Background
For the last several years I have worked for a small venture fund based in the UK and Ireland. Many of our investments have been in small technology startups. One of my main conclusions from working with these small company founders and management is that they find the mechanisms and management of corporate finance, law, accountancy, board meetings and investor relations a serious pain point in terms of knowledge and time. The most technically gifted programmer, engineer or marketeer can quickly find himself a blind man stumbling around in unknown territory where his day-to-day skill sets are of little use. The world of finance is a dark art to the uninitiated.The aim of this blog is to try and inform and educate small company founders about what their shareholders and board members expect from them. Getting to grips with these expectations can greatly enhance communications with these folks and lead to a much more friction free relationship (even when you fail to meet your sales projections!)
I really want to try and get startup founders to understand the thinking on the investor side of the fence. Understanding each other better will lead to better communication which will lead to less arguments and less pressure. It will enable the startup founder to think more calmly and clearly on the key issue of running and creating a business.
In addition, it's critical to understand the investor's way of thinking because, once you do, you can protect yourself from the wrong type of investors. You need to understand the investor's rationale and logic, where the line in the sand is, so that you can push back when it's crossed with rational counter arguments. If a potential investor can't negotiate along reasonable lines then you should probably avoid them. This doesn't necessarily mean an investor should not be an "out there" eccentric. Lots of them are. They are risk takers after all. Don't judge a book by its cover. Focus on the content.
I will kick of this series of articles with some 10 tips about negotiating for funding.
1 You need to be motivated
You require a reasonable amount of ordinary shares/common stock. My advice here is a little vague but here are some guidelines. Ordinary shares are important because voting rights, in how the company is run, are usually attached to them. At the end of the day you need to be motivated. Certainly you and the other founders should always aim to keep above 25%. In many countries 75%+ ordinary shareholders usually can do anything they want to with the business. Investors may try to keep you less than 50%. This can work well for you if you bring at least two other investors on board. For giving away this type of control in your business you need to be looking for a chunky investment. I would always recommend embracing lean startup principles and resist outside investor funding until you feel it is really worth it ie typically when you see you a need for funding to scale. You also need to take into account that investors may want a mix of ordinary stock and debt, convertible loan notes and/or preference shares. In this event you should really push for more ordinary stock.2 You won't get rich through your salary
Don't expect a big salary. You're trying to start up a business and your spending other people's money (OPM).3 An investor's downside threat is your upside opportunity
Ideally you should try to get your investor to buy ordinary shares. It makes everything easier to understand. If your investor wants preference shares, loans or Convertible Loan Notes for his or her money then the investor is looking to protect their downside in the deal. As a quid pro quo you should ask for an upside by way of share options and/or an 'overage' deal. You need to be motivated.Example
Let's say your ordinary stockholding in a company is 25% but that you have an overage deal to take 50% of final sales price over $800,000. So if the company sells for $1M you will get $100,000 (0.5*$1M - $0.8M) plus $200,000 (your share of the $800,000). This means you make $300,000 instead of $250,000.
4 Convertible Loan Notes
In many cases an investor may want a Convertible Loan Note rather than preference shares and/or a pure loan. A convertible loan note is good for an investor because he or she gets the best of both worlds. If the company is going well then the the investor can opt to convert the loan note principle into ordinary shares at some defined price. If things are not going well then the investor can opt to hold on to the loan note. Convertible Loan Notes (CLNs) typically have a maturity period of 3-5 years in which the investor can opt to convert the loan to ordinary shares. After the maturity period the CLN will become a normal loan which usually can't be paid as things have not gone well. Typically the investor will look to renegotiate a CLN with even tougher terms. If this scenario occurs keep in mind that you need to be motivated and you need to communicate this. CLNs are common enough in software investments because this type of investment is risky and can be hard to source cash for.5 Understand what you will really get when you sell
Understand the implication of preference shares, loans and CLNs in the sales process. Typically the value of the preference shares and loans plus interest are paid from the proceeds of sale before the ordinary share holders get anything. You should run a few sales scenarios from the low end to the high end of the spectrum to understand what everyone will be getting out of the venture before signing up to an investment.Example
So let's say your company received preference share investment of $300,000 in year 1 with a 10% annual simple interest coupon and the founders are left controlling 100% of the ordinary shares. Suppose the company sells in year 5 for $500,000. Then the preference shares plus the interest will equal $300,000 + ($30,000 X 5 yrs) = $450,000. This means the preference share holder will be paid $450,000 and the ordinary share holders would only receive $50,000 to share between them!6 Respect the Board of Directors
A seat on the Board of Directors for you and your other founders. It's obvious I know. Don't under estimate the time commitment in preparing for board meetings. It's important that you prepare well and show respect to your investors.7 Don't be afraid to say no
Don't be afraid to say no to investors who want a hand in running the business. If you have a good chemistry with them and believe they are up to the work then fine. Of course some investors may require a senior role in return for an investment and sometimes you may have nowhere else to go. Just make sure you spend time getting to know that person. Some people would say that signing a shareholders agreement is like getting married!8 The more the better
Try to get two to four investors to invest in your initial funding round. There are many good reasons for this:- Wider range of skills and experience to draw on.It's far easier to ask for further funding of $100,000 from 3 people than just 1 person.
- The more investors there are the more chance you have of establishing good chemistry with someone in the investor group who can be a useful ally in difficult times.
- A group investors will positively re-enforce their decision to have invested with you even if things get tough. A single investor can get spooked easily if things go bad.
- It's good to be able to to talk to folks who share the same problem you have.
9 Directors Fees
Investors who make a significant investment should get a seat on the Board of Directors. Many investors who have hold a board seat will expect Director's fees. In my own experience in this part of the world $1000 per month (maybe a little more) is the going rate.10 Exit
Investors will look for a defined exit. Five years is the going rate but it's rare that you exit within five years in my own personal experience. I think startup founders should really look to 7-10 year window.Hope you found this article informative and please leave your comments below.
