I passed on an investment this week because the terms of the deal didn’t include the right for investors in the current round to maintain their percentage ownership in the company, through additional investment, in future rounds. This is usually outlined in the term sheet, in legalese, as “Preemptive Rights,” “Right of First Refusal” or even “Right of First Offer.” Basically, such a right simply allows early investors to keep themselves from being diluted in future investment rounds. There is no free ride in this situation, of course, the investor must pay for their pro rata share at the next round’s price, just like everyone else. What was particularly troubling about the term sheet in question was that it was pretty clear that the lead investor excluded such rights from the terms in order to have the ability to flush out smaller, early investors in subsequent rounds of financing.
I’ve seen this before (although less frequently over time) and it boggles my mind. Yeah, if you have a boatload of little investments the cap table can be a bit complicated, but that’s just math. Generally speaking, smaller investors don’t have any strong voting rights, board seats or other forms of control so punting on them doesn’t improve the speed or operations of the company. It’s treating form well ahead of function.
So why explicitly exclude or inhibit any investor small or large from investing in your next round? Are you afraid that you might scare off a large, future investor who doesn’t want smaller investors involved financially? Think about it. Are there rational people who would take this position? If so, are these people you want to deal with? To me, the fact that existing investors want to invest more money to retain their ownership is a hugely positive signal indicating that the people who know a lot about the company have faith in its progress and opportunities for success. As an entrepreneur, don’t you want to encourage such behavior?
By not explicitly giving investors pro rata rights (keep in mind that this provision simply grants the investor the right, it’s not a requirement – I’ll write a post on “Pay-to-Play” term sheet weirdness soon), you not only create a problem in subsequent rounds of funding, but you also create a problem now, in the current round. If, as a potential investor, I fear that I may not be able to prevent my dilution in future rounds, how anxious a I going to be to get involved. I’m not. Thus, my exit from the deal this week.
As my long-time friend and corporate general counsel, Peter Johnson, always says, “it’s, at worst, giving them the sleeves of your vest.” “Them,” in this case, being the investors you want to have involved in the company now and, hopefully, in the future.
BTW, there are loads of resources on the web discussing term sheets from many points of view. I highly recommend you take a look at Brad Feld’s and Jason Mendelson’s term sheet series as a starting point.