After watching an episode or two of the Dragon’s Den or Sharks Tank founders might be tempted to think that negotiating a deal to raise equity capital from investors is simply a matter of valuing shares and dividing up equity. It’s not.
The handshake deals made on TV are not final. After the show, ‘Sharks’ have their team do lengthy due diligence on each company, after which a term sheet may (or may not) be presented.
The due diligence may involve (to name only a few items) investigating the founder’s background, financial and sales audits, a review of key customers (and whether they are still customers), corporate debts, liability risks, employee option plans, other securities outstanding and even due diligence on the other shareholders involved in the business. Kevin O’Leary points out that sometimes founders overestimate their company’s abilities under the excitement of the show, leading to discrepancies during due diligence.
Even with extensive due diligence, investors will likely ask for representations and warranties, in the investment contract, that all the information disclosed, such as financial statements, sales history etc. are accurate. There may also be a negotiation on things like the founder’s salary, before you get a term sheet, or investment contract.
It is not surprising that a study of deals from the first 14 seasons of Shark Tank revealed that while 60.13% of companies made a deal on air, only about 48% of those deals actually closed.
Aside from investors not proceeding, in some cases, the founders themselves may get legal advice on the terms proposed by the ‘Shark’ and choose not to move forward. In this section we look at a list of some of the issues that founders need to address, and issues that need to be negotiated before a deal is ‘inked’.
Private equity and venture investors should be regarded as more shrewd and seasoned investors, particularly in relation to any equity crowdfunding or friends and family round you close. In equity crowdfunding and friends and family rounds, by in large, you set the terms of the deal and investors decide if they will play ball or not. That is, in equity crowdfunding offerings, there isn’t an opportunity for the crowd to negotiate, nor would such negotiations with hundreds of people be practical. Friends and family rounds may be subject to some negotiation, but likely not to the same extent as a private equity or venture investment, where the investors typically set the deal framework in a term sheet.
The Process
The typical process for onboarding venture and private equity investors starts with entering a non-disclosure agreement. This puts your company in a better position to disclose certain confidential information about your tech, your finances, trade secrets etc., as part of a due diligence process. After conducting their due diligence, the investors will decide whether they want to proceed with an investment and start negotiating on the deal structure. To do so, the investor typically presents the company with a term sheet, setting out the high-level terms on issues like:
- The type of security (for example, convertible debt vs equity);
- The class of shares and their corresponding liquidation preferences. Liquidation preferences determine the payout order to investors (i.e. return of their capital) in the event of a company’s liquidation or insolvency;
- Voting and dividend rights;
- The valuation (price per share);
- Anti-dilution protections, such as rights of first refusal on new share issuances;
- Information rights, for example, some firms negotiate for the right to see company documents as if they were a board member, even if they have no board nominee;
- The use of the proceeds from the investment; and
- Some investors will want an employment agreement with the founders to make sure their salary expectations are set, and maybe have the founder’s shares tied to a vesting schedule. They may also want non-compete and non-solicit obligations in the employment agreements, among other provisions.
Professional investors will be pointed in negotiating their term sheet, hitting all the pain points for founders around ownership (percentage of equity), control (board seats etc.) and minority shareholder rights.
While some of the issues you negotiate with a private equity investor will replicate the issues you cover off in a founder agreement (as we discussed in previous chapters) the considerations are fresh in the private equity and venture capital context.
Negotiating Ownership and Control in Venture Capital and Private Equity Deals
The classic struggle between founders and investors is over ownership and control.
Often those two concepts are misconstrued by founders. It is easy to assume that your level of equity ownership of a corporation dictates your level of control of that corporation. While that can be true, experience venture and private equity investors often try to extend their control of the company despite being minority shareholders. It is for that reason that understanding the dynamics between these two concepts is crucial when negotiating investment deals.
- Ownership: Ownership refers to the percentage of a company held by its various stakeholders, including founders, employees, and investors. In an investment transaction, investors acquire a portion of the company’s ownership through equity, which dilutes the ownership of existing stakeholders. It’s essential for founders to understand and manage dilution (and anticipate how future share issuances will impact ownership and control) while raising capital.
- Control: Control relates to the decision-making authority within a company. VC and private equity investments often include control provisions such as board seats, protective provisions (veto rights on specific decisions), and other governance mechanisms. Control provisions can impact a founder’s ability to make independent decisions and may sometimes result in conflicts between founders and investors.
The perfect illustration is Mark Zuckerberg’s ownership and control of Meta. At the time of writing, Zuckerberg owned just 13 percent of Meta’s stock, but controls 61.1 percent of the shareholder vote. This is achieved, in Zuckerberg’s situation, because Meta has two separate classes of voting shares. Class A shares grant one vote per share and Class B shares hold 10 votes per share. Zuckerberg owns 99.8 percent of the Class B stock available, allowing him to outvote the Class A shareholders in many instances.
What Zuckerberg achieved with a class of shares carrying additional voting rights, private investors may seek to achieve using other mechanisms. For example, it is not uncommon to see minority shareholders, who are making a large investment in a company, seek:
- Board seats, where they have oversight over their investment and may seek to influence other board members, or even seek to have a deciding vote in the event of a tie;
- Various types of anti-dilution protection;
- Veto rights on decisions like:
- Raising more money and issuing new shares (or other securities like employee stock options);
- Paying dividends;
- Management salaries;
- Hiring and firing;
- Spending on certain assets and capital expenditures;
- Selling the company;
- Buying shares back from other shareholders;
- Entering mergers or large deals;
- Changing the nature of the business; and
- Commencing or settling lawsuits.
Investors like Mark Cuban may even go further and require that his team take over aspects like accounting and website design.
Consider the two extremes, in terms of investors seeking control. On one end of the spectrum you have passive investors who do not partake in management and have no appointee on the board of directors. On the other, you’ve got an investor with a right to appoint one or more board members, rights to approve budgets and spending or even appoint management (CEO’s etc.). As the company requires additional cash, consider that VC and private equity investors may seek additional board seats, further impacting the element of control.
Some investors will be content to be passive, step back and let their money ride, trusting the founders to move the needle on the investment and growing the company. Others will require significant control, or plan for contingencies to take control in the event the company is not performing. The role of the entrepreneur is often to negotiate for the former; to maintain control. Seasoned investors often want the latter, some element of control, beyond what their 1 vote per share would carry when it comes time to elect the board.
You can see how dramatically the control rights in an investment transaction or shareholder agreement can impact the outcome of the company, how it is managed and decisions that get made on its growth trajectory.
Some founders turn to entering voting trust agreements with their friends and family, or other passive or early-stage investors, to lock up the right to vote their shares at shareholder meetings, further extending their voting control of the company. This can be helpful in later rounds of financing where, without the votes being assigned, you would lose the ability to control 50% +1 of the vote.
When engaging with professional investors, many first-time founders do not appreciate control as an issue, until they engage a lawyer (sometimes after a term sheet is signed) and the lawyer explains the impact of the control mechanisms in their particular circumstances.
First time founders are often excited to get a cheque, announce their company raised money, and get to work. They want the lawyer to just get the deal done fast, and not nit-pick a term sheet or shareholder agreement, line for line. Those types of clients can be hard for lawyers to advise. Undoubtably, the lawyer will be in the background advising them on all the nuances to the deal, and how various provisions may impact their control of the company either when the deal closes, or sometimes, down the road.
Those same clients, who may not heed their lawyer’s advice, will be surprised when the investor’s board appointee calls a meeting wanting to discuss the burn rate and the founder’s compensation. It is all fun and games when the cash is fresh and no tough decisions have to be made. However, when cash is tight, the burn rate is high and investors are worried about their investment, you should assume VC and private equity investors will shrewdly protect their investment and exercise the rights, over control, to the maximum extent possible.
That may mean influencing the termination of employees or founders, selling divisions of the business etc. Or worse, it could mean that if the same VC or private equity firm as debts outstanding, that they exercise rights to liquidate company assets to repay their debts, and take further control of the company or its main assets (software code, trademarks etc.)
Striking the Right Balance
The key to successful investment negotiations is knowing the ownership vs control issue exists and being proactive with investors about your expectations on both. For some founders, giving up any bit of control may be a deal breaker. Others may be so motivated to get a cheque that ceding a level of control to investors is worthwhile; to keep the company alive or accelerate growth.
While investors will naturally seek a level of control to safeguard their investments, in my view founders should ensure they maintain sufficient ownership and control to guide the company’s vision and make critical decisions. This can require careful planning (including in a shareholder agreement) with foresight around future share issuances and rounds of investment.
There are many moving parts and various mechanisms that impact control. Scenarios may exist in the company’s trajectory that materially change the control issue. Take for example a situation where a co-founder exits a company and resigns from the board. Originally, both co-founders might have had the combined voting power to pass board resolutions (with 2 of 3 board members), with a private equity firm having a right to appoint a third board member. However, this dynamic changes when the board is left with only the investor’s nominee and the remaining founder. All of a sudden the company faces a 2 of 2 voting situation, where both directors must agree to pass any resolution. In such cases, the control previously held by the co-founders is disrupted, altering the decision-making process substantially.
By understanding the implications of various control mechanisms, founders can strike a balance that aligns their interests with those of investors, while maintaining the flexibility and autonomy needed to grow the business successfully.
Positioning Your Company for Investment
When an investor is deciding to cut a cheque, they will likely undertake legal, financial and business due diligence on you. As part of the financial due diligence, investors will ask for copies of your financial statements, tax returns, audits, credit agreements/lines of credit and other records. In the context of SaaS and e-Commerce companies, they may even ask to see the backend of your online store (showing sales records etc.) or payment processor accounts like Stripe, PayPal etc. to verify revenue and sales figures.
As part of the legal due diligence, whether you are raising money with friends and family, accredited investors, an equity crowdfunding campaign, or institutional investors, you will need to make sure your company has a clean corporate minute book.
As we explored previously, a minute book is a vital record for corporations, holding key documents like the articles and certificate of incorporation, by-laws, meeting minutes, resolutions, share certificates, shareholder registers and records of directors, officers, and shareholders. It’s legally required for compliance and governance, documenting corporate decisions and actions. The minute book is essential during audits, legal disputes and due diligence (including when investors are looking to invest, or when the company is being sold).
Investors will want to see the minute book to confirm things like how many shares and other securities are outstanding, who owns them, how the company operates (for example how the by-laws set out calling shareholder and director meetings, whether a chairperson has a deciding vote in the event of a tie, etc.). They may also want to see past board and shareholder resolutions to understand the corporate history, and even look at what past investors and founders paid to acquire their shares.
To make a good first impression with investors and potential acquirers, having your minute book and a due diligence package ready to be shared is essential. It is not uncommon for early-stage companies to overlook their minute book, which requires lawyers to prepare rectification resolutions and update the minute book before investors are on-boarded.
Aside from a well-kept minute book, other legal due diligence items you should be prepared for include things like:
- The company’s capital structure, including a list of holders of any other form of security such as options, warrants or convertible debt, and any agreements affecting the shares of the corporation.
- IP records and registrations, for example, the status of trademark and patent applications and registrations.
- IP licences (either held or granted by the company).
- A list of key employees and the terms of their employment agreements (for example whether they have non-compete or non-solicit obligations).
- Any settled, outstanding or prospective litigation or disputes.
- A list of key suppliers, retailers, resellers or distributors and the terms of their agreements.
- Other material contracts that impact the business (service agreements, contractor agreements, leases, real estate etc.).
- Loan and financing agreements.
- PPSA registrations (a topic covered above).
- Information about any parent or subsidiary companies.
- Corporate profile reports and status certificates, showing the company is in good standing.
Keep in mind the above information is not exhaustive, some investors will be more detailed in what they ask for, and others may overlook these types of requests. Some investors may even rely on a lead investor to have done due diligence, resulting in others piggy backing on and assuming the lead investor’s due diligence was satisfactory (a mistake many investors in the now defunct crypto exchange FTX made).
Aside from due diligence on the company, investors may undertake due diligence on you as well, as a founder. For example, they may conduct criminal background checks, talk to other investors, talk to your colleagues and other people.
Many founders often view legal due diligence as a routine step following the signing of a term sheet, underestimating its significance. In reality, legal due diligence can profoundly influence a financing transaction. This process impacts key aspects such as the company’s valuation, the timing of the transaction’s completion, and sometimes, the likelihood of the deal’s closure itself.
So, prepare your company for potential investments by anticipating that investors will conduct thorough due diligence, inquiring on the above topics, information and documents. Possessing a comprehensive and organized due diligence package beforehand can streamline the process and facilitate discussions about the business and legal terms of your deal, impressing your lawyer in the process.
Due Diligence on Investors
Just like everything else in life, there are good and bad investors. There are ones that pester founders week after week, acting as a hindrance on your operations. Or worse, ones that are a stain on the company’s reputation.
There are others who you may not hear from in years, that you contact from time to time with company updates and maybe a dividend payment. In my view, the perfect investor is one that is somewhere in the middle, but eager to help the company grow when called upon. That may mean they make important introductions, help with recruiting talent or get you a meeting with potential clients.
Strategic investors may act as partners too, for example, a professional athlete like Mike Camilleri (a former NHL hockey player my brother played with) investing in the early days of Biosteel. Camilleri became a major reason behind Biosteel’s success, leading other NHL’ers to use and endorse the drink.
Another example of a strategic investor is Tim Ferris, who is rumoured to have done deals where he doesn’t invest any capital, but simply takes equity for both endorsing a product and acting as an advisor.
To protect against having a ‘bad’ investor, it’s ok to do some of your own due diligence on accredited or private investors cutting you a cheque. I have seen horrible situations where, for example, a company closed an investment with someone who it later became clear was using ‘ill-gotten gains’ to make the investment. That can later impact the company in many ways, the least of which is a lawsuit tracing the proceeds of the investment, but also making it harder to raise subsequent rounds of financing, or worse, harder to sell the company because of the smell left from the bad actor. If you were an investor doing due diligence and the cap-table had the name of someone accused of fraud in national newspapers, you might pass on the investment.
At a minimum, do some Google and case law research on the investor, but also consider having a lawyer or professional advisor do more extensive due diligence on firms cutting you a cheque. You may even ask VC and private equity investors to put you in touch with the CEOs of other companies they have invested in. This could give you a sense of what they are like to deal with post-closing.
John Wires
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