When you want funds from your business there are a lot of resources that you may consider. You can consider investing your savings or applying for a bank loan or from any other line of credit. You may turn towards private money lenders, your family and friends even. You may look for crowdfunding as well.
You may also consider venture capitalist financing or Angel investors as well but for this, you will need to be a bit more careful. There is a fair amount of risk of losing control of your business eventually in such finance options which is not the case in other financial sources until you default in the payment of course.
Things to look for
You will certainly not want a person to invest in your business which you have nurtured for so long caringly to take it away from you or have the major control on its operation and decision. Therefore, you will need to know the ways in which you can protect your business and what the things that you should look for and safeguard.
Participating or non-participating: If you want venture capital financing then the preference is the first thing that you should consider. Ideally, venture investors will request that they want a stock that is “participating preferred.” This means they will first receive their liquidation preference back on the sale of the company. It is after that the remaining owners or founders will receive the proceeds according to their respective percentage of ownership share. On the other hand, if the preferred in non-participating, the proceeds will be split in half. Participating preferred is comparatively rare and hurts the Series A investors down the road. If you are forced to accept participation, make sure that you negotiate that this feature is removed when the VC has received back a multiple of their investment.
Protective provisions: Venture investors will often hold a minority interest in your company after the financing is complete. However, they will typically insist on veto rights or “protective provisions” on particular actions of the company. This may adversely affect the investment or the projected return. The types of actions that are usually vetoed are amendment of the company’s charter, change in bylaws, change in the rights of the preferred, change in the authorized number of shares of preferred or common stock, creation of new series, class of shares senior to or on parity with the preferred, acquiring or redeeming shares of common, sale or liquidation of the company, payments of dividends, incurring debt, and increasing the size of the Board of Directors of the company. However, you may sometimes mitigate this veto right by arguing that it should be removed since the VC has received a minimum return on the investment which is often 3 to 5 time of the original.
Anti-dilution protection: Also look for the anti-dilution protection while opting for venture financing instead of any other traditional forms of funding from banks or other sources like liberty lending. This is wanted by the investors when the company issues stocks at a valuation that is lower than the valuation signified by their investment. However, the most common of all is the “weighted average” anti-dilution protection as it reduces the conversion price and therefore it increases the conversion rate of the preferred stock inversely. With this weighted average anti-dilution when more shares are issued at a lower price of the shares, it will provide greater adjustment. On the other hand, if you opt for the more severe “full ratchet” anti-dilution clause it will reduce the conversion price of the existing preferred to match with the price of the new stock irrespective of how many shares are issued. However, in most of the times, the venture investors will typically agree to exempt anti-dilution protection of specific types of equity issuances such as incentive equity for employees, equity issued in connection with bank financings, equity issued in acquiring other companies, real estate, and equipment leases and others.
Stock option issues: This is another aspect that you should care for so that you make sure that the venture investor is assured that the company will have adequate stock option reserve for future equity grants. This should be ideally 10% to 20% of the capitalization of the company but the later-stage companies will usually have a smaller pool. When you do not forego this option you will be able to use it to attract and retain employees, Board members, and advisors. Ideally, VCs will almost always assert that this option pool is included in the pre-money valuation of your company which is also a standard to do so. However, as a founder, you must realize that any escalation in this option pool will also come with a cost and will eventually reduce your percentage ownership in the company. Assuming that the size of the pool becomes an issue for you when it comes to term sheet negotiation, it is a good idea to produce a grounds-up “budget” for the future options after you estimate the options that you will need for future hires till the following round of financing.
Insurance obligations: According to the term sheet your company may be obligated to maintain the directors and officer’s liability insurance. This insurance usually covers the officers and directors of the company when it comes to litigation of duties they need to perform for the company. In the term sheet, the dollar amount of coverage will be specified which is ideally between $2 million and $10 million. The venture investors may occasionally require your company to maintain the “key man” life insurance policies. These are the insurance policies of the key founders. These policies will provide cash to the company in the event of the death of a founder. The fund will enable you to recover and hire new talent to replace the deceased founder.
Considering all these points and not letting go any of it will ensure that you have the desired control and ownership of your company and not the angel or venture investors.
Marina Thomas is a marketing and communication expert. She also serves as a content developer with many years of experience. She helps clients in long-term wealth plans. She has previously covered an extensive range of topics in her posts, including money saving, Budgeting, business debt consolidation, business, and start-ups.