By Michael Whitehouse
Whether you are an investor browsing through 1000 Angels looking to put money into a startup, or an entrepreneur attempting to bring finances into your project, it is critical that you understand the terms and conditions of any investment. While legal advice is of paramount importance to ensure that any contract of investment is above board, you still need to know what is being asked of you so that you can decide whether such stipulations are acceptable or not. Furthermore, showing that you have knowledge of such things will generate more confidence in you as an investor or a startup businessperson during negotiations.
With this in mind, let's discuss the most common forms of investment agreement, focusing on items an investor may ask for in return for their financial support. This list is by no means exhaustive, but it will provide insight by increasing your knowledge of available avenues open to all parties.
A common request from an investor is for a stock option – essentially a percentage of available shares in return for investment. This is a standard request when investors are not acting as a creditor, lending money to the company to be paid back at a later date when specific goals have been met. Most investors will ask for a share in a company as standard. Depending on the amount, this could be anything from 1% to a majority stake of 51% or over. Once a majority stake has been achieved an investor essentially has control of a company. Most don't actually want this and instead opt for 15% - 30%, but this depends entirely on how much is being invested against the value of the company overall.
Also known as “investment tranches,” this refers to an investor making their funds available in stages as the business reaches specific milestones. This helps to limit any risk of losing the entire investment amount for the investor, and ensures that the business is on track and meeting an agreed time-frame. While this option can be attractive to an investor, it is also difficult to manage as milestones can be unstable and ill-defined even when applied to a successful business. A startup may grow at an unexpected rate, and so funds may be required before a milestone is met. For this reason investors often make the entire amount available immediately.
In some cases an investor may request a presence on a company's board of directors, if it has one. This can take the form of a representative or the investor themselves. While not every startup will have a board of directors, in places such as Europe a board can be created as part of the investment agreement. This is a good option for investors who want to maintain an influence on the running of a company and be more hands on. A board of directors typically has to approve spending strategies and so an investor with representation on a board will have more control over how money is spent within the company. It should be noted that this does not mean complete control unless an investor has influence over the majority of board members.
Startup founders tend to want to maintain majority control as without it they could find themselves locked out of the decision making process. A good compromise in terms of influence is normally agreed upon in advance.
In this scenario, also known as a “lock-up”, an investor must give their consent to a business if those running it wish to sell their shares at a later date. Startup investment often requires that the founders who came up with the idea stay in place, giving their passion and dedication to the project. A lock-up stipulation protects the investor from a startup entrepreneur selling up, after acquiring investment, to a third party who may not be what the investor is looking for.
This stipulation also protects the investor. Should shares be sold or investment secured for equity from another party at a later date, the original investor's share in the business does not become diluted. There are two forms of anti-dilution which need to be understood:
Full Ratchet: In this scenario only the founders of the company dilute their share when securing future investment. If a third party agrees to invest money, the original investor's stake remains the same in terms of value and control, while the founders have to dilute theirs in order to offer equity to the new investor(s).
Weighted: Here, dilution of the original investor's stake does occur, but it is calculated against the number of shares offered to a new investor. Legal expertise is usually required in order to agree on how much dilution takes place.
Anti-dilution agreements are offered under some circumstances, but can in some cases be seen as a hindrance to the entrepreneurial process.
Other investors and startup founders who agree to this stipulation must offer to sell their shares to the original investor first. If they decline, then they are free to sell their shares to the highest bidder. This offers an investor some control over who owns equity in a company.
Also referred to as “tag-along rights”, this agreement stipulates that if a founder decides to sell their shares to a potential buyer, the original investor can demand that their shares are offered to the buyer for the same amount. If the buyer is unable or unwilling to purchase both founder and investor shares for the same price, then the founder cannot sell their stake. Again, this provides an element of control where an investor can put a halt on a sale or ensure that they receive a return on their investment when a founder sells up.
Understand Each Stipulation
While there are other forms of agreement available – and they may alter depending on the legalities of each region – the above stipulations should help any prospective investor or a startup founder understand what might be offered. With this information in hand, more productive negotiations can be had during investment rounds.