Stepping into the ring with investors

Stepping into the ring with investors

Stepping into the ring with equity investors is a challenge fraught with danger for any entrepreneur – and especially if they have never experienced a capital raising before. Here are a few insights to key concepts in the business of equity investing:

Pre-money vs. Post-money

Any serious equity investor – and savvy entrepreneur – will focus on the pre-money valuation of a company. Both pre-money and post-money are simply valuation measures. The difference between them is simply a matter of timing of valuation.

Pre-money valuation refers to a company’s value before it receives outside financing or the latest round of financing, while post-money refers to the company’s value after it gets outside funds or its latest capital injection. It is important to know which is being referred to as they are critical concepts in valuation.

Here’s the basic maths:

• Pre-money Valuation + Invested Capital = Postmoney Valuation

• Price per Share = Pre-money Valuation/Pre-money Shares

I’ll explain the difference using an example:

In a company with a pre-money valuation of $5 million, a $5 million investment would buy a 50% ownership stake and would give a $10 million postmoney valuation. Suppose that an Angel investor is looking to invest in an early stage venture with high growth potential. The entrepreneur and the Angel investor both agree that the company is worth $1 million and the investor agrees to put in $250,000.

The ownership percentages will depend on whether this is a $1 million pre-money or post-money valuation.

If the $1 million valuation is pre-money, the company is valued at $1 million before the investment and after investment will be valued at $1.25 million. If the $1 million valuation takes into consideration the $250,000 investment, it is referred to as post-money.

As you can see, the valuation method used can affect the ownership percentages in a very sizeable way. This is due to the amount of value being placed on the company before investment. If a company is valued at $1 million, it is worth more if the valuation is pre-money compared to post-money because the pre-money valuation does not include the $250,000 invested. While this ends up affecting the entrepreneur’s ownership by a small percentage of 5%, it can represent millions of dollars if the company goes to an IPO at some future date.

Equity Dilution Factor

The key number that should be front of mind for the savvy entrepreneur is the Equity Dilution Factor. This is the percentage of equity that is owned by the previous holder(s) of equity, prior to an equity investment.

The equity dilution factor is how value is created for shareholders and how CEOs achieve their most important Key Performance Indicator – to make the company more valuable. Over a five-year period a typical fund raising campaign might go like this:

• Year 1: The company is founded with seed capital of $100,000, usually from family, friends and “the faithful”

• Year 2: A small group of Business Angels puts in $500,000 for one-third of the company, valuing it at $1.5 million.

• Year 3: The first Venture Capital investor puts in a million for 25% of the company, valuing it at $4 million.

• Year 4: Another 3 VCs put in a million each for 20% of the company, valuing it at $15 million.

• Year 5: The company does an IPO, the business raises $10 million for 20%, valuing the company at $50 million.

What happens (ideally) is that:

1. For each round the valuation rises.

2. The founders raise new capital from new investors. (If one investor ends up with a majority stake, the entrepreneurs simply become employees. The entrepreneur’s strategy should be to “divide and conquer” – ensuring each investor has only a small piece of the pie and no single investor wields control).

3. With each new capital raising, the current shareholders get diluted (unless they exercise their preemptive rights and re-invest to maintain their original stake), but the increase in valuation more than compensates for the reduction in equity.

As stated previously, the key number is the equity dilution factor. This is the percentage of equity that is owned by the previous holders of equity. In the first round of the example above, the equity dilution factor is 67%; in the next round, it is 75%; 80% in year 4 and 80% in year 5.

So for the founders, the amount of equity they hold at the IPO is (100%x67%x75%x80%x80%) – or 32%. Using the same methodology, both the angel group and VC 1 hold 16% each.


A key term in the Terms Sheet is the timing of the investment. The investors may wish to make their investment in stages – known as tranches – with each tranche conditional upon the company achieving certain milestones. While milestone-based funding is a fair approach, it is useful to link payments to a pro rata of milestone achievement. If 75% of the milestones have been achieved in good faith, then 75% of the payment should be made.

There is nothing worse than the entrepreneur working hard to reach the milestone and just falling short with the investor using this as a way to punish the entrepreneur with more punitive terms, such as withholding the (usually critical) funds unless certain actions are taken. It’s a not-uncommon ploy to force the founder off the board or even out of the company – and I say that from painful first-hand experience!

Pre-emptive Rights

Invariably the Shareholders’ Agreement will stipulate that the new and existing shareholders have preemptive rights on any future share offers – meaning the company must offer all shareholders the opportunity to acquire the new shares on a pro rata basis to their shareholding, before offering them to third parties.

By exercising their pre-emptive rights, shareholders will prevent dilution to their shareholding when new shares are issued. What commonly occurs is that the founding shareholders – the entrepreneur, the ‘friends, family and faithful’ and initial Angel investors – do not have the funds available to ‘pay to play’ in the next and subsequent rounds and will see their shareholding diluted down with each new round of investment.

While not pleasant, this should be palatable as long as the price per share has increased with each new investment and a ‘down round’ avoided.

Down Rounds

Real problems can be encountered when there is a down round – where the price per share is lower than in the previous round. Those who do not participate financially in the new round suffer dilution as well as seeing their share value decrease. There is nothing that will make shareholders more disgruntled than seeing value stripped from their investment.

There is potential for conflict of interest when pricing the next round: it is not in the investors’ financial interest to have a higher price per share, particularly if the value was increased on the back of the cash they initially invested. This is where strong leadership from the board – and especially the independent Chairperson, is required.

If the company has experienced difficulties, such as milestone slips and is running low on cash, an internal round of funding – by the existing shareholders – might need to be undertaken. There will be at least three camps in this discussion: those investors willing to invest more, those investors unwilling or unable to invest more and management which needs the cash to run the company.

A severe down round – with the share price halved or more – is often the proposed solution resulting in the re-investors owning a very large share of the company, and causing severe dilution of those not willing or unable to “pay to play”.

When it comes to making a decision about such a down round, each of the parties will feel tension between their fiduciary duty as directors and the strict interests of the shareholder group they represent. However, at the board table, fiduciary duty must predominate.

Terms Sheets

The Terms Sheet is perhaps the most important document the entrepreneur can get right. All else falls – or hangs – from it. The Terms Sheet precedes the Shareholders Agreement and sets out the basic framework for the deal. Like the Shareholders Agreement, the Terms Sheet can be excruciatingly boring to develop and read – particularly as the language tends to be like a foreign tongue. However, serious entrepreneurs must embrace it and get comfortable with it as their wealth is secured or squandered in this one document.

Once an Angel, an Angel syndicate or a Venture Capital firm declares its intention to invest in a company, there are several important issues to be negotiated. Once agreed, this framework for the investment will be set out in a Terms Sheet which records the parties’ understanding of the key issues. Think of the Terms Sheet as a Heads of Agreement.

The Terms Sheet will govern the investment until such time as Due Diligence is completed by the investor and the parties negotiate the detailed legal Shareholders’ and Subscription Agreement. The major benefit of a Terms Sheet is that it focuses the energies of the parties on the major issues early in the process, saving both time and expense in drafting formal agreements later.

The real issue here is that the Terms Sheet is usually written by the investors’ side of the deal – their lawyers in particular. They have done them many times and know what protections best suit the investor to the detriment of the entrepreneur. It is usually a good idea for the entrepreneur to pre-draft a Terms Sheet with his/her advisor so they know what they want – and don’t want – in the document before meeting with the investor. Tabling the Terms Sheet first is an interesting ploy which can tilt the balance of power. It shows the investor you have done your homework and are not to be hoodwinked.

An issue to bear in mind with the Terms Sheet is that the company is likely to need subsequent rounds of financing. Future investors are likely to want the same, or similar rights to those granted to early round investors, and the company should weigh the impact of this in negotiating the early rounds.

Depending on how formal the investors are (i.e. less formal Angels versus Professional VC) the following issues are likely to arise in the negotiations of the Terms Sheet: Key issues to be resolved at this stage include the form and timing of the investment, protections to be given to the investors, rights of the investors to appoint board representatives, control over major decisions, information rights, pre-emptive rights and exit strategies.

• Pre-money Valuation: The value of all shares in the company immediately prior the proposed investment.

• The Strike Price: The agreed price per share once the investment deal has been struck.

• Post-money Valuation: The pre-money value of the company plus the investment amount.

• Form of Investment Consideration: The consideration for the investment may take the form of ordinary shares, preference shares or convertible notes. Sophisticated investors will generally seek preference shares as they confer additional protection without leveraging the balance sheet. Rights attached to Preference Shares include: Preferential rights to dividends; Preferential right on a liquidation or winding up of the company, and the right to convert preference shares into ordinary shares at any time.

• Timing of Investment: Investors may wish to make their investment in stages – known as tranches – with each tranche conditional upon the company achieving certain milestones (refer above).

• Number of Directors: Investors will want to oversee and control the progress of their investment. In order to do this, they will seek to appoint a certain number of Directors to the Board and tailor the matters which must be considered by the Board.

• Control over major decisions: Investors will most likely demand the right to veto major decisions to be taken by the company – such as approving major expenditure, undertaking a new capital raising and recruiting key personnel.

• Anti-dilution: There are two types of anti-dilution protection: 1) Restructures – protection against share dividends, share splits, reverse splits and similar recapitalisations occurs by adjusting the conversion price or preference shares to ensure that the number of ordinary shares issued on conversion represents the same percentage of ownership. 2) Price Protection – if the company issues shares at a discount to the shares bought by an investor, the conversion ratio is adjusted to ensure the number of ordinary shares issued on conversion represents the same percentage of ownership.

• Redemption Rights: Investors may seek the right to force the company to realise the value of the investment at some point in the future by requiring the company to buy back or ‘redeem’ their shares if a liquidity event – usually either an IPO or trade sale – has not occurred by a certain date.

• Facilitation of Sale of all Issued Shares: Investors may also require a “Drag Along” clause which compels all shareholders to sell their shares if more than a specified percentage of shareholders (usually 75%) accept a third party offer.

• Standstill for Founding Shareholders: Investors may also require that the founding shareholders agree to a standstill provision which prevent them from selling their shares in the company for a period of time

• Executive Service Agreements: Key executives may be required to sign appropriate Executive Service Agreements usually linked to the company’s performance-based milestones.

• Information Rights: Investors may want the right to receive certain information, such as monthly financial statements, annual audited financial statements and the annual business plan and budget approved by the Board.

• Intellectual Property Rights: Investors will want assurances that the company has sole ‘legal and beneficial ownership’ of the intellectual property rights.

• Pre-emptive Rights: Investors will require a preemptive right to invest in future issues of shares before they are offered to a third party (refer above).

• Exit Strategy for Investors: Equity investors – in particular VCs – are driven by the need to realise the value of their investment and may seek to impose a provision enabling them to force a liquidity event – usually a trade sale, if such an event has not occurred with 3 or 4 years of the investment.

• Additional Management Members: Investors may require the company to recruit additional executives – typically a CEO or CFO – to the management team.

• Exclusivity Period: Investors may seek a period of exclusivity after signing the Terms Sheet, typically in the region of 30 to 60 days, where the investor has the right, but not the obligation to invest.

Reverse Due Diligence

Companies intending to market some or all of their equity in order to raise growth capital should be prepared for the significant amount of Due Diligence that an Angel, Venture Capital or Private Equity investor and their advisors may require before consummating an equity financing deal.

A broad definition of Due Diligence is an investigation into the financial, legal, commercial, marketing and operational activities of a business in connection with a proposed investment – or acquisition – of the business, so that the investing or acquiring party enters into the deal with full knowledge of the facts.

A Due Diligence exercise is carried out to validate strategic ideas and to provide an independent review and support for assumptions underlying the investment opportunity. It identifies negotiation points and can help determine practical solutions for the tactical implementation of a strategy. It may also form the basis of the Terms Sheet. As such, the ‘DD process’ will usually run parallel with Terms Sheet negotiations.

The investor and its lawyers and accountants will usually undertake a Due Diligence checklist – as illustrated below. The savvy entrepreneur can literally shave weeks off the Due Diligence process by preparing the answers and documents in advance that are likely to be asked or sought after – I call this Reverse Due Diligence:

• Corporate: A review of the company’s corporate structure including any subsidiaries, business names, constituent documents, shares issued and debt securities convertible into shares.

• Assets: A review of assets owned by the company including real property, intellectual property, contractual rights and intangibles, a list of who owns the assets and any mortgages or charges over them.

• Intellectual Property: Verified ownership of any intellectual property.

• Financial Statements: The financial statements and accounts of the company will be reviewed extensively to assess the past performance and prospects of the business.

• Systems & Procedures: Well documented operational systems and procedures that clearly define how the company is managed and how key business outcomes are systematically performed and quality measured.

• Material Contracts: A review of the company’s key contractual relationships with suppliers and customers, key employees, strategic alliances, licensing agreements, etc.

• Employees: The company’s standard employment agreements, relationships with key employees, employee option plans, staff turnover levels and the history of disputes.

• Litigation: Any actual or threatened litigation or dispute in which the company has been or is currently involved.

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