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.
Do you ever combine the liquidation preference and the pro-rata participation term, to (basically) prevent/limit down-rounds?
I don’t think you want to limit down rounds. You should let the market work
I agree liquidation preference is probably a very important matter for VC and you example is cristal clear… but there are a lot of VC who will ask for a double (or even triple) liquidation preference, which means they get 2 (or more) times their investments before the founders get anything. What do you think of that? Fair?
It’s fair because you don’t have to take it. The best way to get the best terms is to create a market for your company and get competing bids.
Exactly – supply and demand for capital ultimately decides.
thats true in the abstract, in theoryas a practical matter the VCs act ina coordinated fashion, often explicitly coordinating terms amongst themselves before offering term to a company. sure, sometimes there are companies or deals that are so hot and exciting that true comoetitive biding occurs. much much much more often, one VC will decide to bid on a deal and then will participate in securing other investors, sometimes (usually) discussing the investment directly with other prospective inmvestors and not communicating thru the companyi’m not passing judgement, just saying — this is what happens
Spoken like an entrepreneur, and a damn good one tooThat’s not the market we operate in steveIt’s very competitive for the best deals out there
Actually equally important is the question of liquidation preference and if it is participating or non-participating. Fred, any thoughts on the coupling of liquidation preference and participation in the liquidity event?
I prefer a straight preferred but when we are paying a price that is too high and one that the company will need to ‘grow into’ I do think its an appropriate structure to add for up to 3x the going in valuationAgain, you don’t ever want to block a sale. That’s a reputation killer. Just look at the wine.com story to see how that plays outSo what you want to do is set up a structure via the liq pref and possibly a limited participation right so that you are always comfortable going with a sale if that’s what the team wants
Multiple liquidation preferences are a problem. They don’t create alignment between the investor and entrepreneur.The only time I am in favor of them is when a transaction is likley and its the only way to get paid for an incremental investment. That is usually late in the deal when you’ve got a complicated cap tableThey make no sense in an early stage deal
Fred, nice article. Love pithy advice like this. As you probably know, B-School classes make this all much more complicated and can forget to drive home the most core points. :-)Question: what’s your take on having a put option to require an exit within a given timeframe such that the fund would get at least its investment back by the end of its life?My understanding is that Microsoft’s investment in Facebook had this provision in it (based on rumors of course…). Clearly it can create incentives to exit which can be good, but it can also create moral hazards to exit early, cause exit at a detriment to other investors when coupled with a liquidation preference or require a new round of debt/equity financing.Curious what your thoughts are on this.
I think you are talking about redemption rights. We only see those in about one-third of deals. As a practical matter, redemption rights, like demand registration rights, are almost never exercised. If the company is doing so poorly that the investors want their money back, there probably isn’t any money left to redeem the shares. However, the threat of redemption is probably helpful to provide investors with leverage against “walking dead” portfolio companies that generate enough revenue to stay alive in a niche market, but haven’t grown enough to be interesting M&A or IPO candidate.
Whomever wrote this (I’m on a blackberry and only see a facebook profile with numbers in it) knows what they are talking about. Great comment
OopsNow I see it. Yokum from WSGR. Thanks for joining this discussion Yokum
Its called a redemption right and we get them sometimes. I’ve seen it used once in 23 years
At the end of the day it has to be a win-win partnership where the entrepreneur has the motivation, financial resources and advice/guidance to make the business successful and where the investor has the best chance of getting the return they desire. If its too onerous or lopsided – on either side – the likely outcome is a lose-lose. For an entrepreneur you should be suspicious of an investor who does not want these 3 things – you want them to be committed enough to the business – and you to them – to be able invest in future rounds (if they want), you should want them to be an active rather than a passive investor (at least for the main investors), and they should have some right to at least get their money back in some balanced manner in the event of a liquidity event. On the other hand if the preferences are too onerous or there are too many hurdles thrown in by the investor then sooner or later there is a sub-optimal result from the people engaged to make the business successful.
Bad terms (not price, but terms) often come from bad investors
Drag along rights are increasingly important.
Yes, particularly when you have someone (or some entity or corporation) in the syndicate you don’t know and have not invested with in the pastThe coinvestors are so important in a venture deal. Get that right and much of this stuff isn’t necessary
Fred,with respect to #2, can you comment on what happens when the VCs is tapped out and can no longer participate? This seems to be happening quite a lot recently…
They get diluted out, the team gets re-upped, and the founder is caught in the middle. It sucks. Don’t take money from VCs with limited reserves. It is a company killer
they only get diluted out if1. there is a “pay to play” provision2. the other VCs enforce that “pay to play” provisioni’ve ben in a deal where there was such a provision but the other VCs volunteered not to enforce it (because the VC who wssn’t re-upping investment wasn’t dying, just opting out of that deal, so would be around in future for future deals.)now THAT sucksi suggest entrepreneurs/founders make extra efforts to ensure pay to play provision is unequivocal and un-revokable
Nice post, Fred. I think the VC world would be a better place if the only advantages to venture Preferred Stock were numbers 1 (non-participating and 1x only, thank you) and 2. The board seat can be contained in an Investor Rights Agreement separate from the stock itself. Further, if people really want to get to a world where stock in private companies can be traded on a secondary basis (as has been discussed here), there has to be some standardization of terms. So many venture terms are really there to drive down the valuation through a back door. In most cases all they do is increase complexity, create accounting issues (does a mandatory redemption feature in eight years make this debt under FASB 150?) and drive up legal and audit bills.
A lot of the law firms we work with are coming up with light preferred docs that require no negotiation.This innovation comes from Y Combinator (in my opinion) and is a good thing for all the reasons you describeIf VC and entrepreneur can agree on a win/win valuation, terms should not be a big deal
Totally agree with this post. It’s your money you’re putting at risk – the key issue for me is the x factor in the preference. 1x is your money back which is fine, 3x is a tad on the greedy side (seen some VC’s do this). Board seat is a must have, got to be there when things get hairy and they always do. As for the other – all in, you bet and I really mean it’s your bet. You took the risk you should get to play.
Great post.I agree with you that these are good things to have and make sense for both the investor, the company and the entrepreneur.One thing which is extremely common as well and disturbs me a little more is preferred shares. Liquidation preference is one thing. But imagine the same business that you invested $1m in for 10pct is sold on eBay for $750K ; since the VC has preferred shares he gets $750K and the entrepreneur gets zero. You might say, “them’s the breaks”, but zero dollars for months/years of working 80 hours a week and building something which, although not as successful as hoped for, is worth a lot more than nothing, is pretty bad.You might say it gives the entrepreneur an extra incentive to make sure the business succeeds but I would respond that if the entrepreneur needs any extra incentive other than wanting success for his business he shouldn’t have started it and you shouldn’t invest. What I do believe is that it can create different incentives for entrepreneurs and VCs, especially in bad times — precisely when they need to pull together — where the VCs might give up on the business and try to engineer a sale at a price just high enough to recoup their investment, when the entrepreneur would rather try to power through the Dip (a la Blogger, a company whose difficulties I assume you’re familiar with).In this vein, I assume you’ve already been asked and answered this question three-thousand times, but what do you think about Series FF shares?Also, somewhat unrelatedly, what do you think about the option pool? How big should it be, especially at the beginning when there’s little visibility as to the scale of the business? I watched a video yesterday of AdMob’s Omar Hamoui where he said he turned down several VCs before Sequoia because he felt they were trying to create a big option pool in order to dilute him. I actually think it’s a good idea to have even the founders have options rather than stock, but it’s hard to figure out what an optimal ratio would be.
Its worth less than the amount invested in the company. That means the entrepreneur could not create an incremental value with the invested capital. In fact, in your scenario, the entrepreneur made the 1mm invested worth less. That is complete and total failure and should not be rewarded.But in most cases it is because the buyer wants the founder. So the investor has to cut some of that 750k back to the founder, further increasing his or her lossesThe entrepreneur should not take capital if he or she is not sure they can increase the value of the company over the amount of capital investedThis fact is lost on so many people and it is the basis of all capitalism
These are good ponts, although I’m not sure how an entrepreneur (or aninvestor!) can be “sure” he can increase the value of the company.
With regard to Series FF, there are a couple of tax (and other) issues that cause many lawyers to caution against implementing it. The more fatal of them relates to a risk that it is deemed deferred compensation for Section 409A purposes, leading to ordinary income treatment, plus 20% federal and potentially 20% state (in CA) penalty taxes. See generally http://www.startupcompanyla… for an overview. (I’ve intentionally not described the tax issues in the post as it shows up high in google search results and I don’t want to give the IRS too many hints at what they should focus on.)
Good to know. Thanks.
Is Milt Pappas related to former Cubs pitcher Milt Pappas?
Nope. But he got asked that all the time
if the board seat is not a must, how do you feel about demanding an observer seat, so that even if you’re not a voting member, you get rights to all materials and can still make sure your investment is headed in a satisfactory direction
That’s very typical and we do that, but as someone who sits on a lot of boards, I think observers can be overdone and too many takes away from the right board dynamic
I am so fascinated by your post I don’t even know where to begin. A new business is like an engine that needs fuel (capital) to run. Unlike a real engine, a business engine can actually generate fuel – and a lot of it. Profitable businesses do not heed the 2nd law of thermodynamics, which is rather remarkable!Businesses sometimes have to strike a deal for the initial fuel. Unfortunate but true. They sometimes agree to semi-standardized but rather arcane terms for this fuel. At this point in the life of a business the terms “shares” and “ownership” are red herrings – they are misleading. The bottom line is that the investor has some money, and wants to use it to make more money. It is the deal, or the contract, that matters, and which can be infinitely variable. The terms can range from a loan to indentured servitude (which is apparently still legal if the servant is a corporation).What’s really interesting are the “event hooks” for which investors get paid – and hooks for when they need to make a decision. The major hook is the sale of the company. But I assume that another hook could be a particular revenue target? Or perhaps the revenue target just informs valuation which informs sale price? Are there terms that let investors start getting paid when the company is “in the black”, at least at the founder’s discretion? Or is that uncommon because it’s a bad use of capital?It makes things especially complicated when more than one deal is made, because deals interact with each other. The fact that an investor has to wait for so long to get paid makes the likelihood of overlapping deals very high. You talk about the “right to participate pro-rata in future rounds”. What does that mean?My take away is that there is a large pressure for entrepreneurs to avoid taking investment of any sort, if only to simplify the situation so that the engine can run cleanly (without additives to the fuel, so to speak). With the reduction in cost of starting up information-oriented businesses, perhaps the terms will get better as demand falls.
Why is the future pro-rata the most important? Would you actually get shut out of future deals? And if the deal is that hot, isn’t your initial investment relatively much more valuable?
If you are an angel investor, then it might not beBut if you are managing a $100mm fund (or more) then it is very important to be able to scale your capital into future roundsAnd when a deal gets super hot, everyone wants in and it is very possible you’d get cut back (or even cut out) without it
Fred, I was really pleased to see you are so clear about multiple x liquidation preferences and participation being unhelpful in the early stages. I and some of my clients have the sense that certain VCs are being opportunistic in recent months on this, and I think the implications of what you are saying is that these kinds of deal terms help no one (or companies simply shouldn’t take them).
Very informative and thoughtful blog. I myself is looking for a VC for my startup and your blogs explains alot about a VC’s mindset and expectations. Great!
This is a great post because it works for entrepreneurs as well as VCs: most entrepreneurs are exclusively focused on valuation, when liquidation preference and the selection of the right board members have more influence on the amount of money you’re likely to get out of the deal.I’ve seen friends negotiate for a high price rather than a more favorable liquidation preference, and the result is particularly deadly: compounding a high price with a higher liquidation preference just raises the bar that you as the entrepreneur will have to clear to make money.The only color I would add is that liquidation preference, pro-rata rights and board members don’t change: the A round terms will almost always be “back to back” on the terms from the seed round, and the B round will be back to back with A. You can thus think of those terms as “DNA terms,” because they get transcribed from round to round.Valuation is just the opposite in that it changes every time. Especially in an initial round, it doesn’t seem like valuations vary that much, so the other terms are really where an entrepreneur should be focused. And I agree with Yokum that all other terms almost never matter and shouldn’t be gamed.
Great point about these terms becoming standard in future rounds
Governance matters.The right to the board seat changes dramatically depending on the syndicate of investors. The board seats must evolve with each round. That said, the % ownership of the converted common stock should not be the determining factor for the makeup of the board. A couple of founders with 75% of the company should still only have 2 out of 5 board seats. Likewise, an investor syndicate with 75% of the company should still have 2 out of 5 board seats. There are 2 keys to making this structure work:A truly independent 5th board member. Someone who can take recommendations from both sides and make objective decisions for the good of the company.Investor protective provisions. These are the negative provisions the investors, as a group, have to prevent massive changes in company strategy or capitalization. They go a long way to reassuring investors who have only observation rights on a board and allow a company to keep the voting group small.Dick Costolo, founder of feedburner wrote a great post about this: http://www.burningdoor.com/…
I am a big fan of independent directorsThe more the better (within reason, of course)
Much appreciate your writings like this — baring best practices in a way that’s not only a tutorial, but peels back the covers on matters many others won’t speak so frankly about.
Charlie – you are so right about the preferences. The basic simple idea of a liquidation preference has been used (at times) to create structures that are not that good. The multiple liquidation preference is particularly damaging to the capital structure and should only be used in the late stages of a deal when a transaction is imminent and you need the multiple to incent investors to “bridge” to a sale. The participating preferred (which your math is all about) is also something that isn’t ideal either and should only be used when the valuation is ahead of where the company is at the time of investment. And participating preferreds should be capped.
That’s our whole strategy in a nutshell