A Small Primer on Terms
How do we think about setting the terms of a venture capital investment? To begin, investors need to understand the basics of the companies and industries they invest in – e.g., revenues and profits over time; similar companies and their track record; size of the market; management experience; and expected return on investment. Is there an eventual exit from the investment and a chance to see a return? Investors use this information to decide how much they like a company and how valuable a deal is to them.
After understanding the basics about a company and industry, investors can begin to form the primary terms of a deal, such as settling on an investment vehicle, price, and an amount to invest. An investment vehicle can come in two forms: equity or convertible note. Equity allows investors to immediately retain ownership in a company. A convertible note—short-term debt that converts into equity—delays company valuation to a later round of financing when there is more data available on the company. Investors can then negotiate a price for the equity or a conversion value cap—the maximum price that a convertible note will convert into equity.
Once an investor has established these initial terms, it’s time to begin hammering down the specifics of a more holistic agreement. Often, venture capital investors take advantage of a wide variety of financial tools—advisory shares, additional option grants, warrants, etc—to negotiate the best deal possible. For instance, an investor may agree to a higher price in exchange for an extra portion of a company in advisory shares—type of stock that is given to business advisors in exchange for their insight and expertise. Preferred stock is when shareholders have priority over a company's income but lack voting rights. Or stock options—a contract which conveys its owner, the holder, the right, but not the obligation, to buy or sell an underlying asset or instrument at a specific price prior to or on a specified date. Or common stock. When financing an equity round or convertible note round, investors need to understand the different financial tools available to them. Negotiations revolve around having the right levers.
During a negotiation, investors can also leverage their knowledge and experience to craft better deals. For instance, a venture capital firm can leverage their knowledge about general strategy, experience putting together deals, and technical knowledge regarding a certain industry to provide additional value to a company. Investors should always posture their firm in a way that provides help beyond merely financing. Entrepreneurs will be drawn to investors that can be thought partners in addition to financiers. Whether it’s technical assistance or business strategy, investors can leverage their ability to add value to the company when negotiating terms. Venture capital firms often specify target performance goals in doling out investments over time as the company meets agreed goals. In addition to leveraging the expertise of the venture firm, there is an agreement to the kind of operational and financial oversight that the firm can exercise. Deal execution takes time and effort, but the best deals leave everyone going home excited.