This article is the twelfth in an ongoing series on Due Diligence. To learn more about performing due diligence quickly and effectively, download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.
As the diligence process proceeds towards conclusion, thoughts naturally turn to the terms of the deal. Regardless of whether there is an existing term sheet to review, or a need to negotiate and establish a set of terms for the deal, thought needs to be given to the terms of the deal. Just like the various risks reviewed in diligence, deal terms can have a huge impact on the outcome of an investment.
The findings from the diligence process will inform the deal terms in two ways. First, important risks may need to be addressed by extra emphasis on specific deal terms. Second, the learnings about the company’s anticipated capital path and likely exit scenarios will inform the approach taken with terms relating to deal economics.
As we have noted, all deal terms can be grouped into four categories, and each of them can be used to address specific aspects of the diligence findings:
Deal Economics - Investors want to make sure they get a big enough slice of the pie to make the investment worthwhile on a risk-adjusted basis. They want to make sure they get paid back first. They want to put a time-clock on the founders. And they want to make sure employee options don’t dilute them inappropriately.
Investor Rights / Protection - Investors want to make sure no future financing deals contain terms which unduly diminish the value of their investment or lead to someone moving into a superior liquidity position (without paying appropriately for that right).
Governance, Management & Control - Investors want to know what’s going on in the company, have a say in critical decisions, and protect against founder behavior that could be damaging to the company.
Exit / Liquidity - Investors want to make sure they maximize the chances to get their money back in all possible exit scenarios (positive or negative), even if they have to force such a situation to occur.
Q: Christopher, where do you start when approaching deal terms in the diligence context?
Deal economics are always the starting point because, if you cannot make the deal work from an economic standpoint, nothing else matters much. When establishing deal terms, obviously the pre-money valuation matters a great deal because it drives how large a piece of the company you start out with, which is the foundation of your returns. It is important to pay attention to the fine print in deal economics, however, because beyond the issue of pre-money valuation, there are a number of terms that really drive returns.
But let’s start with valuation. If you get the valuation wrong (as in, too high), you are really hurting yourself in two ways:
Your out-right return multiple will naturally be lower even if the company succeeds, because you received a smaller stake for your investing dollar, but
Less obviously, you may also be significantly reducing the chances of the company even succeeding at all.
Far too many start-ups run into trouble because they let their valuation get away from them in the early rounds. They end up being unable to raise money in later rounds without a very damaging down round because their valuation becomes unattractive relative to the progress they’ve made. So they struggle to raise, are over-shopped and pick up a “company in trouble” stigma, and then ultimately have no option other than to try to do a cram-down at a lower price. Best case, such a cram-down badly hurts all the early supporters of the company (most critically the founders). But that's the best case - in most cases the company doesn’t ever recover and ends up failing. Thus, getting the valuation right is job one.
Another very basic driver of returns is your liquidation preference, which is your right to get paid before common stockholders. It can be expressed as a 1X which gives you the right to get one times your money back, or as a 2x or 3X or higher. Your diligence findings will inform how you approach this clause in particular. Every term that early stage investors ask for, later stage investors will feel entitled to, and this one can have a multiplying effect on the size of the preference stack, which very directly affects your returns, particularly in less than home-run situations. There are a lot of good reasons to avoid multiple liquidation preferences and instead stick with a 1X.
So if you are going with a 1X liquidation preference, the main question is whether to go with participating preferred stock or not (a topic we discussed at length in the Term Sheet Series). Suffice it to say that participating preferred will have better investor economics in mediocre outcomes, provided the company does not go on to raise several additional rounds from investors who also demand participating preferred. In bad outcomes and homerun outcomes, participating preferred won’t make an enormous difference in your returns.
The option pool is another term very much driven by diligence fact-finding. How many shares are needed in the option pool is a function of what advisors and senior team members still need to be added, in addition to what the hiring plan looks like during the milestone period covered by the round. Option pool sizing obviously affects the company’s ability to attract and retain talent, but it can also affect returns pretty significantly because it has a major impact on valuation. If the pool is established prior to investment, that is equivalent to a lower valuation, and if it is established after investment, that is the dilution equivalent of a higher valuation. (For more on option pool economics see our post on Equity Deal Terms and Pure Upside: Understanding Stock Options and Restricted Stock for Angels).
Depending on the structure and experience of the team, protective provisions, which give investors some say in decision-making, can also be important protections. In this category you will find things like board seats which ensure investors information and control, as well as approval rights, which allow a class of investors to have a say in future financings.
The other terms worth paying close attention to at this stage are participation rights in future financings, which give you the ability to double-down when a company starts to look like a winner, and exit options like co-sale rights and drag-along rights to help force exits and partial exits when things are kind of stuck. If you are dealing with a founding team whose members have different experience levels or economic situations, making sure you have a solid drag along to force a consensus may be the difference between getting a mediocre return and no return at all.
One frequently-overlooked term is the dividend. If your diligence suggests that the market size may not be huge or you fear the team is cautious and may move more slowly and deliberately than average, you could be looking at a very long holding period for your stock. In these cases, having a dividend accumulating in the background can make an enormous difference in returns. For example, using the rule of 72, an 8% dividend alone will give you a 2X if left to run for 9 years.
Q: Of those deal economic terms, which should be the priority? Which has the greatest real-world effect on angel returns?
Most people would say that the initial valuation you pay (and the resulting size of your stake) is the most important. And valuation is very important, but if you study the way a typical portfolio works, it is clear that the rare big winners really drive the majority of your returns, so I could make a great case that there is no term more important than participation rights in future financings. If you have the ability to double and triple down into a huge win as it is taking off, the importance of that right will dwarf all the other rights in all the other deals put together.
In more normal companies delivering solid but not spectacular returns, your liquidation preferences, your protective provisions and your drag-along rights might end up being the most important. And in some minority of cases, your anti-dilution protection might matter, though as I have noted, few companies go on to survive down rounds.
Q: If Diligence is about getting to know the team, do you look for extra control in cases where some or all of the founders seem strong-willed?
This is where the terms on governance, management and control are important. These terms don’t actually vary as much as you might think, however. In an extraordinary situation you might seek some extra control, but typical preferred stock investing terms give most of the day-to-day control of the company to the board of directors, and reserve approval of really major decisions (such as M&A transactions) and really economically impactful decisions (such as issuing more stock for another financing) to some or all classes of shareholders. So in the real world what you typically see is that the board negotiates and approves the typical M&A transaction but the actual deal documents require shareholder approval before the final close. Since the directors are closest to the situation and they have legal duties to act in the best interests of the shareholders, it is pretty rare to see a situation with young companies where the board approves and recommends a transaction and the shareholders disagree. Thus, as you are completing your diligence and thinking about who to put on the board, you are obviously making a very important decision.
Individual shareholders are typically not going to be able to block a transaction they disagree with unless they have such a large stake in the company that they can prevent a majority from being reached by other means. As part of your diligence, you should pay close attention the capitalization of the company - both before and after giving effect to the financing. If there are particular issues to be concerned about, for example, a departed founder who has some grievances, you should consider making adjustments to the capitalization of the company or the terms of the voting agreement. For example, you might enlarge the option pool beyond the normal size and grant some of that stock to the CEO, or, as a condition of investment, you might take extra care to require all the founders to agree to voting provisions and drag-along clauses which stipulate that they will vote with the will of the majority of the preferred stockholders.
Q: Where your diligence raises specific concerns about the team’s commitment to an exit, are there things you can do? For example are there deal terms that might allow investors to force an exit?
Yes there are. The most common, reasonable and egalitarian provision is the drag-along right, which requires the minority to vote with the majority when an exit opportunity is on the table. Other common forcing functions favoring smaller classes of investors include debt maturity dates and redemption rights windows, which both tend to require an exit (or a refinancing) to provide the liquidity necessary to meet the payment or redemption obligation.
Less common, but equally effective (some might say equally destructive) is the demand dividend, which can be structured to allow a class of shareholders to demand a cash pay-out proportional to their shareholdings. If demand dividends and redemption rights provisions are not carefully structured with some balance and some protections, they can be like giving one class of shareholder the right to pull the pin out of the grenade at will, based solely on what is good for that class (i.e. VC fund expiration date or the like) without regard to what is best for the company or the other shareholders. Arguably, if your diligence finds issues so significant that you feel you need very strong terms to remedy them, you might want to revisit whether the deal is a good idea in the first place.
Q: What about situations where your diligence raises concerns that the team wants to flip the company to the first buyer they can find or accept an “acqui-hire” deal? Are there deal terms that might allow investors to block an exit?
Yes. The most common are (i) the right to appoint board directors and (ii) clauses which fall under the heading of protective provisions (which are also sometimes called “negative covenants”). Protective provisions can require super-majorities on board votes or shareholder votes; may require certain decisions to go to the board or to a class of stock; or may reserve approval/veto rights for certain directors or certain classes of stock.
Q: What about capital intensity? Are there terms that you should pay extra attention to if your diligence suggests a company is going to need a lot of capital?
This is where the investor rights and protection clauses are important. Investors want to make sure no future financing deals contain terms which unduly diminish the value of their investment or lead to someone moving into a superior liquidity position (without paying appropriately for that right). In situations where a company is going to be needing to raise significant capital, you need to look carefully at the terms that allow you to control future financing rounds.
Why is this so important? Because VCs coming in after angels may end up in a position to block an exit that would be a great return for founders and angels. Why would they do that? Because VC economics are different from angel economics. VCs are generally running large funds and are required to distribute returned capital to limited partners. An exit that provides a really good return to founders or early shareholders (who have typically been waiting longer), might not be such a good return for the VC who came in at a much higher valuation. They may have a strong preference for instead putting more money in and going for more aggressive growth before selling. This not only gives them more management fees on the newly invested money, but it also gives them a greater chance of having an exit with enough scale to “move the needle” in terms of their overall fund returns.
This dichotomy of perspectives is a classic illustration of the dangers of mixing different kinds of investors. During the due diligence period before investing, angels should always consider how much capital a company is likely to need, where it is likely going to come from, and how it is going to be staged in over time. The golden rule in investing is that that last round to bring the gold generally makes the rules, so it is important to make sure everyone is on the same page before co-investing.
Want to learn more about performing due diligence quickly and effectively? Download this free eBook today Stones Unturned: An Investor's Guide to Due Diligence in Early Stage Companies or purchase our books at Amazon.com.