Reading the fine print | Decoding important details in an investment agreement protects owner and investor
In venture capital investment, professional investors trade their capital for ownership and a voice in companies that have potential for outsized growth and returns. From the company owner’s perspective, a valuable and supportive business partner who will invest in the company ranks pretty high on the wish list. The agreement between the venture capitalist and the business owner hinges on what the owner’s business is worth in terms of its historical performance, as well as the potential growth the company needs venture capital to realize.
What can you expect if you’re looking for an investor? You enter the money marketplace looking for a buyer for what you’re selling — your team, your business and the chance to make investors happy they risked their capital. After a two- to three-month due-diligence evaluation, the investor will sit down with you and discuss the economics — in other words, how much ownership you will have to give the investor for a certain amount of capital. The investor will analyze and assess your past successes, your present team and your future potential to get a sense of the risks and opportunities your company presents. This assessment translates to a valuation that will determine the nature of the investor’s ownership.
The simple math
In the vernacular of my trade, “pre-money” valuation is the value ascribed to your company at present, based on what it can achieve with its own capital and resources. Investors’ capital is called “new money,” and the combination of pre and new is the “post-money” valuation. New money divided by post-money establishes the investor’s percentage ownership. For example, we agree your business is worth, say, $2 million pre-money. If I propose to invest $1 million in new money, then I will own 33% of your company, or $1 million divided by the post-money value of $3 million. (This ignores any value-related terms, which I’ll get into later.)
The only hitch to this plan is that venture investors are not willing to purchase common stock — the same class of shares founders and owners have issued to themselves. For good reasons, investors demand a new class of “preferred” stock because they need certain unique protective and economic rights that common stock does not have. So, in return for me providing you with risk capital for a minority position, you agree to create a new class of stock that can either be repaid with a modest interest rate just like debt or can be converted to common stock at the investor’s discretion. While there are a few kinds of preferred stock — such as convertible, participating or redeemable stock — most preferred stock includes minority rights that give the investor a board seat or two and approval rights for key decisions, and the option to convert preferred stock into common stock if the company goes public or is bought by a corporation.
Value-related terms
Owners new to venture investment tend to focus on pre-money and believe ownership control will always translate to a split reflected in the math above. But what is often a surprise to owners is that the investment deal is only partly defined by pre-money. Why? Well, an investor who is concerned that the company’s valuation is too high may structure a deal with pricing and terms that vary according to the size of the return. In other words, the deal described above (the $1 million buys one-third of the company arrangement) could be tweaked to include a preferred-stock security that protects investors against low value “exits.” Exits are terms of the trade for the realization of the projected value of a company when it is sold, merged or gone public. In the example above, an investor concerned about the risk of overpaying might structure a form of preferred stock (so-called “participating preferred stock”) that ensures that they first get their money back and, after repayment, take their proportional share of what’s left. So, in the example above, if the company that was valued at $3 million post-money was sold for $5 million with a participating preferred stock structure, investors would first get back their $1 million and then would take their as-converted share (33%) of the remaining balance, or one-third of $4 million. Under this exit plan, the investor leaves with $2.3 million, or 46% of the $5 million the company ended up being worth, despite the fact that the investor’s share was originally only 33%. A common stock deal would have given the investor only $1.3 million (a poor return) while management would have kept $3.7 million for what was a poor performance. The participating preferred stock structure, therefore, generated more return for the investor, who usually expects to make closer to 10 times his money.
The message here is that entrepreneurs and business owners need to consider and understand the structure of an investment as much as they do their company’s pre-money valuation. While venture investors are not necessarily trying to hide their true economics, their legitimate efforts to protect themselves have real economic and control consequences for the business owner.
Michael Gurau, managing general partner of Clear Venture Partners in Portland, can be reached at mg@clearvcs.com.
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