Question

Term Sheet

Raising capital from the right people on the right terms with the right relationships is critical to the success of any venture. In this section, we’ll discuss deal terms and valuation. It’s a big, complicated topic, and we can’t cover all the possibilities. Our goal is to introduce some of the concepts and tools that can help you on your journey.  

You should understand by now that investing in private companies is very different from buying a share of common stock on the stock exchange. If you purchase one of Amazon’s 500 million outstanding common shares, for example, you have a valuable economic claim on Amazon, but you don’t really have any governance rights beyond voting that share each year. If you don’t like what Jeff Bezos and the Amazon board are doing, you can sell your share, but you can’t do much beyond that.  

Investing in private companies is very different from buying public stock. An investor can’t simply sell shares until there is some event like a bankruptcy, strategic sale, or initial public offering. Investors have to worry about the operating and financial decisions entrepreneurs make that affect the value of their position - decisions they often have little control over. For this reason, they need a different contractual relationship with entrepreneurial ventures than simple common stock with limited rights.

Let me give an example. Suppose three engineers come to you with a plan for a disruptive, yet-to-be developed software program that seems compelling. They are asking for $10 million, the amount they think they will need over the next three years to reach cash flow positive. They have a pitch deck that includes a proposed deal. They are offering you 25% of the company. The founders own the remaining 75%. You will buy common stock, and are entitled to one of four seats on the board of directors; they hold the other three seats. One slide in the deck contains a detailed prediction of the value of the company. If you invest $10 million, you will own shares that are worth at least $50 million at the end of the third year.  

What do you think of this proposed deal? What counteroffer would you make?

Answer 1

The Proposed deal is in favor of the entrepreneurs rather than the investor since all the capital is coming from the investor and he is getting only 25% for the deal while taking all the risk of loss of capital. The entrepreneurs are not putting in any capital of their own and only have the idea. They also have a larger say in the management of the business and the investor has no control over the decision since he carries only 25% votes. Therefore, it is not a good deal for the investor considering the risk-reward scenario.

The counter-offer would be to raise the proposed equity percentage to 50% as well as another seat on the board so that they have equal control over the management and its decisions. The lowest the investor can go down is 40%. stake in equity.