- She won’t do a deal if the legal documents aren’t good.
- She won’t do a deal if she doesn’t get pro-rata rights.
She then goes on to discuss a thing that happens continually in VC deals. When VCs invest in rounds, they set a threshold for “major investors” and, if you aren’t a major investor, you lose your pro-rata rights. In Joanne’s case, she hates this because her angel strategy is to maintain her pro-rata through the life of the company.
As a VC investor, I always insist on pro-rata rights. I did also when I invested as an angel, although my angel strategy was to invest in only the first two rounds. As an angel, I’d do the seed round, then one more round if needed, and then I’d stop. Occasionally I’d do a later round, especially if my investment was needed for positive signaling, or if it was a down round because of some circumstance, but I still believed in the company.
I know many VC investors who aggressively cut angels out of the pro-rata rights in later rounds. I’ve ended up deals where that’s in the docs, almost always driven by someone else. I’m generally indifferent – I’m delighted to have angels continue to participate if they want, and not if they don’t (my personal syndication agnostic view that I’ve talked about on Feld Thoughts many times.)
As an angel, it’s important to know the lay of the land and how it coud impact you in the future. Joanne does an awesome job of laying to the issue of pro-rata rights in this post – go read it now.
Question: Most VCs commented that they can not fund current cap table where the CEO and COO would get 10% equity once fully vested while the current investors have 80%. We talked to our investors and they have agreed to rework the cap table, however, I would like to understand from you what should I change my cap table to?
More Context: I recently joined a very early stage company as their CEO. The company was founded by two people three years back who have funded it since inception to the tune of ~$200k out of which $60k is in loans and is on the books of the company. The rest of $140k are unbilled expenses. The company has ~1000 paying customers and in 3 years has earned ~$160k. Last years revenue was $52k. The company is still burning money to the tune of $24000 per annum. I am not taking a salary right now, but my salary (at 80% discount to my market salary) is getting accrued since January. Also, I have been offered 10% equity with 4 year vesting and 1 year cliff. At this point of time we are trying to raise ~300k at 2.4 mn pre money. Most VCs in India say we are too early stage for them and we have just started looking at angel investment as an option.
This is a tricky one because it’s not clear whether the two original founders are still active in the business. If they are, then the hired CEO and COO getting 10% equity each is probably not unreasonable given that the founders are separate from the investors. In the case where the founders are also the early investors, this doesn’t matter, as you can separate their contribution conceptually.
If the early founders are no longer involved in the company and you are effectively restarting the business, then this feels light given this stage. However, there is no standard situation. It ultimately a negotiation with the founders and with your new investors. It’s easy for an investor to say “this doesn’t work for me” – a logical response, if you believe they are interested, is “what works for you?” Basically, have them propose something and then work with the founders to see if you can get to a deal.
There are definitely cases where the early investors own too much of the company to make it fundable. For example, let’s assume the the early investors put up $200k cash for 80% of the company. These investors are not active in the company, but instead you and your COO are running it (from day 1). In that case, a new investor would look at it and say that the early investors ended up with too much of the company since they effectively got 80% for investing a mere $200k.
Finally, if you raise money, you should use the event to clean up the existing balance sheet. If you raise $300k, you don’t want the $60k loan outstanding (it should probably convert into equity) and you definitely don’t want the $160k of unbilled expenses hanging out there. In addition, your accrued salary shouldn’t be continuing to accrue or get paid out. One tool you can use to normalize the equity some would be to roll the existing $200k into the ownership that the founders have (e.g. they still have 80% but now have a cost basis of $200k and the loan + the unbilled expenses go away) and then you pick up additional equity associated with converting your deferred salary into equity (e.g. if you defer $135k over the year, you get another 5% in options post financing ($135k / $2.7m post)).