Nearly everything is a matter of experience and style with angel investors. Some will negotiate the terms of the deal, while others have a no-negotiation policy. So, what do we need to know when negotiating with the investors and what are the main aspects we have to follow?

Key elements:

• The economic terms and terms granting control are the most important ones, don’t spend too much time on terms that do not create value;
• Be aware of the liquidation preference which defines how much money must be returned to the investors;
• Think about the ESOP and find the optimal solution for your employees;
• Be prepared for dilution and anti-dilution provisions. It is really needed for investors.

A startup usually attracts capital by issuing convertible bonds or shares. In doing so, it may enter into a convertible bond subscription agreement, a share subscription agreement, or an investment agreement, as appropriate. We can generally refer to all these agreements as an investment agreement. It is important to understand the economic terms and terms granting control because they are material ones in the negotiations.

Let’s take a look at the preferences in a little more detail:

The process begins with the so-called term sheet. The term sheet is presented by investors to the founders, outlining the terms they expect to see in the investment agreement. The term sheet is a non-binding document, whereas the investment agreement already creates an obligation.

The share value is probably the key economic term. It is this value that the founders and the investors have to agree upon. It is not that easy, because the usual business valuation methods such as the multiple methods or cash flow methods do not apply here. After all, usually, the cash flows are negative and the company does not generate any profit yet. That is why the parties are looking for other criteria, usually by assessing the product as such, looking at the market situation, and, of course, the team. Once the parties reach an agreement on the share value, they also need to decide on the necessary amount of investment in the company, and the method of investment – by issuing convertible bonds or shares. This, too, depends on the stage.

If the company is in an early stage – the so-called pre-seed or seed – stage, convertible bonds are usually the preferred option. This favors the investor because convertible bonds are basically an interest loan that must be repaid or may be converted into shares, should the value of the shares go up. The investors may decide if they would benefit more from converting bonds into shares.

Whereas in later-stage companies, investments usually are made into shares. And investors become shareholders and receive partial control as of the day X. The most common type of share in Lithuania is the ordinary share; however, preferred shares are sometimes issued as well. The only difference between the two is that preferred shares are tied to a fixed dividend, which can also be cumulative. And the preference means that this amount would be paid out to holders of preferred shares before payment is made to holders of ordinary shares. So here we have the so-called preference established by the law.

In the investment agreement, we can find a term liquidation preference. In essence, it indicates the amount of money to be repaid to the investor. It means that, if the company is sold (liquidation event), the investor would receive out of the share price, say, twice the amount invested, if the multiple is two, and the remaining portion of the share price would be distributed among other shareholders – the employees and the founders. Therefore, one should really scrutinize this provision and consider the amount of money that will ultimately go to investors.

Another important economic condition is the employee share option pool (ESOP). Usually, it ranges from 10 to 15 percent. Understanding from which capital it is formed is very important as well. If it is made from the capital before investment (pre-money), the founders’ shares shall be diluted. Whereas if it is made out of capital after investment (post-money), the founders’ and the investors’ share of the capital will go down in proportion to the number of shares issued to incentivize employees. Thus, it would seem that the smaller the pool, the better; however, one must estimate the optimal amount of shares required to incentivize employees.

That process we have just mentioned is in fact called dilution. When new investors appear, new shares are issued to them; accordingly, the current shareholders’ share of the capital shrinks. This is a normal situation. But the existing shareholders have the pre-emption right to purchase shares of a new issue and to keep their share of the capital if they make additional cash contributions to participate and to secure their share of the capital. If they decide not to participate and not to make additional cash contributions, their share of the capital decreases appropriately, even though the number of shares held by them remains the same.

More problems occur with the down rounds – dilution in value when shares to new investors are issued at a price lower than that of the issue price of the previous round, which drives the value of the previous investment down. In that case, the so-called anti-dilution provisions are applied to protect the previous investors. This could be achieved by granting additional shares to the investors or by altering the rate at which their bonds are converted into shares.

Well, if you have reached this stage, you should already have a pretty good idea of what you are getting yourself into with the investor. Remember, each investor will have a different approach. Find the investor whose approach works best for you and your ventures.

Thanks, Rūta Armonė, Associate Partner at Ellex Valiunas, for sharing this with the startups’ community!

Also, we invite you to take a look at the video made by Ellex Valiunas, regarding this topic: https://youtu.be/8F1zhHzDrm4