Angel and venture investors in startups and early-stage companies frequently have the option to determine the extent to which they intend to contribute intellectual capital, beyond their financial commitments. “Value-added” private venture investors often lend their business skills, resources and rolodex to their interests, helping the company solve tough problems, prioritize objectives, build a great team and even seek out strategic partners and potential customers.

Equally compelling to private venture investors is the ability to influence the terms of engagement of their capital in a manner that increases the opportunity for a favorable investment outcome. Unlike conventional public investment vehicles and most alternative products such as hedge funds, the investment terms for private venture investments are generally negotiable…depending on the size of the contemplated investment and stage of the company and the funding history.

Evaluate—Negotiate–Allocate

Between due diligence and the investment decision is the opportunity to influence and negotiate investment terms in a manner that increases the probability of a positive asymmetric outcome. It surprises me when angel allocators, particularly lead investors in a seed round, simply accept the offering terms of a private venture without fully leveraging their currency to negotiate the best deal for their capital. Startup capital for new ventures is scarce today relative to the halcyon days of the 1990’s. That tilts the advantage in favor of capital and provides early-stage venture investors with an opportunity to materially improve upon their position.

Angel round investors are a unique breed. They take on startups at the riskier seed stage (in pursuit of higher-multiple exits) at a point where venture capital firms will typically not engage. VCs and institutional investors are more apt to require some evidence of progress with a startup…whether with regards to financing, product development, a proven business model or market traction. Yet that does not prevent VCs from coming to the table with their own terms for a Series A financing.

On the other hand, angels too often let the entrepreneur set the terms for the seed and bridge financing rounds.

So, which provisions in an angel round’s term sheet are generally negotiable? All of them.

I am humored by entrepreneurs who describe their terms as being “market”. Because there is no market without the angel’s capital, and that means that valuation, liquidation preference, anti-dilution protection, dividends, various protective provisions, board composition and even the vesting of the founder’s stock can and often should be subject to negotiation…particularly in a smaller financing round.

Each of these terms may have a critical influence on the outcome of an early-stage investment, but valuation is arguably the most difficult for angel investors to negotiate as there is little meaningful company history to assess…rather, merely a vision around an idea, a market and a management team, and perhaps a business plan.

The “market” (of angel investors and entrepreneurs) has responded to this quandary by predominantly relying upon Convertible Notes to fund seed-stage companies. Rather than dickering endlessly about the present value of a future uncertainty, angels and entrepreneurs agree to lend their capital to the new venture in the form of a note (often secured with some form of collateral and offering a dividend) and agree to convert their debt to equity at the price set in the subsequent round of financing.

The theory is at that point in the future, much more will be known about the business, market, competition and opportunity and that it will be easier to agree on a valuation.

Consequently, Convertible Notes have become the primary template for seeding young companies and providing “bridge” financing from the concept stage to a larger, subsequent financing round.

Early-stage investors should engage the growing universe of online content that speaks to best practices, suggested deal terms and negotiation tips for investors in early-stage ventures. Most critically, tyro angels should engage a securities attorney with ample experience in private venture financings to advise them on term sheet negotiation.

In Woody Alan’s 1994 crime-comedy Bullets Over Broadway, the gangster-financier played by Chazz Palminteri exploited his angel status by casting his girlfriend in a lead role and rewriting the play’s script.

In early-stage financings artful angels should always consider opportunities to leverage their currency to rewrite the script of the bridge note and positively influence their investment’s ultimate optionality and outcome.

Album:   Script of the Bridge, The Chameleons, 1983

Private venture investors consciously embrace the notion of swapping liquidity and safety of principal in the pursuit of positive asymmetrical outcomes and the higher risk premium associated with venture capital. Against the certainty of uncertain outcomes, the venture investor accepts liquidity and principal risks as the apropos quid pro quo towards achieving high double-digit and triple-digit IRRs on investment.

But, venture investors too willingly accept the notion that their investments outcomes will be the result of a binary set of events—characterized either by loss of capital or an attractive multiple on exit as the result of an IPO, sale, merger or other change of control transaction.

These investors can become more effective fiduciaries of their capital by demanding investment terms that broaden the variety of each investment’s potential returns. I refer to this as increasing an investment’s “optionality” beyond a binary set of boom or bust outcomes.

Among the most frustrating venture investment experience is the non-outcome outcome. In an earlier post (Hits & Exit Wounds) we described this sort of venture purgatory as “My Grandkids Company”—a private company that is successful but there is no exit in sight. (Perhaps your grandchildren’s inheritance?). You were prescient enough to back an early-stage venture that is now successful yet all you have to show for it is an annual K-1. This is where investment term sheet mechanisms that enhance the investor’s optionality really come in handy.

I have become a strong proponent of requiring that venture investors demand a “put right” (or, put option) as a contingency to committing venture capital to an angel round or early-stage equity financing. A well-conceived put option may reduce unintended gifting to your grandchildren by giving you one way out of a private investment without an exit in near sight.

Typically, a venture investor’s exercise of a “put” would require the company to repurchase their equity securities at fair market value. Investor put rights have been around venture transactions for years for the express purpose of providing a way out of an investment with no liquidity event in near site. But, because of the terms by which they have generally been structured, they have been rarely exercised.

That’s because if the company appears to be on the right track, investor’s are more likely to let their fortunes play out. On the other hand, if the company is not performing to plan it is not likely to be able to afford to honor the investor’s put—rendering the option worthless.

With investors rarely exercising these puts and with companies generally apprehensive of the uncertain implications of any non-budgeted hit to their balance sheet, issuers are less willing to draft investor put rights into their offerings…but you should insist.

It works like this…upon completing due diligence and deeming a venture to be worthy of a capital commitment the investor reviews the company’s anticipated revenue projections to identify a period in the future (beginning at 30 or 36 months out) at which the company’s cash flow model and pro forma balance sheet suggests that it would be able to return the investor’s initial capital contribution along with any accrued dividend. As a contingency to financing the venture, the investor requires the company to grant a put option for that future point in the company’s growth trajectory.

If the investor exercises the put, the investor is entitled to redeem all or a portion of their equity interests in exchange for the initial capital contribution value plus a nominal return above the risk-free rate. In addition to the return of investment, the put right allows the investor to maintain a reduced equity position in the company…perhaps, somewhere between 50% to 75%. (This would imply an increase two to four times higher than the company’s initial valuation)

Essentially, the exercise of the put allows the investor the ability to take “risk off the table” (the initial contribution) while still maintaining a material amount of “skin in the game”.

To prevent the investor from exercising the put at a moment when the company’s financial stability or expansion plans could be jeopardized, the company can require that in addition to a prescribed time period restriction, certain revenue and/or R&D milestones must be achieved and set as “triggers” before the put may be exercised.

The put option must be constructed in a manner that enhances the investor’s optionality, without putting the company at balance sheet risk. It is possible to achieve that balance. The company that achieves the predetermined revenue milestones would likely savor the opportunity to buy back its stock to the pro-rata benefit of the remaining stakeholders, and of course the investor benefits from the possibility of a wider variety of liquidity events and exit outcomes…which, in turn, enhances the ultimate appeal of venture capital as an asset class.

Album:    One Way Out, The Allman Brothers Band, 2004

Private investments in venture and early-stage companies are characterized by their potential for positive asymmetrical outcomes (PAO). The risk of losing the entire investment is offset against the potential for high-multiple ROIs. But asymmetric outcomes refers to more than the non-linear relationship between risk and return…it also refers to the appeal of investments where multiple liquidity and exit outcomes are possible.

This is often referred to as optionality…current knowledge of the potential for multiple future outcomes.

According to his book, In an Uncertain World, Robert Rubin, the nine-figure alumni chairman of Citi, is said to have developed his appreciation of optionality in his prior days of risk arbitrage at Goldman. While practicing risk arbitrage, Rubin developed a penchant for optionality (keeping ones options open) and avoidance of a mindset that restricted decision-making to binary and zero-sum outcomes.

It is believed that Larry Summers ultimately coined the phrase “preserving optionality” back when he was deputy secretary of the treasury under Robert Rubin in the Clinton administration. It was meant to describe a strategy of keeping options open and fluid, before all of the uncertainties have been resolved in dynamic environments where there is a high likelihood for the emergence of new and material information.

The phrase is relevant in venture circles for investors, as well as, entrepreneurs.

Preserving Optionality for Investors and Entrepreneurs

For entrepreneurs, optionality in rapidly evolving scenarios (such as a start-up) means leveraging real-time data and experience before making important decisions that are either resource intensive or cannot be easily reverse…such as pursuing a market vertical, developing a new technology or application, embarking on a joint venture or contemplating multiple exit strategies.

In most instances these options were not conceivable at the outset of the venture because, at best, a start-up’s business plan is to an entrepreneur what a treatment is to a script writer…it’s simply a first draft. It is the actual, real-time development of the story line and its characters that ultimately determines the final draft of a movie script…or the path to monetization for a new business venture.

Investors and experienced entrepreneurs know this. I have rarely seen a startup that successfully monetized itself based upon the mission, objectives and milestones envisioned in its original business plan. That’s because time in the market is often more valuable than time to market with respect to improving the quality of the critical decisions that are of material consequence.

Technology consultant Sean Hull of the Heavyweight Internet Group notes this nuance…“preserving optionality is a philosophy that takes some getting used to. It involves having a sense of humor, and realizing our own human limitations.”

Author-epistemologist-investor Nassim Taleb gets it as well. In Fooled by Randomness he characteristically opines “people overestimate their knowledge and underestimate the probability of their being wrong“. He suggests that by being ever aware of our limitations of prescience, and keeping our eyes and our options open, we can make better, more educated, and lower risk decisions. He is correct.

This implications and realities of preserving optionality, often positions entrepreneurs at odds with investors. The interests of optionality must be balanced.

For the entrepreneur, preserving optionality is an interest that frequently requires a balancing act against intrusive, non-strategic, no-value-add investors who view accountability and measurability as metrics preeminent to the benefits of prudent executive flexibility and strategic discretion.

On the other hand, the investor’s needs for optionality is particularly relevant today in light of the macro market malaise and minimal marquis exits. With venture-backed IPOs now more an exception, venture investors need to stipulate optionality with respect to cash-flow and exit rights as a contingency to their investment commitment.

Investors need to see visibility to alternative liquidity events such as dividend distributions or return of initial capital beyond the sale or merger of the company or its assets, or a less than likely IPO.

It is of no surprise that investors have a preference for positively-skewed outcomes and hold an aversion to negatively-skewed outcomes despite the fact that linear or variance-based risk measures generally weigh the outcomes equally.

Yet, investors seeking the potential for multiple and positive asymmetric outcomes on their commitments must also apply the measures of asymmetry and optionality to their deal diligence and terms. More than ever, investors should require visibility on multiple paths to liquidity. The investor has the responsibility to appropriately balance their interest in ROI with the survival or expansion cash-flow needs of the portfolio company.

Why so many “professional” investors are so passive on this issue is puzzling.

Investors and entrepreneurs alike both benefit from preserving optionality and having the pre-negotiated discretion to pursue a prudent Plan B.

We will discuss those some of those options in upcoming posts.

Album:   Balance & Options, DJ Quik, 2000