Raising a first round of venture capital is often challenging, but at least the negotiating dynamics are usually pretty straightforward. On the “company” side of the table sit the founders, and on the opposite side of the table sit the investors, usually in the form of a lead investor. While intra-founder and intra-investor issues can arise, they are generally worked out off-line by the respective parties.
Follow-on rounds – investment rounds post the initial financing round – are more complicated. In the typical follow-on round, you’ve got four groups of people around the negotiating table, with variously overlapping and diverse interests, and a mix of legal and practical tools for advancing those interests. There are two sets of investors - the investors in the prior round(s) (the “Old Money”), and the new investors (the “New Money”); and two groups of founders/employees (key folks going forward (the “Relevant Team”) and legacy folks who were important getting the startup to where it is, but less so going forward (the “Legacy Team”).
There are, of course, multiple significant financing terms in any given capital raise and you can’t really say who “won” the negotiation exclusively by the valuation metric. That said, valuation – more particularly how valuation plays out in terms of dilution and the post-round cap table – is a good place explore how the four parties think about financing negotiations. Essentially, everyone – New Money, Old Money, Relevant Team and Legacy Team – wants to maximize their share of the cap table pie.
Now, the thing is, while everyone wants a bigger piece of the equity pie, the various parties are also concerned about whose ox is gored to supply their equity. And, as well, each party has a mix of legal (de jure) and practical (de facto) tools to advance its interests. Let’s look at how those concerns look for each of the key players at the follow-on negotiating table.
The New Money.
Interests. Beyond maximizing their own ownership, the New Money has a strong interest in making sure that the Relevant Team has a strong equity incentive going forward – in terms of both size and vesting schedule. On the other hand, the New Money has little interest in protecting the equity shares of either the Old Money or the Legacy Team.
Negotiating Leverage. What the New Money lacks in de jure leverage – they essentially have no real legal tools at their disposal in the negotiations – they make up for in the ultimate de facto leverage: the well-known Golden Rule (she who has the gold ...). In some situations, for example there is no competition for the deal from other potential new or existing investors, and the company’s cash back is to the wall) the Golden Rule can be almost all-powerful in its impact on the final deal terms. In others (real competition for the deal, and a company with significant cash runway ahead of it) it can be far less decisive. But, it’s impact on the Old Money and particularly the Legacy Team is always significant.
The Old Money.
Interests. The Old Money’s obvious interest is in minimizing the dilution it will suffer from the new round of financing, which is to say maximizing the valuation. Secondarily, though, it has an important interest (shared with the New Money) in seeing that the Relevant Team is adequately incented and, like the New Money, no real interest in where the Legacy Team winds up when the deal is made.
Negotiating Leverage. The Old Money almost certainly has some important de jure tools at its disposal. Typically, the agreements supporting their own investment(s) included “protective provisions” that likely give them a virtual veto power over the terms of future investments. In the event, those rights are limited by practical considerations (the extent to which the company actually needs the money and the Old Money is not in a position to satisfy that need). To the extent any protective provisions are at the Board level (i.e. the new financing transaction requires the approval of the Directors representing the Old Money) there are also fiduciary limits. Directors – even those appointed by and representing the Old Money - are legally bound to vote in the interests of all the shareholders, not any one faction. There’s a lot of room for maneuver there, but there are limits, albeit not well-defined.
The Relevant Team.
Interests. The Relevant Team, like the New Money, seeks to maximize its ownership, which is a subtler game than simply minimizing dilution. All other things equal, of course, a higher valuation is better than a lower valuation, in terms of dilution. But all other things are not necessarily equal: a lower valuation might be just fine with the Relevant Team if it is accompanied by a pop in the Relevant Team’s equity incentive. It’s an important dynamic, as it makes for a natural partnership with the New Money – a partnership that views the Legacy Team and the Old Money as ripe for the picking, in terms of valuation for the New Money and incentive shares for the Relevant Team.
Negotiating Leverage. The Relevant Team’s leverage is the mirror image of the New Money’s leverage: not much in de jure terms, but quite large in de facto terms. At pretty much every stage of venture investment, the investors’ take on the management team – the Relevant Team’s portion of it – is a, if not the, leading factor in getting a deal done. That puts the Relevant Team in a pretty strong position. Beyond its own equity share, the New Money’s principal concern in terms of deal structure is keeping the Relevant Team in good spirits.
The Legacy Team.
Interests. As the Old Money, so the Legacy Team’s primary interest is minimizing dilution.
Negotiating Leverage. Well, truthfully, I can’t think of any. While it’s possible, and now and again even happens, for the New Money, Old Money, and Relevant Team to so use their positions as to create some plausibly actionable legal recourse for the Legacy Team, those folks can usually accomplish what they want to accomplish (put as much of the dilution from the financing on the Legacy Team as practical) without resorting to wrongful behavior.
There are four take home messages from this quick review of the negotiating dynamics of follow-on financing rounds. First, it’s difficult to be on the Legacy Team: it has no real leverage (legal or practical) and no natural allies. Second, legal leverage is real, but so is practical leverage. If/when push comes to shove, practical leverage usually carries the day (when it doesn’t, things can turn out poorly all round). Third, no matter how warm and fuzzy the various parties may be, at the end of the day they all have interests, not friends. It’s nice to be nice to the nice, but don’t count on goodwill as a negotiating partner. Finally, the only thing the other parties can do to rein in the power that the golden rule supplies the New Money, is generate competition for the deal. That’s something the Legacy Team and Old Money should focus on as the financing plan takes shape and moves along.