This is primarily directed at entrepreneurs raising seed or their first round of funding
So often, in deal negotiation with founders, there are disputes regarding a few terms for an investment. Some of these terms are meant to protect an investor’s upside, while others are meant to protect an investor’s downside. I have encountered a number of entrepreneurs who don’t consider the difference, but simply think of each incremental term on the scale of “not founder-friendly” to “founder-friendly”.
So I think it’s worthwhile to list just two examples below to illustrate the point.
If a company is not going to be a home run, where and how the shareholders get compensated matters. A 1x preference means the investor gets their money back, and that’s that. A 2x preference means the investor gets double their money first (before the common stock shareholders – employees – get anything). And so on. I’ve seen term sheets with a 2.5x and even a 3x preference. This is an example of an investor protecting her downside.
Discussed at length by Mark Suster this week, and followed-up by Fred Wilson today. These rights are what they sound like: allowing an investor to keep their ownership percentage in subsequent rounds of funding. If a company is going out to raise a round at a much higher valuation, the investor has the right to invest more money to keep their percentage ownership in the company the same. Without this right, as a company takes off and takes on more preferred equity, an investor can get diluted all the way down. This is an example of an investor protecting her upside.
Upside protection tends to require more capital infusion from the original investor (hence the discussion referenced above), and is a sign that things are going well, of course. If someone invests in you now, should they necessarily be diluted as you scale? Some entrepreneurs think so, some don’t. But if the investor has the capacity and desire to continue to invest, this allows them to. Some institutional investors don’t ask for pro rata rights, and some angel investors do, but since pro rata usually implies “I will invest more if this goes well”, it’s often the opposite way around.
This is very different than downside protection, which usually means that the investor gets paid first, or most, when things aren’t going great. Investors who think of each portfolio company as a 1 or a 0 – a home run or not – care less about downside protection. Investors who want to optimize for whatever outcome the entrepreneur ends up with care more. This isn’t as simple as it looks. Many boards of directors have voted down acquisition offers that would have changed an entrepreneur’s life, because they only cared about making a company a home run (even if it meant risking the company’s life). And on the other hand, many investors have extracted cash from businesses that were dying, or walked away with a multiple while the entrepreneur was empty-handed.
If you’re an entrepreneur working on a negotiation, particularly at the seed level, where convertible notes with none of these rights are standard, it’s worth deeply considering the implications of each kind of term.