How To Keep A Big Stake In Your Company
Okay, now let's talk deal terms the nitty grady's if we run out of time again, we have 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 may be friends and family members are all going to get common stock common shares investors were at least thesame fistic ated investors that we refer to from angel investment clubs and ventures. Certainly venture capital funds they don't want to buy common stock if you think you're selling common stock to them at this seat in early stage level, you don't get it, you don't get it. You will get a term sheet that says the seas 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 inc. Otherwise we have to re dio your incorporation documents what isthe preferred shares me or convertible...
preferred shares. I like to put it in terms of rights and privileges common shareholders year riding coach investors were right in first class why don't 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 lobo more without exception if you raise multiple rounds from investors unless there are specific carve out it's for you which can happen we'll get to all investors come out before this crowd plus they're agreed profit that locks in their profit 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're not still on board fifteen years from now is we're creating a little bit of pain for you where we went out in four to seven years we don't want to go around the world ten times so the longer our money is in a common deal term is tohave 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 simple find these dean of 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 questions on this that evidence in the form of mohr preferred shares of more common shares a lot of these deal terms are entirely negotiable it could be either and there could be said different points of when they can convert into common stock all of these things and I'm going to put as a very strong action point who's your best ally to help you negotiate the best deal terms and understand the implications of these deals terms is somebody who has seen a term sheet before don't hire your best friend attorney who has never seen a venture deal term sheet before and may not understand how it really works under different scenarios you want a been there done their securities attorney or sec attorney who specializes in this and then when you interview two or three of them I want you to ask them what size deals have you worked on? Ideally you want somebody who's sophisticated at your level so seed in early stage deals are very different than securities transactions for moez deals recap buyout bankruptcy recaps expansion stage companies investors asked for different things because they match where you are in business but this is the thing they get preferred shares they have a preference they have a better deal in terms of the specific security initially eventually every baby may roll over and convert common stock before public offering or before a sale to the company but during the period of highest risk before you've proven you can accomplish anything they're going to be sitting in first class with preferred shares makes sense and it's to help them minimize risk in case things fall apart usually just classifies preferred advisory shares a meaning for being an adviser to accompany her on shark tank in a particular deal where is like twelve percent equity plus three percent in the lottery shares? I'm guessing this probably preferred or some kind of maybe a term that they're using maybe it's they're not putting in cash and oh I bet I know what they're talking about for cash they get this and pull for being an advisor to the company and the value of that strategic advice you're going to give me another three percent five percent or whatever that's what I'm betting they were referring to it like I'm giving you this cash for this chunk of your company and because of all the value I'm giving you now the season angels especially at the v c level they do believe it's part of their job to help mentor and strategize with you and help you solve problems and help connect the dots so that you build faster without the least amount with the least amount of risk so you probably won't see that in a vc deal if you hire somebody to do a specific task or service and interim officer director or something then you may structure something different just for that employment relationship but not no not normal not normal but you won't see it their monies and it is expected that there helping out I think you may well be right there, susan I just did a quick search just says there's actually no such thing it is a term that's becoming more popular but has no legal reconnection whatsoever and it says on this particular blogged about venture hacks it's called it says that anyone who asked for adviser shares is someone you should stay clear off interesting you know what v c level are term sheets are really straightforward pretty black and white there is their terms you may never seen before and you don't sign a term shed or accept a deal unless you understand it at all so you need somebody to sit down with you and brainstorm what might happen if things go well and what might happen talked this over with your lord what if I run out of cash to soon what happens? Brainstorm those things and feel comfortable with um so you know the upside and the risk of not meeting those objectives and needing more cash before you expect youll especially if you don't need a higher milestone a financial saving safety and accomplishment if you don't get what you think you're supposed to get done in time, you could be facing a down round likes that veces who improved furred shares have protections and down rounds built him a lot of angels who don't ask for it too bad ok a preference multiple so often entrepreneurs will boast and say I got a five million dollar valuation for my company and they fought hard, hard, hard to boost that value the perceived business 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 mohr important deal terms that will affect your outcome and how far back you are in that plane code the coach line how many your exit hero forty five or whatever versus wrote him one of the go to the first things I want you to understand is the preference multiple without me let's say I invest a million and a half dollars uh or no three million dollars in andrew's new company the's use deal you've ever come across right? Yeah, 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 three million dollars to expand her furniture and 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. One point five times three is the amount of money that comes back to me, the investor first before the common shareholders get a dime, so if she sells her business for four million dollars which we know it'll probably forty million or four hundred million andrea doesn't get anything because the first four and a half million for the most part we'll go to me they 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 eleventh hour, maybe I will be really obnoxious say all right, I give I'll let you have that evaluation 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 five million dollar valuation for the most part vcs are not going to behave like ask for preference multiples of four five, six hundred crazy stuff he's 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 ron saying is be aware of this that negotiating deal terms is never just one deal term it is the entire package and appreciate accumulating dividends if they're part of the term sheet and the preference multiple will matter at the time of exit common shareholders or last this is what they prefer stock maine 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 which you want to aspire for is a fair deal something that gives the investor's 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 wanted 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 terms shoots the more risky the deal the higher preference multiples the later you approach the investor the eleventh hour deal the higher the preference multiple the companies that are most likely to go out of business the higher preference multiple sitting with everybody empowering huh? Scary stuff those who it's it's all doable, right? Right here's what you do know a lot of the companies that you and the brands you love have succeeded with us. So the twitters, the facebooks, the google lt's 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 put no cash into your big idea investors just saying, come on, give me my money back first that's a rational 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 no that if we're here helping you build the value of your business, we want to make sure we get that value it 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 here's what's gonna happen doesn't seem fair, but it will happen veces we'll have their own law firm and you will have your own sec attorney negotiating the terms she 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 veces attorney and guess who has prepared you and I guarantee you the bill that will come from the veces 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 cap it you're gonna have to pay it one way or another sometimes some vcs will and maybe this is somewhat related to the adviser fees may take out and this is more something in more advanced stage businesses some management fees on 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 did they do anything for it? Probably not in the later stage deals especially if it's emin a acquisitions stuff board seats and I'm going to 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 happened? My little gotsche is a typical vc deal at the time of inc you probably told the state probably the state you reside in that gear company will always have five to seven five to eleven some a number of board members but no less in some amount likely you wantto 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 port see, 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, see and your attorney doesn't pick up ceo versus susan schrader shame on the attorney you're looking at me with a draw drop he's kind of gotcha is that he just don't think about this is what's so incredible about this I think it's so funny I look at your face, but of course it's like all of a sudden it's like you're the janitor than that, you know, after it get you get all over on the board yeah, and you say if you don't, if you don't control the board, you don't control the company, so I want the founders on the board absolutely so the best way is to put your name in those documents. Andrew, don't you want to be on the board so put your name there, but this is this would be something I would agree to because I am the ceo and I would say, of course absolutely it's so easy that I my mission in life is to expose the koch is right this isn't it more fun when you know about those wrinkles before and then you get to collaborate with your own attorney I always won fair deals don't expect the term shade which will just be an outline of deal terms to be to expose all the gotsche is 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 she 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 surprise 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 back 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 d'oh 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 we'll get to later the investors 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 elaborate you've lost her 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 make sense to negotiate an employment agreement a fair one when your team's 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 might say in the term shape employment agreement for the ceo jack but what is it is a three year dear 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 current cure cause again employment agreements matter control but if you don't want to be fired have a good employment agreement if you don't want to be fired don't sign you know 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 whose whose 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 going to watch out better for you than your own legal counsel who only represents you is it the investors job to watch out for you know 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 gonna 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 and that's why we're not willing unless we have to to give her up every little area of leverage that we can did this shock the chat room on the confusion questions coolness was asking how do you get the independent director who decides? I mean, how do you find that person is in the ball to decides no here's what I recommend here's what I recommend before you even go out and solicit investors I want you to first start thinking about an independent director said not your brother sister best friend people who will be your best buddy from college I want an independent director who is already experience 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 I'm in an a c d fellow but there are people who have experience 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 in meetings and bob their heads where do you want to go is 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 and independent director means somebody who is not beholden to the vc 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 one thousand companies and you're not a great its sales maybe think about bringing in a director who has that's experience and contact base just 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 will 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 this ceo who invites director in where they understand your passion and how much dedication you have to the business that likes and respects you will not they'll be loyal to you until they absolutely can't they will give you the benefit of the doubt independent directors that maybe slated in and brought in because of prior relationships with the vcs are likely to favor the veces 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 tohave keep that director in the fold so I want you picking for 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 could be awesome directors now it's not uncommon for vcs not tow one 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 stacking the deck is too strong a word if you don't stack the dick a little bit in your favor, veces for sure will stack the deck in their favor thank you is 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 it 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 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 an 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 another boards in good times and in bad some of my best days, run boards and some of my worst days for serving imports. Not kidding has it sit with everybody? Usually you will find this 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 tenth 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 vc can have. This is party your firepower. This is going to be a resource, especially when problems happen off 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 thumb. You always want to keep board 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 air important. What are the conditions when preferred stock and convert into common stock I don't want to dive down to deep, but that is worth a discussion with your securities counsel different term sheets compose different things it's important claw backs and they're different words for this cousin doesn't that sound nasty to begin with? Who 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 performed that well. There may be certain scenarios in which investors create conditions that if certain things air 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 and for entrepreneurial companies and no one ever really does it. 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 turn 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 teo key ad 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 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 could be a collaborative discussion now why would investor entertain that view? Beecher goals if you're growing at an unbelievable rate and especially if you don't need more, more rounds of cash j they don't lose, they may lose a little equity stake, but if the company is growing beyond, they're more have been happy to motivate you to work harder password 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 ten deals, there is a reason why they need some of this stuff in there. Just be fair is part of it sometimes on carve outs, especially in companies where there are multiple rounds going in where veces 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 tot some top people coming in so it's on the ghoshal, 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 the 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, we'll say, unless you change it, we're not investing keep it fair and reasonable securities attorney and when you're working with attorney or your vcs were angel investors agrium milestones make sure you really well aligned so that confusion doesn't start from day one on what you can accomplish agree on this milestone objectives that everybody's working teo 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 asked 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 air not necessarily immediate delusion because this stock option means those employees eventually have to pay some amount for the shares an exercise and they contribute cash to your company but in general pool terms, especially for high flying companies that air really going for the big bucks a good ten to fifty, fifteen percent of outstanding com shares is a good round number that you'll probably see in deal terms she's but you can participate in that to that's a rough again the investor steak is highly dependent on the company and how much cash you have 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 but in general ten to fifteen percent is a good target amount as a set aside for future stock options just think about it like in my own company I've got myself at seventy five percent and my partner at twenty five percent say we get into something like this where how is it how is it carved up so so the other percentages can go it out like you're talking about there does that does that have to come out of both of ours or one of them here's what happens? Uh this is where drawing might help but I'll do try and do it this way right now your pie looks like this and what was the percentage you seventy five percent and he's fifty eight twenty five ok so new capital comes in more shares are issued so the pie is like this but you now own a smaller slice depending on the shares and how you negotiate you may now own sixty percent of your company that reduction in your percentage ownership is called dilution the more investors that come in, the more your percentage your equity position gets ratcheted back, but this has come down at the same percentage rate the twenty five percent yes, unless you have signed a new agreement with that investor that has somewhere in those deal terms some anti dilution rights and the fact that you don't think so I was going to, you know, six years, so I have got to look at it. Yeah, so anti delusion rights are one thing to watch out for deals where they say we will forever or on your certain circumstances always maintained this specific percentage, but in general, when you bring in more investors in or of stock options or converted, you get deluded your equity stake the percentage of your company that you own gets smaller and smaller, but I would rather own five percent of a billion dollar company than one hundred percent of what and investors do deserve that ownership stake for the cash and the opportunity for you to become a millionaire or a billionaire but negotiated and don't be afraid to do it if you come across a term that hasn't been raised here you don't understand talk to your attorney even asked the investor put them on the spot what does this mean? You explain this to me, you'll see them well, you really don't have to worry about it, but asked understand what you're signing it will make you feel as an emp powered entrepreneur but just because he's seen these deal terms seen onerous, it should not be the reason you should take the cash if it is the best deal you that you negotiate at that moment and to get you in the game go for 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 re 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 when the things I love for entrepreneurs to d'oh it's maybe a little monthly bullet point list well, what went well this month on what didn't go so well if you wait to talk about something that is a problem what do you think that those two 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 tohave with veces that will set the month 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 way have a question here I think is good as we're coming to the end of this kind of summarize what we've been talking about cashes clay wants to know how fast is the v c and angel investing advice changing now does all this information is this gonna have a long range importance here because I know a lot of industries are changing very rapidly in this digital age is there any advice you can give to people about how to you know kind of keep pace with this industry I should just took follow on from that because also got a question about crowd sourcing and is that something that's now playing just sneak all parties vc funding and angel investing well the rules have not been fully laid down from the securities exchange commission about crowdfunding and let's face it crowd funding is pretty much at the angel level they will not replace veces veces can write big amounts big checks to accomplish big goals the average crowdfunding deal is still going to be in the hundreds of thousands best case if you want multi millions veces they're going to be your best go to partner now markets change but the same aspects and when we were developing this course we wanted to do it in a way that didn't become dated quickly. All of the initiatives in action steps that it takes to raise cash from lenders or investors are pretty much not going to change that much we know investors want will only make money by the growing value of your business. Yes, but what will change is the industries that are hot and the types of products they invest in that will always be changing if we look back at the deals what types of products and services that were funded twenty years ago it will be you know, very different than what we're looking at today but the rules of the game remain unchanged we're out investors want to make money and it comes from the growth and value of your business lenders have a very different mojo of what they want to fund, they will be here today and tomorrow to fund cash flow