Note: This article is the second in an ongoing series on Exits. To learn more about how to plan for exits and maximize returns, download our free eBook today Angel Exits: Perspectives and Techniques for Maximizing Investment Returns or purchase our books at Amazon.com.
It’s exciting news! The CEO of one of your investments tells you that a buyer expressed serious interest in acquiring her company for $30M. Since the company has struggled to find huge growth, you are relieved and do a quick mental “back of the envelope” calculation and you figure you’ve bagged a 5x return in a couple of years. Not too bad for one of your first angel deals!
Before you count your chickens, that great exit might not actually materialize in the way you think it will. Based on the terms of the deal you invested in, and any future rounds of investment the company raised, the actual outcome can range from far worse than that (a significant reduction in the 5x you thought you were going to get) to infinitely worse than that (the deal never materializes after company-crippling delay and distraction.) So what can go wrong? Let’s dig in a bit and take a closer look at how deal terms can dramatically impact your investment returns.
Christopher pulled together an in-depth discussion helping investors understand deal terms found in investment term sheets. Many of the deal terms focus on key issues that you need to understand to have a sense for how your share of the exit pie gets calculated.
Q: Christopher, let’s start with the investment terms that are focused on Deal Economics. What are the key deal terms that an investor needs to focus on?
It’s important to pay attention to the fine print here because beyond the obvious 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: (i) 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 (ii) 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 because their valuation is 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.
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. There are a lot of good reasons to avoid multiple liquidation preferences and instead stick with a 1X. The main reason being that later rounds will want the same thing, which is very costly.
So the main question is whether to go with participating preferred stock or not (a topic I have discussed at length in my 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 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 posts on Equity Deal Terms and Pure Upside: Understanding Stock Options and Restricted Stock for Angels, and How Startup Options (and Ownership) Works by Scott Kupor at Andreessen Horowitz.).
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 give 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 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.
One frequently-overlooked term is the dividend. Many exits end up taking far longer than anyone originally anticipated. 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 terms, which has the greatest real-world effect on angel returns?
If you consider the way a typical portfolio works as outlined above, it is clear that the rare big winners really drive 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 on a huge win, the importance of that right will dwarf all the other rights in all the other deals put together.
In more normal companies, 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: Who has the decision making authority as to whether to accept the acquiring company’s offer? What if an individual shareholder disagrees?
Typical preferred stock investing terms give most of the day-to-day control of the company to the board of directors, but 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.
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. You sometimes see large blocks like this with big VCs in early rounds, but it gets harder and harder as the company’s capitalization and valuation increase. You also see large blocks of common stock in the hands of founders, but even in situations where founders control large chunks of common stock, as a condition of investment, the preferred stockholders typically require 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.
The corporate law of Delaware and some other states do grant appraisal rights to minority shareholders as a way to level the playing field in deals where the price may not be reflective of the true value of the company. And Delaware also has provisions to protect against the oppression of minority shareholders. The level of unfairness and lack of due process required to qualify for these protections is relatively high, and the cost and hassle of exercising your rights is high enough that it is pretty unlikely to be worth pursuing in the typical $25K-$50K angel context. Instead, situations like this end up getting thrown into the “lessons learned” heap along with the other 40-60% of your portfolio that is unsuccessful.
Q: Are there deal terms that might allow investors to force an exit?
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 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 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.
Q: And how about the other way around… 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: Why would a VC want to block an exit that would be a great return for the founders and the angel investors?
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. 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 the 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 how to plan for exits and maximize returns? Download our free eBook today Angel Exits: Perspectives and Techniques for Maximizing Investment Returns or purchase our books at Amazon.com.