How To Keep A Big Stake In Your Company
Okay now let's talk deal terms, the nitty gritty. If we run out of time again, we of course, materials that will lay out a little bit more about these deal terms specifics. How do you think about company stock? And I think the best way to think about it is you are likely in forming a c corporation, founders, maybe friends and family members are all going to get common stock, common shares, investors or at least the sophisticated investors that we refer to from angel investment clubs and venture, certainly venture capital funds. They don't want to buy common stock. If you think you're selling common stock to them at the seed and early stage level, you don't get it, You don't get it, you will get a term sheet that says VCS will buy preferred shares. So right then and there you need a corporate vehicle that has authorized preferred shares as well as common shares at the time of incorporation. Otherwise, we have to redo your incorporation documents, what does preferred shares mean or conve...
rtible preferred shares? I like to put it in terms of rights and privileges. Common shareholders, you're writing coach Investors were writing 1st class. What do we get at the time of exit? We leave the plane first, which means we get paid off first before all common shareholders get a penny. Next slide will show you a little bit more. Without exception. If you raise multiple rounds from investors, unless there are specific carve outs for you, which can happen, we'll get to it. All investors come out before this crowd plus there agreed profit that locks in their profits. Sometimes along this venture journey that you're taking together, they will get dividends accumulating dividends that at your option you can pay out in cash, but let's face it, you don't have the cash to pay for them. So one way we can ensure on this venture flight together That we are not still on board 15 years from now is we're creating a little bit of pain for you. However, we went out in 4-7 years. We don't want to go around the world 10 times. So the longer our money is in a common deal term is to have accumulating dividends, the longer they're on that venture flight with you, what happens the more accumulating dividends that are paid in stock. So what happens to your equity stake goes down over time? I'm really simplifying these dealer terms to kind of analogies, you know in broad strokes here. So they're first in first out and they get fed dividends that you don't get fed early on. Okay. A preference multiple. So often entrepreneurs will boast And say I got a $5 million dollar valuation for my company and they thought hard, hard, hard to boost that value. The perceived pre money valuation of the company that is the term before new money comes in. But they completely overlook all of what I consider are the more important deal terms that will affect your outcome and how far back you are In that plane on the coach line. How many your exit Euro 45 or whatever vs row 10. One of the go to is the first things I want you to understand is the preference multiple. What's that mean? Let's say I invest a million and a half dollars Or no $3 million dollars in Andrew's new company. Yeah. The easiest deal you've ever come across, right? And if and let's assume that her company is not out of cash. She is operating from a position of strength. She knows what she's going to do with that $3 million dollars to expand her furniture in her art online and open up many more customer relationships as we know she can. But this multiple preference multiple means at the time of sale or a liquidity event 15 times three is the amount of money that comes back to me. The investor first before the common share holders get a dime. So if she sells her business for $4 million dollars, Which we know it will probably be 40 million or million Andrea doesn't get anything. This is the 1st 4.5 million for the most part we'll go to me. I might take her out for lunch. You know, that's the preference multiple. The higher perceived risk of your deal. If you're coming to me at the 11th hour, maybe I will be really obnoxious. Say. All right, I give I'll let you have that valuation that you think you are worth. But I wanted three times multiple and you don't fight back on him Because you think I got a $5 million dollar valuation for the most part. Vcs are not going to behave like ask for preference multiples of 456 Crazy stuff. Because what does that do once you realize what you've signed? It's taken all your motivation out of building. Especially if you have to raise rounds of several rounds of cash. But all I'm saying is be aware of this that negotiating deal terms is never just one deal term. It is the entire package and appreciate the accumulating dividends if they are part of the term sheet and the preference multiple will matter at the time of exit. Common shareholders are last. This is what the preferred stock mean. Is there a black and white are all preferred stock deals the same? Not at all. They are only limited to the creativity of the attorneys that negotiate them so there's room for negotiation. What you want to aspire for is a fair deal. Something that gives the investors confidence that they will eventually get their money back and you will be motivated at some point to organize an investment and it won't go on forever. And we want to build the value of your shares together, but we want to lock in a return. We want to last money in first money out. For the most part, there will be a preference multiple. A lot of times it may be just one times you get that when you have multiple term shoots. The more risky the deal of the higher preference multiples. The later you approach the investor, The 11th hour deal, the higher the preference multiple. The companies that are most likely to go out of business. The higher preference multiple. How's that sitting with everybody empowering huh stuff too. But it's scary stuff though too. It's all doable right? Here's what you do know a lot of the companies that you and the brands you love have succeeded with this. So the twitters, the Facebooks, the googles all did this and they're here. So just because it's new to you should not scare you. All it is is balancing the very high risk of investors losing money and just making sure they're the ones putting in the cash, especially if you've put no cash into your big idea, investors are saying, come on, give me my money back first. That's the rationale. Now there are ways we're going to talk about them for you to create specific carve outs for yourself. You've got to negotiate them. But know that this stuff will be a part of a term sheet at the Angel Club and certainly the V. C. Level and you can succeed within these deal terms. We're giving you a lot of time to succeed. We're not saying you have to double the value of business in six months or a year, but know that if we're here helping you build the value of your business, we want to make sure we get that value. Plus you here are some other things. Some of them are a little shocking and surprising that you may find as part of negotiating your terms with investors, let's start out with VC legal fees. Just what's going to happen. Doesn't seem fair, but it will happen. VCS will have their own law firm and you will have your own sec attorney negotiating the term sheet and the final investor documents. And after closing, you're going to get a bill from your own attorney and then you're going to get a bill for the VCS attorney and guess who has to pay it. You. And I guarantee you the bill that would come from the VCS attorney is going to be a lot higher then the bill from your own attorney, unless that one eventually morphs into your own corporate counsel, but not likely swallow it. You may be able to negotiate a cap on that attorneys bill. So capital, you're going to have to pay it one way or another. Sometimes some VCS will and maybe this is somewhat related to the advisory fees may take out. And this is more something in more advanced stage businesses, some management fees and it's strictly cash flow back to the private equity fund negotiated again, I'm emphasizing, I like to present it. It's strictly a management fee. Do they do anything for it? Probably not. And the later stage deals, especially if it's M and A acquisition stuff. Board seats. And I'm gonna jump forward then jump back because I promised, I don't want to make sure we have time for questions. But I know early today somebody was asking about board seats. I said, when you control your company, it means controlling your board. So here's what can kind of happen. My little gotchas, a typical VC deal at the time of incorporation, you probably told the state, probably the state you reside in That your company will always have 5-7 5-11, some a number of board members, but no less than some amount likely you want to, you have a board seat. I want the founders to always have a board seat always. But in the VC deal term sheets, it might say the CEO has a board seat. Now you're the company's CEO but suppose you give up that title and become the chief science officer and you agree that a new Ceo should come into play who's lost their board seat. If you don't say Susan Schrader will have a board C and your attorney doesn't pick up Ceo versus Susan Schrader shame on the attorney. Don't expect the term sheet, which will just be an outline of deal terms to be to expose all the gouaches as much as the final investor documents because those get into the details that maybe not fully outlined in the term sheet term sheets are not binding unless they say that they are binding. It is an outline and a proposal of likely deal terms. So it's kind of when you sign a term sheet, you are close, but it's not the final deal. And usually you're so exhausted. You are so over this, you just want to sign whatever they brought in front of you. That's where you need an attorney by your side, who you engage to get the deal done but never let you get too tired that you won't sit down and learn all the different aspects of what is going on higher the attorney to force you to sit. Then you minimize surprises and likely scenarios and you can together strategize how to improve your position. But you will get tired. You'll be so over this. You will want that cash so badly. You will sign anything. You will show up at closing and you will see that document for the first time. Here's something else you're going to do unless you change it. You're going to just say, we'll get to my employment agreement later because you don't want to keep delaying things. Uh, we'll get to it later. The investors to say, oh, we'll tackle that the next board. Mean, what has happened if you agree to work on your employment agreement later after the money goes in, lost your leverage, you've lost your leverage and guess who agrees Ceo employment agreements are agreed to you. Report to the board of directors, which now includes more people who represent investors. Wouldn't it make sense to negotiate an employment agreement? A fair one when your team is part of the director's first or you insist to develop an outline of what the employment agreement deal terms are as part of your term sheet. Usually, you might say in the term sheet employment agreement for the Ceo Jack. But what is it is a three year dear. A five year deal. What are your limits of authority? Obviously you're going to report to the board of directors. What are the conditions of firing you under? What conditions can you Kirk your cause? Again, employment agreements matter control boy. If you don't want to be fired, have a good employment agreement. If you don't want to be fired, don't sign a a deal, make that agreement a condition of closing. But usually it's not the investors who wait to get it done. If you say later is fine, Who's to blame? So, notice all these fears that we talked about in the earlier segment, who's who's problem isn't you have the ability to slow it down, But I know you want the cash and investors. Are they taking advantage of you? You're shaking your head. Yes. So didn't I say no one is going to watch out for you better than you? No one is Gonna watch out better for you than your own legal counsel who only represents you. Is it the investors job to watch out for you? No. Their job to their investors is to make money. That's their job. That's what they're paid a salary for. So who's to playing? I'm saying it's you, if you don't speak up, why are they going to worry about it? We want to keep you happy. But there's a good chance your company or other companies like you may not do as well as fast as you think you will before you even go out and solicit investors. I want you to first start thinking about an independent director, not your brother sister. Best friend. People who will be your best buddy from college. I want an independent director who has already experienced serving on other boards because no been there done that people, it's amazing how people get on boards of directors and don't know what's appropriate for a board meeting. Where can you find great independent Directors? National Association of Corporate Directors has a free registry. I'm on it. Um I'm an N. A. C. D. Fellow, but there are people who have experienced in serving in growth oriented companies. You don't want rookies but who are the best independent directors. I want somebody in my company. I want people for your companies that brings something else to the table, not just show up at meetings and bob their heads. Where do you want to go as business? If you're thinking in a few years, I want to expand to europe. Maybe a great director is somebody who has already has that knowledge base. Wherever your weaknesses are managerial weaknesses. An independent director means somebody who is not beholden to the V. C. But somebody who will contribute value who believes in building the value of your business. If you are a technologist, starting an amazing social marketing platform, maybe there are some independent directors that come from that space. Suppose your marketing plan is dependent on selling to Fortune 1000 companies and you're not a great at sales. Maybe think about bringing in a director who has that experience and contact base to help ease your journey. Whatever your weaknesses are in where you want to go in the next five years, use independent directors to expand your reach, expand your knowledge base, who want you to succeed. Great independent directors, we'll always do the right thing. The fair thing for the company as well as the responsibilities of corporate directors is to protect share all shareholders. Not just a few shareholders but they really believe in good corporate governance. I tend to believe that the Ceo who invites a director in where they understand your passion and how much dedication you have to the business that likes and respects you. Yeah, well not they'll be loyal to you until they absolutely can't. They will give you the benefit of the doubt. Independent directors that may be slated in and brought in because of prior relationships with the VCS are likely to favor the VCS. All independent directors again are likely they'll want to do the right thing. But I want you to find independent directors that all investors say, Gosh, this person is really thinking and shooting for the big time. Look at the great decision and the outrage of pulling in a director who can help the company be more that independent director has to be kind of approved and say, yeah, that's a great director to have keep that director in the fold. So I want you picking an independent director start with one, maybe even two where you always outreach and say I've got a list. You may have some list too. But I have some candidates who can be awesome directors. Now, it's not uncommon for VCS not to want any independent directors, but if they're already there in contributing value, they're not going to not do a deal with you because of it. But Mhm. Stacking the deck is too strong a word if you don't stack the dick a little bit in your favor. VCS for sure. Will stack the deck in their favor. Thank you. Does that work? I think so, definitely. This is what control is all about. Keep your name in the mix. Make it clear you want to be a part of board meetings. If you give up the ceo title, be the chairman of the board. I love it when you go in and you be the chairman of the board. Why not? Sometimes that can go to an independent director. If you don't ask for it, it may go elsewhere. Now. I want you to live up to that role and you can and there are great tools at N A D C and a national association corporate director on how to really live that role. But the best way is to involve people who have already been there, done that and served on other boards in good times and and bad. Some of my best days were on boards and some of my worst days were serving on boards. Not kidding. How does that sit with everybody? Usually you will find as part of every term sheet a certain number of boards, if you have multiple Vcs or have done multiple rounds. Usually those designations will be placed and you want to have the opportunity. Usually that board seat will be taken from somebody in the venture fund and just know That that VC may sit on 10 boards, lots and lots of boards and that's why I value that wonderful working relationship with some independent board members who will end up devoting more time in a different mentoring way than the V. C. Can have. This is part of your firepower. This is going to be a resource, especially when problems happen of people to turn to, who will help you sort through those problems and the earlier you bring those problems up, the easier it is to solve them. You always want to keep ford trust and that's up to you to communicate with the board. We've covered convertible features we talked about a little bit earlier and those deal terms are important. What are the conditions when preferred stock can convert into common stock? I don't want to dive down too deep, but that is worth a discussion with your Securities Council. Different term sheets can pose different things. It's important clawbacks and there are different words for this guy. Doesn't that sound nasty to begin with. Ooh, suppose you say in such a bullish way, my valuation is worth this and I will accomplish this. Suppose you don't in really aggressive deals where maybe the ceo is just not perform that well. There may be certain scenarios in which investors create conditions that if certain things are not accomplished, then you give up more equity. And usually if you ask for some extreme thing, there will be some offsetting things somewhere in that term sheet. I absolutely recommend for entrepreneurial companies and no one ever really doesn't. Why not set some benchmarks for performance when you can earn back a steak? If you exceed expectations beyond certain levels of performance, why not have a discussion? How can, what ways can I earn backs an equity stake and the number one way, by the way, should be aggressive. And in your employment agreement is an allocation of stock options every year. Stock options in your company is away two key add back to your investment position. But why not brainstorm and say, you know what? I am a determined person, I am accustomed to exceeding goals. Is there a way that I can earn back more of my shares for certain levels of performance? How can you motivate me? You might achieve those goals. Why not? If you don't ask, you don't get But this can be a collaborative discussion now. Why would investor entertain that if you beat your goals? If you're growing at an unbelievable rate and especially if you don't need more and more rounds of cash jay, they don't lose, they may lose a little equity stake, but if the company is growing beyond their more, have been happy to motivate you to work harder as for it. So every term sheet is different. Every negotiation is different. What I'd like to see you do is your best approach is a calm approach to not be offended when you receive the first proposal. No. Why If they lose money on five out of 10 deals, there is a reason why they need some of this stuff in there. Just be fair as part of it sometimes on carve outs, especially in companies where there are multiple rounds going in where VCS will say, yeah, let's carve out a little equity stake that is not subject to some of these issues for the ceo, for the some top people coming in. So it's all negotiable. But if you don't ask and you don't have a good security attorney at your side, you're not going to get it. So as I said, what are some of the pre deal strategies? Pre deal strategies to maintain your position? It starts with you? Independent directors, one or two. A reasonable employment agreement. So you have a board with these independent directors before the VCS come in, develop a fair and reasonable employment agreement, then fair and reasonable, not abusive. His otherwise, it will be changed, he'll say, unless you change it, we're not investing. Keep it fair and reasonable securities attorney. And when you're working with attorney, your VCS or angel investors agree on milestones, make sure you're really well aligned. So that confusion doesn't start from day one on what you can accomplish, agree on those milestone objectives that everybody's working too and start raising cash before you need the next round of cash. That is what you should have in your brain. Another thing that people frequently ask me about is what amount of stock option pool should be a good set aside for future employees and managers that you bring to your company. Now, stock options are not necessarily immediate delusion because the stock option means those employees eventually have to pay some amount for the shares and exercise and they contribute cash to your company. But in general, pool terms, especially for high flying companies that are really going for the big bucks, A good 10-50 15 of outstanding um, shares is a good round number that you'll probably see in deal terms. She's, but you can participate in that too. That's a rough again, the investor steak is highly dependent on the company and how much cash you've put in or angels have put in before. See the broad ranges here, don't hold me to this. It really is specific to the situation as you achieve your negotiating power. Certainly once you reach cash flow break even and grows in power, the first deal may be the toughest deal. It should not be the hardest to swallow. But that's what delusion means. Maintaining control and maintaining the control of your board is really dependent on trust. If you take the money and don't talk to your board members or investors on a weekly basis, maybe with independent directors every two weeks or so in a friendly way. Um, you're setting yourself up for trouble if you are communicating. One of the things I love for entrepreneurs to do this may be a little monthly bullet point list what went well this month and what didn't go so well, if you wait to talk about something that is a problem, what do you think that does to the trust level? If you take the impression that, oh my gosh, this went wrong, all I need is a little time to fix it, then I don't have to, I don't want them to think I can't do this. That is the wrong attitude to have with VCS that will set them up and think, you know, we don't want to invest again, they are here to help you because if you win, they win and the reverse problems will happen, surprises will happen, communicated to the board. It is your responsibility, especially if you're chairman of the board and start raising cash before you need more cash. That's how you keep things going. I think I'll take some more questions. Let's take those questions now. But that's my big message. Everything You are empowered to succeed with investor capital. It comes from you. You can maintain control of your business. You really have the power to do that.