, I believe Milt was spot on. The three things that have saved my investment and kept people honest more than any others are the three I listed up front.
The liquidation preference matters because without it, if you invest $1mm for 10pcnt of a business and the next day the entrepreneur gets an offer to sell the business for $5mm, he or she might choose to take it and get $4.5mm while you only get $500k. Sure you could negotiate for a blocking right on a sale, but getting in between an entrepreneur and an exit they want to do is not a recipe for success in the venture business It's much better to say, "give me the option to get my investment back or my negotiated ownership, whichever is more". And that's what a liquidation preference is, plain and simple.
The right to purchase your pro-rata share of future rounds is possibly the most important term of all. In early stage VC, a few investments generally deliver the vast majority of the returns in a fund. When you are in one of those deals, you need to be able to invest in the subsequent rounds (to go "all in" in poker parlance). The pro-rata right is equally critical in down rounds to protect you from getting wiped out in a highly dilutive financing.
The board seat is not something all VCs care about. But you cannot have real impact on an investment without one. Its the best way to make sure the investment is going well and when it is not, the board seat gives you the right to have a say in what is needed to fix the investment.
I am sure there are many opinions on this topic. There's a link at the end of this post that says "comment" on it. Please click on it and tell us what you think.