Taking Care of Early-Stage Investors

Early backers of startup companies, the ones after the seed capital rounds, are the professional risk takers - they are the riverboat gamblers of yesteryear armed with laptop analytical models and hardened by industry experience.  Because they are investing in the early stage of your business, they expect more - financial return, strategic input and information.  Here are some things you will need to know and some simple ways to give them what they want.

Preference Return

No doubt about it, you are going to learn about preferred stock - if you are lucky, several classes of it!!  Early stage institutions are looking for 40% internal rates of return (IRR) on their investment, so one thing they know is to make sure they have a preference position on return.  Preferred stock or demand notes, also usually secured by the company's assets, including intellectual property, are two commonly used investment vehicles.  These financial instruments have claims over those of the common shareholders - you and your seed investors - which will give them the first return of monies back.  That works out fine when your business plan surpasses your expectations and you go public at a huge valuation or are sold to a needy competitor for a gazillion dollars.  But when your plan doesn't quite work out, or the next capital rounds are harder to get and terms are tougher, you and your other common shareholders are going to feel the pinch.  Expect it, deal with it, it is a fact of entrepreneurial life.

Equity Kickers

These early stage instruments generally are convertible into common stock shares and may even have equity warrants that "kick in" with the passage of time.  These equity "kickers" will give them a higher percentage of your company's equity because one of the key elements of risk investment is time - the longer their money is outstanding, the greater the risk.  Again, expect it and deal with it.  Remember, you are looking for a capital partner, not a spouse who will love you, warts and all.

Board Representation

Most early investors will want a seat (or two) on your company's Board of Directors.  And take it from us, you want them on your Board.  These investors have a big stake in your business, maybe not as much as you do emotionally, but probably more than you do financially.  And the more significant their ownership stake, the more they should be sitting on your Board and involved in your company's strategic affairs and governance.  With all the heavily publicized failures of Board governance, as an entrepreneur you will want the assistance and know-how of your institutional investors.

Reporting

Be aware of the reporting requirements for your investor group.  Analyze your current level of reporting to make sure that you can meet their reporting requirements promptly.  Then make plans to be able to provide more detailed information as your relationship evolves.  Gathering and analyzing your company's reporting information is much more than administrative procedure.  You can gain valuable insight by sharing this information and getting feedback from outside parties.  (See SBW's Investor Communications - How, Why and When To Communicate article.)

Your Negotiating Edge - These Are Financial Investors

If you have read this far, it is time to read about your edge - what you can do as an entrepreneur to level the playing field.  While this article might not read quite like all those great entrepreneurial success stories you have read, there are plenty of ways to creatively give your investors what they want - and leave plenty of opportunity for you, your team and original investors to do extremely well.

The key to negotiating and later working with early stage equity investors is to remember that they are return-driven.  The good ones simply are not interested in running your business!  Most equity investors are looking for a certain targeted return, both from this specific investment and from their portfolio.  The good ones have already priced both portfolio and deal risk into the pricing of the term sheet you have received.  So what room does that leave you to negotiate?

You can boil most entrepreneurial negotiations down to financial return and control.  If the institutional investment is all about return (and you will be able to tell) instead of control, then you will be able to negotiate terms which allow you to get what you and your team want out of this venture.  If you are looking for control of your company's (and your own) destiny, then you can have that control - so long as the early stage investors get their return.  If you are looking for financial gain, then you can have that financial gain - after the early stage investors get their return.  Deal points and mechanisms such as salary and bonus, profit-sharing, ESOP's, ISO's and earnback or buyback provisions are all negotiable - if your venture partner is return-driven.  TIP:  The key to successful capital negotiation is to have a great, not just good, "deal" lawyer - a securities counsel who has solid experience in the area of deal structuring and entrepreneurial representation.   Two that come immediately to mind are Jim Abbott and Alan Bernstein of Carter, Ledyard & Milburn in New York.  And don't let that New York address (read, price tag) scare you, these folks are used to working with entrepreneurs.  If you would like a recommendation in this area, please contact me at ahamor@smallbizworthy.com -- over the years our firm has worked with several excellent attorneys who have represented our small and middle market clients - or their equity and debt capital sources.

Are You In It For The Long Haul?

In most cases, time is your friend.  Unless you are looking to cash out in a few years, which is a pretty unrealistic goal, you are in this business for the long haul.  That gives you plenty of time to achieve the kind of financial success you are looking for.  But beware, your capital investors, no matter their stage of investment, should know your goals and plans in this regard.  You should all be on the same page as far as timing is concerned.  TIP:  Be opportunistic about liquidation events like going public, recapitalizations and the sale of your business - take them when you can get them.  The same way it is almost impossible to "time" the public markets when buying a given stock, it is almost impossible to time the liquidation event for your business.  Be smart about "cashing in" your business.