Deal Structuring - part 2 - 05/21/2008

In part 1 of Deal Structuring, we began to look at the 4th fundamental stage of early stage equity investing as defined in Winning Angels: The 7 Fundamentals of Early Stage Investing, by David Amis and Howard Stevenson. Part 1 covered the two primary equity models of early stage financing, the common stock model and the preferred stock model, as well as the most common deal terms used with these financing models.

The 7 Fundamentals of Early Stage Investing

Before moving on to non-equity financing models, we need to look at a very important final deal term that is often used in equity financing structures.

Nothing drives the reputation of venture investors as “vultures” more than anti-dilution or “ratchet” clauses. These clauses are present to ensure the investor will retain the same or significant ownership in the target company if the value of company is lower in a subsequent investment round, or what is called a “down” round. When a down round occurs, the investor protected by anti-dilution provisions will see the price of their original investment adjusted to be more beneficial to them – they have the right to convert their investment to a new, lower price. Of course, in order to provide the protected investor with a higher level of ownership after the later down round, the founders and any earlier, non-protected investors must take significant further dilution.

A full ratchet means that the investor who is protected by the anti-dilution clause is assured to retain the same level of ownership after the down round. This means the price of the prior investment in stock is retroactively re-adjusted to match the new, lower share price of the newer investment round. This can be particularly severe on the other, non-protected or common stockholders and can result in loss of the company by the founders.

A partial ratchet or weighted average anti-dilution provision means that a formula is used, which takes into account factors such the old and new price, or the amount of the new investment, and other factors to provide some upside value to the protected investor but not allow a complete conversion to the new price. The weighted average formula results in a conversion that is less severe for the other common stock holders or unprotected investors.

Ratchets can be complex to negotiate and are commonly used by later, professional investors including most venture firms, and thus should be left to the experts. Anti-dilution clauses can rapidly cause the founders of a company to lose ownership of it, if it is not performing and growing as anticipated. There is a good further discussion on anti-dilution provisions here:

Now that we have covered off the first two investment models, common stock and preferred stock, and the various deal terms that are often used, we can move on to non-stock investment models.

The third main investment structure is a convertible note with a discount. This investment method is structured initially as a loan, with interest. The amount of the loan plus interest can be converted to equity at a later date, usually at the next financing, and is converted at a discount to the other investors and usually on the same terms as the other investors. This model has some very compelling advantages, the most important being that the company does not need to to valued at all! The valuation, terms, and bulk of the deal negotiation is postponed until the later investment round. Furthermore, because the investor is a debt holder, the investor will be paid prior to any shareholders in the event of company liquidation. Holding debt can also get some leverage if the company or team is not performing well. Often a convertible note is combined with other terms as well, including warrants, which give the investor the right to buy shares of stock in the future for an agreed price.

The major downside to the convertible note model is what happens when the company does not seek further investment for a long period of time, or does not seek it at all. Maybe the venture is so successful, that further funding is not required. Maybe the CEO likes his lifestyle and does not push for an exit strategy. And if there is an exit event before any subsequent financing, the investor would not want to be a debt holder as the investor would miss out on the significant capital appreciation the stock would likely see in the exit event (company sale, M&A, or IPO). Investors should consider this model carefully and seek certain terms or time limits that provide the investor the appropriate opportunity to convert the debt into stock or pressure the company management to seek further investment or an exit process in a timely manner. Warrants can provide some additional upside potential.

A final funding model that is sometimes used (and only briefly mentioned in Winning Angels) is the royalty model. This method entitles the investor to a royalty stream once the business if profitable and provides a method for an “investor exit” without an IPO or company sale. The capital put into the business is basically a pre-payment against that future royalty stream. The investor is entitled to a percentage of revenue for a period of time, such as 5 or 10 years, with a maximum payout. Percentage of revenue ranges from 1-5% are common. If the company grows quickly and generates higher revenue, the investor is paid back more quickly and sees a high rate of return on capital. The obvious advantage to the entrepreneur is that there is no dilution of ownership. Some additional useful reading on the royalty model can be found at and

The bottom line on deal structures is that they are important, complex and littered with jargon, and different investors will want to do different things. Thus, a solid understanding of deal terms is important to all investors and entrepreneurs but the dirty work is best left to the experts. A good reference to deal terminology, such as that maintained by Dartmouth (, can help. Even among the experts profiled in Winning Angels, methods vary, but generally angels seem to like preferred stock over everything else, and always try to keep it as simple as possible.

Deal Structuring - part 1 - 05/02/2008

So you are ready to invest in an early stage company, and are prepared to lose all your money, if it comes to that. How should the deal be structured? This is the fourth topic covered in Winning Angels: The 7 Fundamentals of Early Stage Investing, by David Amis and Howard Stevenson.

Structuring an early stage […]

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