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to move the company into becoming a profitable venture.
The last type of risk is a business strategy risk, the assessment of the po-
tential that the company™s targeted market could change during the venture™s
beginning. Can anything occur that might have an impact on the acceptance
of the company and its strategy in the market?
For many private equity investors, the “venture” in venture capital has
been a misnomer. Venture capitalists in many instances have avoided invest-
ing in start-ups because they believed that the risk/reward ratio was unat-
tractive compared with the opportunities to enact mezzanine transactions
with shorter time horizons. This perception has spread, attracting a dispro-
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portionate amount of money over the past several years to the later-stage seg-
ment of the financial spectrum. Inevitably, the market has responded at the
seed end of the spectrum with lower entry level pricing and an improving
risk/reward ratio.


DEFINITION OF NEGOTIATION

Negotiating is a process by which the investors, entrepreneurs, and their ad-
visers reach an interdependent mutual decision that the transaction is a good
deal. This involves clarifying and agreeing on what the investor and entre-
preneur will give to and receive from each other in completing the transac-
tion. It is not win-lose; instead, each person attempts to understand and
consider the other™s concerns. While it is generally believed that “those with
the gold, rule,” entrepreneurs who overly concede accrue resentment and
anger that surface later, confounding relationships with investors. As the
nineteenth century English writer Samuel Butler put it, “ It is not he who
gains the exact point in dispute who scores most in controversy, but he who
has shown the most forbearance and better temper.” Entrepreneurs must
make their negotiation objectives a fair deal, and be willing to give the in-
vestor some protection if the entrepreneur fails to meet milestones.
Negotiating begins after due diligence, and only when the investor has
decided to go forward. At this stage, the entrepreneur needs to negotiate the
structure of the deal and work through development of an agreed-upon pre-
liminary understanding into legal documents. The parties will have to decide
on an array of issues. Commonly, such negotiations are between the lead in-
vestor and the entrepreneur. Remember, investors will be motivated to secure
terms and conditions to protect their financial downside by negotiating an
agreement that allows investors some degree of influence and control in de-
cision making. Following are negotiating guidelines for entrepreneurs:

– Be clear and accurate.
– Take your time.
– Bring in an attorney only after you have reached some level of verbal
agreement with the lead investor.
– Negotiate for yourself; do not delegate to a third party.
– Since angels don™t have to invest, if they reject your offer, try to under-
stand the terms and conditions under which they would invest.
– Avoid feelings of personal rejection; focus instead on issues.
– Constantly requalify the investor prospect to ensure they are “real”
investors.
234 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


ELEMENTS IN STRUCTURING THE PRIVATE PLACEMENT

Based on research by ICR of more of more than 3,000 companies and 480
completed deals, 65 percent of transactions concluded at the seed, R&D,
and start-up stages used the private placement as the transaction structure. It
is no accident that the transaction most commonly used by angels is the pri-
vate placement, which typically involves cash for equity, and is flexible be-
cause it encompasses all types of offerings not publicly sold. The private
placement is the issuance of treasury securities to a small number of sophis-
ticated private or institutional investors. The common exempt offering in-
volves such financing considerations as debt, equity (usually preferred
stock), or some type of investment unit (preferred stock or debt issued with
warrants).
Angel investors use four categories of securities: common stock; pre-
ferred stock; convertible preferred stock; and, of course, convertible longer-
term debt and convertible notes. Warrants are also used with both equity and
debt notes.
The most common investment security in private placements is preferred
stock that converts at the option of the holder into common stock. This fea-
ture will allow the holder to share in the success should the company be sold,
merged with another company in a stock swap, go public, or exit through
some other liquidity event. Preferred stock also customarily has a liquidation
and dividend preference over common stock, “full-ratcheted” or weighted-
average antidilution protection, certain voting rights, and, possibly, a re-
demption feature that becomes effective after a specified number of years.
In almost all cases, the only way investors in these types of transactions
can benefit from the risk that they have assumed is to share in the upside po-
tential if the venture proves to be successful. And the only way they can do
that is through equity. This reliance on preferred stock provides other, less
obvious benefits to investors. For example, it provides leverage to influence
management when things go askew; also, preferred stock requires the entre-
preneur to remain in contact with the investor. This provision creates warn-
ing mechanisms that permit the investor to change management or set time
frames and conditions for making changes when they become necessary.
Preferred stock can also provide some income through dividends, al-
though this is not a circumstance typically arising in early-stage ventures.
However, preferred stock is redeemable by the corporation, which may set
up a sinking fund and establish compulsory payment.
Sometimes companies will issue warrants that can be used to acquire a
greater percentage of the company based on its actual results. For example,
investors who disagree with the premoney valuation proposed by the
entrepreneur can be offered warrants to purchase additional shares of the
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The Venture Investing Process


company as a hedge. The warrants become exercisable if the company
fails to perform according to plan or an agreed-upon set of milestones. They
can also be structured to be exercisable to varying degrees, based on per-
formance criteria.
The exercise price of the warrant is another variable. It could be priced
at the initial closing purchase price, be priced at fair market valued at the
time of exercise, be floating until set based on performance against mile-
stones, or be nominal. Again, the goal of the investor will be to structure the
warrant so that the return on the shares originally purchased, together with
the warrant shares, result in the targeted internal rate of return.
Entrepreneurs will discover that some investors prefer to “lead” the
round, drafting terms of the deal and negotiating terms with the company
and other investors. Other investors may hold a more co-investment strategy
orientation, and be willing to co-invest on terms originated by lead investors.
A variety of motivations lead investors to become more active or passive. We
refer readers to The Angel Investor™s Handbook for a more comprehensive
discussion of active versus passive private investors.


OVERVIEW OF DEAL TERMS AND PROVISIONS
Entrepreneurs have burned up so much of investors™ money that they have to
expect more demanding deal terms. Over a three-year period, a 1.5 multiple
amounts to a 15 percent annualized return”a total that in the minds of ven-
ture investors, who have left trillions of dollars on the table, will not cut it.
As a result, investors may seek more demanding provisions in hopes of im-
proving returns; but in the early rounds of deals, such terms”regardless of
how onerous”most likely will never come into play. This is because it would
be more prudent to just shut down a “washout” company and take the write
off than it would be to execute protections that in the end would provide no
monetary benefit.
For purposes of our discussion, we focus on terms most likely to appear
in earlier-stage term sheets or agreements, with the assumption that punitive
provisions are recognized as not contributing to building great companies;
nor do such provisions foster good relations and long-term alliance between
entrepreneurial managers and investors. However, given current economic
conditions and recent downturns in the capital markets and investment
banking/brokerage prosecutions, the new-found emphasis on such terms is
unlikely to go away any time soon.
Entrepreneurs should be familiar with the many possible deal terms that
can be drafted into placement memoranda, subscription agreement, term
sheet, stock purchase agreement, shareholders agreement, or ancillary legal
236 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


agreements that can be drafted following negotiations. Some of the terms,
such as valuation, security, rights and provisions, we™ve briefly touched on.
Most angels have a set of standard terms as a starting point for their invest-
ments. More experienced entrepreneurs and founders will also be familiar
with these terms. Regardless, all terms should be understandable and ac-
ceptable to subsequent investors, and must accommodate the many potential
“hedging” strategies, such as staged investment, mentioned earlier.
Once the amount of investment is determined, the security to be used is
considered. We have already spoken of common stock, preferred stock, con-
vertible preferred stock, and convertible notes. The security that best pro-
vides upside capital appreciation and downside protection from the investor
perspective is convertible preferred. Convertible debt is much less attractive,
since it carries a negative impact on the balance sheet, and few start-ups can
afford to also pay interest. Preferred stock carries preferences, potential for
dividends (rare in start-ups), liquidation preference, voting rights, convert-
ibility elements, and redemption rights. Preferred shareholders will have a
priority claim over common shareholders to assets if the company fails,
equivalent to the investor™s original purchase price of the security plus any
accrued dividends. Preferred shareholders vote with common shareholders
and are entitled typically to one vote for each common share into which pre-
ferred shares may be converted. They may also have special voting rights, for
example, to elect the majority of the board upon any breach of the terms in
the preferred stock purchase agreements. Preferred stock is normally con-
vertible into common stock at the holder™s discretion, except when automatic
conversion obligations are agreed to.
Convertibility will occur at a specific price per share or at attainment of
a specific goal. The convertibility ratio is commonly expressed by a formula
based on the original purchase price, adjusted for stock splits, dividends,
and sales of common stock at prices lower than those paid by preferred
shareholders.
Redemption terms or rights offer the investor means by which they can
recover their investment. Redemption can be optimal or mandatory after a
specific period of time. A stepped-up redemption price is sometimes built
into the agreement to provide investors with a certain return on investment.
In mandatory redemption, a preferred stockholder may be forced to exercise
conversion or lose the upside potential of his or her investment. In our expe-
rience, the majority of done-deal term sheets provided for mandatory re-
demption or redemption at the option of the venture investor.
Vesting is a term relating to investor demands that shares be issued to the
management team members over time, or, if founders shares have already
been issued, that the company have the right to repurchase shares if an exec-
utive leaves the company. Obviously, entrepreneurs prefer to purchase shares
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The Venture Investing Process


up front and be 100 percent vested without the company having repurchase
rights. Negotiating a compromise is paramount, so that partial vesting oc-
curs at the time that capital infusion occurs, followed by full vesting over
time, while vested shares would be subject to repurchase by the company if
the entrepreneur leaves the company.
Investors will negotiate dilution terms as well. Because companies re-
quire multiple rounds of financing, investors are justifiably concerned about
their equity position being diluted relative to the entrepreneur™s share.
Dilution provisions are designed to prevent dilution. Antidilution adjust-
ments, for example, can affect the number of common shares issued when an
investor™s preferred stock is converted.
Full ratchet antidilution protection, which lowers the conversion price
to the price at which any new stock is sold, no matter the number of shares,
obviously favors the investor. Weighted-average antidilution provisions ad-
just the conversion value by applying a weighted average of the purchase
price of outstanding stock and newly issued stock. Because of the longer
“earn back” period”an average of eight years, based on our research”there
is a greater pressure for investors to negotiate antidilution terms. Remember
Murphy™s Law? In a recent study of 80 venture financings, 36 percent of
terms provided for ratchet antidilution, and 64 percent for weighted-average
antidilution.
In research of recent financings conducted by ICR, 90 percent of the
time liquidation preference was negotiated beyond family and friends and
cradle equity transactions. The majority of these financing were at 1.5 times
to 3 times multiples, and the majority of these provided for participation.
About 25 percent of the time, our review of deals disclosed that price pro-
tection provisions were subject to “pay-to-play” terms. This provision makes
the continuation of protection for the investor contingent on the investor™s
purchasing at least its pro rata share of any future issuance priced below the
conversion price. Pay-to-play provisions usually also provide for conversion
of nonparticipating investors™ preferred stock into common stock.
As angels continue to protect their downside, they also seek terms re-
garding representation on the board of directors. Remember, investors view
themselves as owners. By specifying the percentage of directors to be elected
by each class of stock, investors can address their fear about dilution of rep-
resentation rights that subsequent offerings might cause.
“Drag-along” provisions are more common today than they were five
years ago, as investors include terms requiring a company to vote as told.
Drag-along voting rights, particularly when a big liquidation preference is
present, and there is investor concern that management might not approve
the deal because of their share, are now finding their way into term sheets
and purchase agreements.
238 UNDERSTANDING THE ANGEL INVESTMENT PROCESS


We also see to a lesser extent terms relating to employee stock purchase,
for example, allocation of shares available for employee incentives, co-sale
“take-me-alongs” relating to right of first refusal, and management “carve
outs” or bonus plans upon sale that guarantees that the first $1 million or
more of the sale goes to common holders in addition to anything they might
receive because of the stock that they hold.
Last, entrepreneurs must be ready in the current litigious climate to pro-
vide D&O insurance, ensuring indemnification of investors with board seats,
an expense rarely contemplated in forecasts.


OVERSEEING AND ADVISING POSTINVESTMENT

Investors use the early phases of the venture investment process to manage
risk before investing. To manage risk after the investment is made, however,
investors implement monitoring strategies to track the performance of the
venture. Monitoring strategies are designed to identify problems before they
require drastic action to rectify them. Based on our research at ICR, angel in-
vestors experience a total loss of their investment 11 percent of the time; 24
percent of the time they experience partial loss; one third of the time, early-
stage investors lose investment capital”quite a motivation to monitor
postinvestment venture performance.
Monitoring early-stage investments is a form of control mechanism.
Think of the instrument panel a pilot uses to monitor a flight, particularly a
flight imperiled by low visibility. Like pilots in fog, investors find themselves
flying in bad weather because projections fuel most of what has lifted their
investments off the ground. Little is based on historical financial fact or cur-
rent reality. Fueling an investment™s gas tank are conjectures based on as-
sumptions.
Given these circumstances, investors need to create their own instrument
panel. By doing so, they put in place an early warning system capable of

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