Deal Structures for Startups

Recently on the nextNY mailing list, an entrepreneur asked if there was “one resource out there which describes all the different types of deal structures, and the advantages and disadvantages for each.”  I replied that this was unfortunately an impossible task, given the unique nature of each individual deal, but that I would at least try for a high-level overview. So this is what I answered:

“Believe me, I empathize with your goal. The problem is that in entrepreneurial startups, as with life in general…there is simply no easy answer, no matter how much we’d like it. To put things in perspective, the country’s leading venture lawyers have gotten together and created an exhaustive set of complete, annotated documentation for venture-funding early stage companies, which the National Venture Capital Association has then put on the web, completely for free.  On top of that, several of the firms have gone even further, and invested many thousands of dollars in creating on-line wizards and expert systems to walk you through the process of creating and structuring early stage debt and equity deals…and THEY have put them on the web for free. And then, not to be outdone, but entrepreneurs like Adeo Ressi of TheFunded have worked with counsel to create an alternative set of documents, and they’ve put their term sheet on the web for free.

With all that spectacular quality, freely-available stuff available online, for funding deal after deal in similar situations, you’d think that it was game-set-match and there shouldn’t be any need for any entrepreneur or investor to ever pay legal fees again to document a simple convertible note or Series A deal, right?

WRONG! I don’t believe that there has been a first round financing deal in the past decade that has not generated five figures of legal fees, in the process of taking these completely standard, completely exhaustive documents and tailoring them for the specific situation at hand. And while there are precious few situations where we can get away with $10K in fees (generally only if it’s a brand new company and the entrepreneur is willing to accept the investor’s standard deal with no negotiation) the typical cost of counsel for a Series A is between $25K and $50K.

Is this insane? In one sense yes, and that’s why everyone keeps working furiously to come up with alternatives. But because of the differences and nuances in each deal, investors and entrepreneurs, if they are smart, ultimately have no choice but to cough up the cash if they want to get a deal done. Believe me, it’s not because we’re stupid, or that the lawyers are holding our children hostage…but simply because we understand that there are no shortcuts.

To answer your question with an almost useless (but at least well-meaning) quick few paragraphs, let’s try this:

A Note (or loan) is where the investor ‘rents’ money to the entrepreneur in exchange for getting it paid back by interest. For the entrepreneur, the advantage is that he keeps any upside, the disadvantage is that he has to pay it back. For the investor, the advantage is that it is the first priority money that comes out of the company, but the disadvantage is that it takes all the risk (if the company fails) and doesn’t get the upside of appreciation if the company is a success.

Selling Common Stock (which is what you, the founder start out with) to an investor means that s/he is taking the risk alongside you. For the entrepreneur, the advantage is that it doesn’t have to be paid back if things go badly, the disadvantage is that you are giving up a piece of the upside in the case of success. For the investor, it’s the reverse: the advantage is that you share in the upside, but the disadvantage is that because you’re on an equal footing with the entrepreneur, if things go south and there’s only a little value at the end of the day, the entrepreneur gets most of it, even though the investor has put in all (or most) of the money.

Preferred Stock is much like a loan, except that it doesn’t have to be repaid if the company fails. It means if the company gets ANY cash at the end of the day, it first goes to fully pay back the investor, usually along with dividends (which is like interest). Only after the investor is taken care of does the entrepreneur get his/her piece of the action. For the entrepreneur, the advantage is that aside from the fixed dividend rate, all the profits are retained by the entrepreneur; the disadvantage is that because it comes out first, there may not be anything left after paying the investor back. For the investor, the advantages are, again, the inverse: it has the security of getting paid back first (after any debts or loan repayments the company owes), but it doesn’t reap any of the upside benefits other than fixed dividends if the company is successful.

The standard “Series A” deal which is almost universally used in venture and serious angel investments, is a combination of the above two, known as “Convertible Preferred Stock”. It starts out with the investor buying Preferred stock, thus ensuring that in a not-good scenario the investor will at least get his or her investment dollars back before the entrepreneur makes any money. But the ‘convertible’ provision means that if good things happen and the company ends up being worth a lot of money, the investor can choose to convert the Preferred stock into Common stock at a pre-negotiated valuation, and therefore benefit from the increased value. In tough markets this is sometimes tweaked into a “participating preferred”, in which the investor has his/her cake AND eats it, too. In a participating deal, the investor first gets back the original investment with dividends (like a regular Preferred), and THEN double-dips by converting the full amount into Common, thus sharing in the upside.  For the entrepreneur, the advantage of all this compared to a note are that it is an equity investment and therefore doesn’t have to be paid back, and there are no specific advantages compared to selling the investor Common (until you realize that investor simply won’t buy Common, so I guess the advantage is that they’ll do the deal at all :-). For the investor, the advantage is that they are covered either way, getting their money back in bad times, and getting the upside in good times. That’s why investors do these deals!

Another variant on this is the Convertible Note, which starts out as a loan, and then automatically converts into Convertible Preferred stock at the time and at the valuation of a future investment. The advantage of this for everyone is that it is easier and cheaper to document. The advantage for the company is that it postpones the valuation discussion until the future found, thus giving the company a ‘free ride’ on the invested dollars during the startup period. This in turn is a disadvantage for the investor who takes the risk but doesn’t get the commensurate reward. For that reason, Convertible Notes typically convert into the next round at a discounted price to what the next investor is paying for the same stock. However, there are a lot of challenges doing this, which is why most professional investors won’t do deals like this, but it is usually the best way to structure a Friends & Family round.

Finally, royalties, which seem to be the preferred alternate structure on SharkTank, are used when the company isn’t really a “company”, but is instead a “product”. In that case, the creator of the product licenses someone else the right to make and sell the product, in exchange for getting a fixed percentage of whatever the product sells for. Advantages to the creator is that someone else does all the work and the creator sits back and gets paid. Disadvantages are that the percentage the creator gets are typically quite small (3-5%) with the bulk of the profits going to the licensee, and there are very big differences between gross and net royalties and all the different terms that can be included.

So, there you have it in a nutshell, but in each case there are more possible variations, tweaks and gotchas than there are hairs on Donald Trump’s head, so that’s why the best early stage lawyers on both sides of the venture table routinely bill—and get paid—more than $400/hour to read these things.

Comments

[The Entrepreneur on Campus]

Outstanding post! Very nice summary that any entrepreneur(or in my case entrepreneur educator) can use and appreciate.

[Brooke]

Amazing!$400/hour! That is A LOT.