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You Don't Own What You Think: Percentages Lie

TheFunded.com Advice

Posted by EZ-stuff on 2008-04-21

Tags: Negotiation Terms Equity

PUBLIC:

You have a piece of paper or a spreadsheet that shows how much you own of your company, normally called a capitalization table. You may have common stock. You may have options. When you take a venture round, the capitalization table neither represents your ownership nor the allocation of shareholder value. Most of the terms that create the Preferred Stock for venture capitalists chip away at the value of common stock and options, so much so that, after a few rounds of investments, the value of common and options are largely worthless. Let's take a look at why and what can be done.

There are the obvious "big" preferred terms that eat away at shareholder value in most liquidity events, such as promising to re-pay the investment first through a "liquidation preference" and then allowing the venture investors to "participate" in the remaining value allocation. Another classic term is to place founder equity in escrow and force the founder to earn it back over years. Then, there are the slew of other terms that reallocate smaller chunks of value, such as cumulative dividends, redemption rights, ratchets, right of first refusals, and expense reimbursements. Finally, there are the many uncertain outcomes, such as allocating escrow to a preference waterfall, that force last minute negotiations where the preferred shareholders have control in many liquidity situations.

Here are some tips for a management team to retain value AND ownership through the process:

(1) Encourage competitive bidding among interested investors

(2) Raise more money than you need and limit the number of investment rounds to two

(3) Eliminate all secondary terms from term sheets and investment agreements

(4) Control a majority of the board under all circumstances

(5) Insist on executed employment contracts with equity and cash guarantees on liquidity

(6) Add mandatory preferred approval of liquidity offers at pre-defined prices

If other people have tips. add them below. It is about time that the capitlization table represents reality!

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