Archive for the ‘Terms’ Category

Pro-rata Rights For Angels

Joanne Wilson (aka Gotham Gal) has an outstanding post today titled Pro-rata rights. In it she makes two important points about angel investing.

  1. She won’t do a deal if the legal documents aren’t good.
  2. 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.

Series A Warrants Based On Milestones Versus A Deal With Two Closes

Question: In a Series A, the investor is proposing a preferred stock with warrants. The warrants relate to the accomplishment of milestones, are optional, and are priced at 50% above the initial price. Is there an advantage to this versus structuring a two close deal. How do we make the second investment mandatory, more like a call option?

Ahhh. Nothing like a complicated one to kick off the first Ask the VC question in a while. To understand this a little better, let’s break apart the questions from what is being proposed.

It sounds like the proposal is a “Preferred A” with a “warrant” for more “Preferred A” at a price that is 50% more than the initial price. In simpler terms, let’s assume that it’s a Preferred A investment of $1m at $1 / share (or 1m shares of stock). Let’s assume a post-money valuation of $4m. This means that there are 3m shares of common stock since the 1m shares of Preferred buys 25% of the company.

In addition to the 1m shares of Preferred, in this deal the investor would get another 1m shares of Preferred Warrants priced at $1.50 / share. This means that at some point in the future the investor could invest $1.5m for another 1m shares.

Assuming there were no other changes to the capital structure, if the investor exercises the warrant there is a total of $2.5m that goes into the company (the original $1m plus the $1.5m from the warrant). This buys a total of 2m shares. Since there are 3m common shares, this results in the investor owning 40% of the company for $2.5m (2m investor shares / 5m total shares). The post money valuation after the warrant is exercised is $6.25m (2.5m / 0.40).

Got that? Bottom line – the investor is proposing a $3.75m pre-money / $6.25m post-money for a total investment of $2.5m

Now to the questions: First,¬†Is there an advantage to this versus structuring a two close deal? Unless we address the second question, where the investor is compelled to exercise the warrant upon completion of the milestones, this is a bad deal for the entrepreneur. If the warrant conversion is optional on the part of the investor, it’s simply a pricing mechanism for capturing upside if the company is successful. If things aren’t going well, the investor doesn’t need to exercise the warrant. Depending on the actual warrant terms, the investor may have a limited time window to exercise (1 year, 2, years, 5 years) – the longer the time window, the more “optionality” the investor has. Generally, a warrant like this in an early stage investment (e.g. a Series A round) is unusual and either indicates an investor who is unhappy with the pre-money valuation and trying to capture additional economics, or is unsophisticated about typical Series A investments.

The second question is the important one.¬†How do we make the second investment mandatory, more like a call option? The warrant should be tightly tied to milestones that the entrepreneurs believe are achievable. As VCs, we don’t like this approach, but some VCs do as they believe it focuses the entrepreneurs on what the VCs think are the hurdles (or milestones) that define near term success. If the milestones are clearly defined, achievable, and the warrant has to be exercised upon achievement, then this is merely a pricing mechanism and – as the entrepreneur – you need to decide if you are happy selling 40% of your company for $2.5m.