13 Common Mistakes In Structuring Outside Investments

1. Not documenting the terms of an investment

Let’s get the most obvious one out of the way first.  Even if it’s just a friends and family round.  You must properly paper any outside investment.  Even if it’s as simple as a short purchase agreement and an update to the capital account table in your operating agreement.  Failure to paper an initial investment round can create massive headaches in the future, including making future fundraising problematic.

2. Raising at too high a valuation

Raising capital at the highest valuation possible means that the current investors are taking the least amount of dilution.  That’s a good thing, right?  Yes, in theory, today, that is a good thing.  The problem is you still must think about tomorrow.  And tomorrow, a high previous fundraising valuation can limit your exit opportunities (unattractive return profile for investors) and your ability to raise additional capital (the dreaded down round).  Just ask many of those that raised at 100x ARR in 2020 and 2021 how things are going…

3. Allowing for non-dilutive or anti-dilution terms

 Anti-dilution provisions can be a common ask of VCs.  And I get it, they aim to protect the investor from a decrease in their ownership stake (dilution) if the company issues new shares at a lower price in a future funding round.

Full Ratchet Anti-Dilution:  This provision offers the strongest protection for investors. If the company issues new shares at a price lower than the price at which the investor purchased their shares (conversion price for preferred stock), the conversion price for the investor’s existing shares automatically adjusts downward to the new lower price.  To illustrate the effect on a capital table:

Series A preferred share entry price = $10 per share (conversion price)

Series B price = $5 per common share.

With a full ratchet anti-dilution provision, the investor’s original $10 conversion price adjusts down to $5.

Effectively, this means that the preferred shareholders would need to be given new shares (at no additional cost) in order to ensure that their overall ownership is not diminished by the sale of the new common shares.  We will spare the detailed math for purposes of this blog, but this dynamic can lead to a series of adjustments in which new shares need to be created to satisfy the demands both of the original preferred shareholders (who benefit from the full ratchet provision) and of new investors who wish to purchase a fixed percentage of the company rather than a certain number of shares. After all, investors could care less about the number of shares that they receive.  The focus is on a concrete percentage of ownership.

In this situation, company founders can find their own ownership stakes quickly diminished by the back-and-forth adjustments benefiting old and new investors.

Weighted Average Anti-Dilution (Broad-Based or Narrow-Based): This is a more moderate form of protection. It calculates a new conversion price based on a weighted average of the original price paid by the investor and the lower price of the new shares issued. A “broad based” weighted average considers all shares outstanding, including those held by founders, employees, and other investors.  Whereas, a  ‘narrow-Based” weighted average only considers shares outstanding that hold similar liquidation preferences to the investor’s shares.

Here’s a simplified example (assuming broad-based weighted average):

An investor buys 100 shares at a $10 per share conversion price.

The company issues 200 new shares at $5 per share.

New Conversion Price = ($10 * 100 + $5 * 200) / (100 + 200) = $6.67

This calculation considers the total investment from both funding rounds to determine a new conversion price that reflects the dilution, making it less dilutive to founders, but offers some protection to the investor.

In a similar vein, I have often seen strategics attempt to take a non-dilutive stake as part of an investment or partnership.  “We want to ensure that we keep 20% of the company so that we remain incentivized to help you grow.”  They are a high value partner, so I get the desire to keep them happy.  But anyone holding non-dilutive equity can wreak havoc on future funding rounds as founders and legacy investors get crammed down in subsequent rounds.  Here is a quick example to illustrate:

Strategic partner asks for 20% of the company.  Founders and early investors own the other 80%. New investor comes in and wants to invest $25m for 25% of the company.  If strategic partner’s share is non-dilutive, the other investors are diluted 31.25% instead of being diluted the pro rata 25% they ordinarily would.  So, it ends up:

 Non-Dilutive Stake                        l                  Dilutive Stake

New Investor 25%                           l                  New Investor 25%
Strategic 20%                                   l                  Strategic 15%
Founders/Old Investor 55%         l                 Founders/Old Investors 60%

4. Liquidation Preference

Many may be familiar with the Fanduel exit nightmare, but for those that are not, it’s a perfect illustration of why founders need to pay attention to liquidation preferences.  Fanduel sold for $465m, but it had an aggregate liquidation preference of over $500m.  What does that mean?  That despite selling for an amount that most founders would be really excited about, the common shareholders (i.e. the founders) received nothing in the exit.  A cautionary tale for sure.

It is understandable that many investors want to recoup their money or a multiple of their money before anyone else gets paid.  That is what a liquidation preference provides.  A liquidation preference determines who gets paid first in a liquidation event (e.g. an exit) and how much (1x, 2x, 3x) they get paid first in that liquidation event.  But, there are two components to liquidation preference – (1) the preference multiple, which means the investor gets a certain multiple of their investment amount, and (2) participation, which determines whether the investor can take additional proceeds after the preference multiple is paid.

Example – If the investor invested $5M for 20% and got a 2x preference, they would get paid $10M before the common shareholders got paid anything.  If the liquidation preference is participating, then the investor also will receive 20% of any remaining proceeds.

5. Static Boards

Many early-stage boards are static.  They often consist of founders/management and large investors.  But with static boards, there is less incentive to the board members to be value additive.  There are less options to get a problematic board member off the board.  Boards with at least one seat that is up for election each year allow the founders and the board to maintain some level of flexibility and dynamism.  I have seen that be very valuable on a number of fronts.

6. Poor Use of Caps & Discounts

Convertible notes are common investment securities for early-stage companies that are looking to avoid a priced round.  Most convertible notes have a valuation cap and/or a valuation discount that dictates the price at which the note amount converts into equity.  This blog will not provide a lesson on convertible notes, but rather caution the misuse of caps and discounts.  Fixed caps can create massive dilution on the low end and be viewed unfavorably on the high end.  Percentages provide more flexibility, but again may be viewed less favorably than a hard cap for investors.  Be careful and smart, and, by all means, get some advice when setting convertible note terms.  And remember, caps and discounts can be dynamic.  In fact, I love sliding scale, time-based caps and discounts!

7. Board Composition (disproportionate seats, total count)

Sometimes the math dictates boards needing to be larger (>5 person) to proportion seats as needed.  But large boards create scheduling nightmares and from my experience can be much less effective with a lot of voices at the table.  Also, giving a disproportionately large amount of board seats to an investor can lead to problems later – whether that is an angry investor that is disproportionately effective in the negative direction or the math later requiring the board to grow much larger to even out the disproportion.  Board math can get screwy, and getting good people on the board is very valuable, but just beware the pitfalls.

8. Broad Representations & Warranties

Investment documents often have a litany of representations and warranties (i.e. these statements are true) that the company is making at the time of investment.  Often times, companies are so excited to get the capital in the door that they gloss over these statements.  Don’t.  The ramifications to breach of reps can be very problematic, which is all the more reason to limit the reps being made and ensure that they are indeed accurate.

9. Paid Advisors

Investors that are also paid (whether in cash or additional equity) are common.  But, just because something is commonplace, does not mean that it is without risks and problems.  Make sure that your paid investor advisors are adding value and giving meaningful time.  Depending on the situation, sometimes it’s easier to just give the “strategic investor” better deal terms rather than a formal job.

10. Information Rights/Required Reports

Every operating agreement will have some basic reporting rights (monthly, quarterly, and annual financials).  Even some company specific reporting that helps investors understand the business and its trajectory is common and a valuable way to provide transparency (see Buyout or Bust: Hostile Investors in a Turbulent Economy for why that is important).  However, information rights can get very sideways if (1) the reporting requirements are unduly burdensome on management and take focus off driving key business activity and/or (2) add little value to the owners understanding of company health and growth.  Far too often, I have heard miserable CEO feedback about some report he has taken seven hours to pull together to meet a reporting requirement when the CEO, like most early stage CEOs, remains the key success driver in the business and those lost hours are infinitely better spent elsewhere.

11. Problematic Drag-Along Rights

Drag-along rights give the a certain percentage (%) threshold of shareholders/members the power to force the remaining shareholders/members to participate in the sale of a company.  In a stock sale (as opposed to a merger or asset sale), each shareholder/member has to consent to selling their equity to the buyer.  With a drag-along provision, a large or group of large shareholders can force others to sell, taking away their right to make that decision themselves. 

Example – a company has a majority shareholder who owns 51% of the shares and several minority shareholders, including founders, who collectively own the remaining 49%.  If a buyer emerges interested in acquiring the entire company (100% ownership), the drag-along right allows the majority shareholder to compel the other shareholders to sell their shares along with them under the same terms and conditions of the acquisition.

Drag-Along rights, in and of themselves are not a bad thing.  They can ensure a smoother and more attractive exit strategy for the buyer by offering a clean, complete ownership transfer.  They can eliminate minority holdouts or a small subset of investors from dictating deal terms.  However, if you are a founder and afford an investor or a group of investors a drag along right, you have given up the ability to dictate your own exit and the terms on which you sell your company.  To many founders, who are founders because they want to control their own destiny, that can be problematic.

12. Freely Transferable Shares

It is important to bring on investors/owners that align with your vision; people that you get along with and want to work with.  Further, you probably do not want a direct competitor as a minority investor.  However, if you do not have transfer restrictions and investors/owners can freely sell or transfer their equity in the company, you no longer dictate who is on your capital table.  You have lost control of who you choose to work with.  And worst of all, you may wake up one day with your competitor in your meeting or asking for information based on their information rights as a newly minted part-owner of your company.

13. Closing Timing

Everyone wants to get an investment closed and money in the door to support the business.  But the timing of that closing is very important.  And, investors often drive or dictate that timing.

It is important to be very careful in closing a round early with a limited amount of capital.  If you do not have enough runway, you may have just taken money to build a bridge to nowhere.  This is often done to lock in a valuation, or favorable terms given to those investing at that time.  The other closing trap is having an investor make their round closing conditional on hitting a certain funding milestone (e.g. close when you have $5m in commitments).  This makes sense because those investors do not want to invest in an undercapitalized company, but if you get $4.5m in commitments, but cannot quite make it to $5m, you have in fact raised $0.

A lot can go into closing timing and, again, much of that will be dictated by the investors and circumstance.  But its important to really understand what closing conditions and closing timing really mean for your business.

Bonus item: Harmful limitations on your employee option pool or right to grant further employee equity.  But we will leave that complicated item for another blog post.