View behind the Valuation Veil

"I want to retain more than 50% of my company so that I and not the investor has control." - This is a common sentiment that I hear from many entrepreneurs. The classic mistake being made here is that the entrepreneur equates share ownership to control. At the time of negotiation, this sentiment boils down to a single number - Valuation! Entrepreneurs end up fighting for this magic number like a lioness protecting her cub and as a result I have seen deals die early on at the negotiating table.

My two main goals in this post are to show you that 1) the right valuation for your company is more important than a high valuation and 2) you as an entrepreneur can loose control of your company if you do not pay attention to some of the other terms in the term sheet.

Valuation:
The right valuation is the key to preventing future dilution of ownership. As an entrepreneur it is only natural to want a high valuation for your company but if it is not realistic and does not reflect market expectations, then a subsequent down round will only lead to dilution. Anti-dilution provisions in a term sheet are put in by existing investors as a correction to any potential damage from high valuation. This typically allows the investor to keep their stake in the company intact during a subsequent down round - this essentially provides the investor with additional free shares to counteract their decreased investment value usually at the expense of the common shares - i.e., those of the founders and the employees. Anti-dilution provisions come in different flavors and can be a blog post on their own!

Also, valuation does not guarantee the founder's share in the company, typically there is a vesting schedule in the term sheet. What this means is that the founder(s) give up their shares back to the company and it will be returned back to them over a period of time as stipulated in the term sheet.

In reality, it is the liquidation preference in a term sheet that determines how the proceeds from an event end up being split. So, even if an entrepreneur got his dream valuation with higher stake in the company, a poorly negotiated liquidation preference can mean he or she walks away with a very small piece of the pie or in the worst case even nothing.

Control:
For starters, the norm in the industry is that investors get preferred shares in the company while the founders get common shares. Preferred shares allow the investor to impose certain restrictions and covenants to control the way the company is being run. In the event of an IPO or M&A the preferred shares get converted in to common shares but in the worst case scenario such as bankruptcy the preferred status of the shares allows the investors to walk away with something while the common shareholders usually end up with nothing.

The first level of control that an investor has access to is a seat on the Board of Directors for the company. In a privately held firm, the board can exercise significant control from deciding the company's compensation structure to additional funding needs of the company.

Term sheets may also impose milestone based funding or staged funding which indicate that unless a certain milestone is met the subsequent tranche of funding may not be available which can sometimes force the company in to bankruptcy. As an entrepreneur, commit to such a funding only when you are certain about meeting those milestones.

Another form of control is through veto rights and protective provisions. This ensures that the investors/ preferred share holders are in agreement prior to certain activities that the company wants to pursue such refinancing, sale of the company etc.

While the above list is not exhaustive, I hope this post provides a sense of why there is more to a term sheet negotiation than valuation alone. The terms in a term sheet exist for good reasons but the truth of the matter is some favor the investor while others favor the entrepreneur. There is always a happy medium where both the investor and the entrepreneur walk away feeling good about the deal but unfortunately there is no secret formula or one size fits all.

For what its worth, as an entrepreneur aim to build a pie that is large enough for everyone and negotiate a term sheet that gives you the right balance of control and stake to execute your vision.