The Mistake that Makes Your First Round of Investors the Last

“What do you mean by screwed up?” I said. I had just asked Wells Burke, one of the newer ATDC Entrepreneurs in Residence, what surprised him most in his new job.

Instantly he said, “How screwed up the cap tables are for some startups. Some startups raised money with poor to no qualified advice. Inexperienced angels and the entrepreneurs structured deals improperly. Now they have a cap table which makes it difficult, or even impossible, to attract new investors. A good cap table must be able to take a punch.”

I had to confess in my 23 years as an angel investor, I saw the same thing from time to time. Like the healthcare startup with 15 doctors who combined invested $300,000 and own 51% of the business. Don’t get me wrong. I love doctors, but I just don’t want 15 of them as controlling partners in a new venture.

Just recently a founder contacted me. He told me he finally received a term sheet from angel investors. He asked if I would be willing to review it to see if the terms were fair or not.

I asked, “Did you agree to the business terms with your investors before the term sheet was drafted?”

He said, “No.”

The question is “Why not?”

First the Business Deal

If you were selling your car or your house, you would be crystal clear on the terms before committing them to writing. So why not have this same discussion on terms of investment before agreeing to sell a part of your company?

I see too many entrepreneurs simply wait to receive a term sheet. The negotiation then becomes the term sheet instead of the envisioned business arrangement.

When you spend time talking through the deal before the lawyers get involved, you will capture the spirit of the deal. The areas which must be addressed are:

  1. How much will be invested, and when and how much gets returned?
  2. How is the company run so the investment is protected?

In the absence of a business agreement first, the term sheet drafted by the investors’ lawyer is going to heavily favor and protect the investors. This most likely will cause a confrontation and tough negotiation. This negotiation could end in failure or, worse, terms which preclude future investment.

When to Get Lawyers

To be fair and save on legal fees, the entrepreneur and investors should agree to the financial and operating terms prior to lawyers getting involved. This way, the lawyers’ jobs are to advise and then memorialize the business terms and provide mutual protection through agreed corporate controls.

Come to a handshake deal prior to the lawyers getting involved. But don’t do the deal until after your lawyers write it up. Then you can have confidence the deal is done right. A deal which will work today and tomorrow. A deal which will not discourage the next round of investors.

That first term sheet is really important. It establishes the foundation and flexibility of capitalizing the company. If the cap table after the initial angel round is too onerous or restrictive, attracting quality investors in future rounds is very difficult.

This is because later stage investors don’t want their first discussion with prior investors to be a confrontation focused on overly protective terms. Unless your business has proven itself to be an incredible opportunity, new investors will pass because there are cleaner deals out there.