Three Funding Terms Every Startup Should Understand

10/29/13Follow @WilmerHale

We’ve seen tremendous growth in the number of new startups in recent years, but the pool of VC funding is not keeping pace with this growth. This can put cash-starved startups at a disadvantage when it comes to negotiating company-favorable investment terms from VCs.

But regardless of how eager founders may be to secure the funds needed to scale quickly, they should think very carefully before agreeing to any of the following three funding terms, which could limit their economic upside and control in the company they built.

Multiple liquidation preference. When a startup is sold or liquidated, investors generally are entitled to get their money back before founders and employees receive any payments. This provides down-side protection to the investors. But with a multiple liquidation preference, the investor will get anywhere from 1.25 to 3 times the amount of their investment back first. Under this scenario, the investor can realize a sizable return before the common shareholders receive anything. In those situations, even where the company does reasonably well (but not great) the founders and early contributors may be left with little to nothing.

Fully participation preferred. If the funding terms include full participation, investors will first get their investment back and will also participate in any remaining proceeds on a proportional basis with the common holders. Because the investors get their investment dollars back and then also participate with the common holders, the common holders will receive less on an acquisition.

Founders should be wary of participation features that are coupled with other terms (like a multiple liquidation preference) as they can be especially burdensome. A more founder-favorable alternative is to offer investors non-participating preferred stock. If the investor insists on a participation feature, a typical middle ground would be to place a cap on the preference to be paid to the investors.

Without a participation feature, the investor will either get his money back first or will participate in the residual value (but not both).

Extensive protective provisions. Protective provisions are clauses that give the investor a right to approve various material activities of the business. It’s common for investors to request roughly 5 to 10 protective provisions. But if the number of these provisions creeps too high, it should be cause for concern, particularly if the provisions turn over control of routine company operations to the investor, such as making cash disbursements or entering into a material contract.

Most investors active in the startup community understand that under normal circumstances these three types of terms can be burdensome and misalign interests between investors and employees. But some who are more risk-averse or more active on the periphery of the sector might attempt to introduce overly investor-favorable terms to less savvy or more cash-strapped startups. In such cases, startups should not be afraid to negotiate more favorable terms or simply wait for a better offer.

Gary Schall practices law at WilmerHale, where he advises emerging growth companies and venture capital firms on corporate, financial, and business management matters. Follow @WilmerHale

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