Two Primary Considerations When Raising Money for Your Business

Are you in the process of raising money for your business?  If so, there are two primary considerations you should have in mind as you negotiate the terms of that investment with your prospective investor.  That’s right, just two.

Keep these considerations in mind, and you’ll be well positioned to accomplish a successful fundraising without getting lost in the minutia of secondary business issues and legal jargon.  Lose focus on these considerations, and you might just end up giving away a lot more than you should over the long term in order to raise funds needed for the short term.  The venture capitalist looking to invest in your company is focused on these terms, and you should be too.

Want to know what the two primary considerations are?  Well here’s the answer: “economics” and “control.”  Let’s take each one on separately:

1)      “Economics” for this purpose can be defined very simply – it’s the return your investor will get when your company is sold or completes an IPO.  More return for your investor means less return for the founders, at least in a relative sense.  As such, the deal terms that have an impact on return should always be a primary consideration.  And which deal terms are those?  Let’s start with a few of the biggies:

  • Price and valuation.  The higher the valuation of your company, the lesser the percentage of the overall ownership (equity) the investor will get in your company in return for the funds being invested.  To protect yourself in valuation discussions, be sure you are clear as to when your investor is talking about “premoney” valuation (i.e., the company’s value today, prior to the investment) and “postmoney” valuation.  Valuation discussions are typically tied closely to two related outcomes: what percentage of the company will the investor own postmoney and what price-per-share your investor will pay to get to that percentage.  Both of these will in turn be subject to other considerations, including the size of any option pool reserved for issuance of shares to deserving employees, and whether any warrants will be issued to the investor as part of the financing.  Valuation can be a complicated and many times contentious subject.  Suffice it to say for now that your business and legal advisors can and should play a critical role early in the process of negotiating price and valuation.
  • Liquidation Preference.  Simply put, an investor’s liquidation preference determines how much your investor will get upon a “liquidation.”  A “liquidation” is typically defined to include a sale of your company’s assets or a sale of control of your company, although the term may be expanded in negotiations to include other things.  A “preference” in this context is the priority given to your investor upon a liquidation event to get its invested funds (or not uncommonly, a multiple of its invested funds) back before the founders and other common shareholders get any money out.  Instead of or in addition to a liquidation preference, the investor may also get the right to “participate” with the common shareholders in receiving a portion of any funds that are left over after the liquidation preference is paid out.
  • Anti-dilution Protection.  Anti-dilution provisions address the scenario where the company later issues shares to a second investor at a lower price than the one paid by the first investor today, thereby allowing the second investor to obtain more equity for less money and diluting the first investor’s stake in the company.  These provisions protect the first investor by ensuring that if and when it later goes to convert its preferred shares to common shares (something it might do, upon a sale of the company, in order to receive a portion of a liquidating distribution being made to all the common shareholders), it will be entitled to receive a higher ratio of common shares for each of its preferred shares than it was originally entitled to receive.  There are several different flavors of anti-dilution protection (“weighted average,” “ratchet-based,” etc.), and you should look to your lawyer to help you understand the differences, as well as the pros and cons of the anti-dilution protection that your investor is requesting.

2)      “Control” for this purpose refers to the extent to which your investor will have the right to participate in and control important activities of the company.  Your investor will have a legitimate desire to exercise adequate control to permit it to protect (and hopefully grow) the value of its investment.  The company’s management, on the other hand, will want to retain authority over the company’s day-to-day operations without undue interference from the investor, particularly if its efforts to date have been successful.  The key for the company will be to give up only enough control to make the investor comfortable enough to invest – clearly a balancing act.  The parties’ competing desires will set the tone for discussions of key terms involving control, including the following:

  • Board Seats The investor will likely want one or two seats on the company’s board but, for emerging companies, should only hold a minority of the total board seats.  By contrast, some VCs will request only that they be entitled to have an “observer” attend board meetings for the purpose of ensuring a free flow of communication between the investor and the board.
  • Voting Rights.  When it comes to voting rights generally, key questions include whether the investor will, as holder of preferred shares, have the right to vote with the common shareholders; or whether it can only vote as a separate class.  If the latter, on what matters will that preferred vote be required?  If the former, the number of votes that the investor can cast will be based usually upon the number of common shares into which the investor’s preferred shares can convert.
  • Protective Provisions.  Protective provisions are a brand of voting rights that give the investor the right to reject (or “veto”) any of a specific list of actions negotiated between the parties.  Many of the company actions subject to investor approval are fairly standard, including changes to the investor’s rights, changes in the company’s capitalization, amendments to the company’s organizational documents, and a merger or sale of the company’s assets; while others are less standard and subject to negotiation.  The trick, as with the other control provisions, is to strike a careful balance between giving the investor enough authority to protect its investment, while preserving management’s freedom to control the fast moving, daily affairs of the business.

So, where does this leave you?  If nothing else, you hopefully now have two things: a sense of what considerations are most important when negotiating with potential investors; and a basic understanding of a few key deal terms that underpin these considerations.  Armed with this knowledge, the next thing you should do is challenge your legal and other advisors to explain why the proposed “economic” and “control” terms proposed by your prospective investor do or do not make sense.  After that, work with your advisors to come up with a recipe of optimal deal terms that serve the needs and desires of both your prospective investor and your management team.

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One Response to “Two Primary Considerations When Raising Money for Your Business”

  1. Aaron — Great article. I’m doing some consulting work for an early stage company that will be seeking financing soon. I’m not nearly as well versed on the legal issues as the financing, so this very helpful.

    The name of the company is RedCap, http://www.redcap.com. It’s a membership based personal driving service that leverages technology and a channel partner marketing strategy to disrupt the taxi and town car / limousine services industry. The company offers a higher quality personal driving experience by crowdsourcing certified RedCap personal drivers.

    Brad