Startup financing and investment is essentially an exchange of assets, and the fairness and benefits of this exchange depend on the definitions and terms used in the agreement.
The asset which is being offered by the entrepreneur to the investor is possible significant capital appreciation based on the benefits of the intellectual property to be developed and also on the possible success of the venture. If the venture fails the investor will have an income tax-deductible loss and possibly a professional embarrassment. The loss may be annoying, frustrating, disappointing, but is unlikely to be tragic.
For the entrepreneur, the inability to achieve success can be personally devastating financially and psychologically. Such a failure can be due to the original concept being flawed, poor management of the development process, insufficient funding or a lack of sufficient guidance. In any case, the personal risk to the entrepreneur is significantly greater than the risk to the investor, who if a professional investor, will not be investing their own funds.
If investors do not believe in the possibility that the company will succeed they will be uninterested no matter what the approach or terms. Therefore, the entrepreneur should understand that the word “no” can be both a full sentence and the most important word in any negotiation. The investor believes and wants to participate. The investor also wants to make the best deal possible for the investor.
However, that deal could also, in the case of a startup, end up being the worst deal for the entrepreneur if it takes the form of convertible debt or convertible preferred stock. Such an arrangement provides a superiority of terminal position to the investor in the case of the company being liquidated and may even require liquidating preferences requiring a certain multiple of times the investor’s cost before any of the other shareholders receive a return.
Furthermore, the valuation basis of the conversion rate will likely be preferential to the investor rather than being based on the success of the company. So, in the convertible debt or preferred stock approach the entrepreneur has both a bad deal if the company succeeds and will likely be required to include the investor in the decision-making of the company, with investors therefore also having the ability to protect their interests over that of the entrepreneur’s interests.
Ok, so what if money is needed to move forward and there is no other investor willing to do a better deal? Well, if the company is not going to be successful it really doesn’t make much difference whether the investor’s money enables the entrepreneur to make a profit, as there is unlikely to be one.
However, there are two other considerations for the entrepreneur. The first is whether the money being provided will be sufficient to allow the progress necessary to enable the company to acquire additional funds, which are almost certain to be needed, on favorable terms? The worst thing which can and frequently does happen is the underestimation of the amount of funding needed to get to the point of being better positioned for new funding negotiations with investors. It’s the “more money needed to get to where we thought we would be” which results in the really terrible terms for the entrepreneur re their functional and ownership position in the company. Experienced early stage company investors know this fully well and expect to make their real deal when the company desperately needs the additional funding to survive and complete the development process.
A possible alternative to the unnecessary and unhappy position of giving investors senior financial and decision-making positions is the sale of a percentage of future revenues, called a royalty. The royalty purchaser needs to be favorably impressed with the possibility of the company being able to generate significant and increasing revenues or the ability to be bought out in a reasonable period of time. If the company is unable to generate revenues the royalty investor will lose the money invested in the purchase of the agreed percentage of revenues.
However, if successful the company will have the ability to redeem the royalties sold and terminate the required royalty payments. Most importantly royalty investors do not own any shares of the company and therefore the entrepreneur will not be restricted in their decision-making nor diluted in their ownership. The company continues to be the property of the founder to manage or sell.
Not all companies will be able to attract royalty investors but many early stage companies, particularly those with the sorts of ideas being developed by experts working at my favorite research university should be able to make royalty deals and retain the benefit of almost full ownership of the equity of their companies. The university will probably have to be granted a bit of equity and the entrepreneurs may want to employ equity, or options to acquire equity, to reward and attract advisors.
It’s not magic, just logic. It’s better for the entrepreneur to retain as much equity as possible and to not clutter up the project with debt or preferred stock obligations.
We may be able to help and would like to try.
Arthur Lipper, Chairman
British Far East Holdings Ltd
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