Debt, Equity and Control...Term Sheet CautionMar 20 2017 Joshua Watkins
Many investors, eager to get started and get their company moving, will agree to terms that are not good business in the long run. It is understandable, and I have a client and friend that is fond of saying "we hope that is a problem" because if it is then the deal has probably been successful. Unfortunately, because of the inequity some deals will get sideways almost immediately and never reach their potential (or even launch).
The results tend to get even worse if a company tries to raise a second round after a poorly negotiated first round. In that situation, either the parties have to recast the deal or the deal will usual blows apart because the shorted party has the incentive eliminated.
Normally, if an early investor is worries about control, it is much better to bring them in as convertible debt and add a control provision giving them voting control until the debt is paid back at which point they convert to common ownership based on the negotiated pre-money valuation of the company and the capital amount they invested. That structure is a lot less likely to blow up and become inequitable over time and a lot less likely to mess up a follow on round of funding.
It is certainly real poker to negotiate an early round hard, with real risks on the other side as well, but the risks entrepreneurs take when they sign on to a bad deal is that they have really signed the death certificate for their company and just don't know it yet.
Mr. Watkins is the Managing Member at Watkins Law Firm, LLC. His legal practice has primarily focused on working with private companies as general counsel. As general counsel his duties typically include an array of tasks such as: in-house day-to-day activities, advising the company’s board of directors on their oversight responsibilities, planning and preparing complex corporate transactions, commercial litigation, tax planning, oversight of the corporation’s compliance with federal and state regulations, legal budget management, and specialized outsourcing of legal matters to other counsel when appropriate.
When counsel to emerging start-up companies, Josh often brings critical expertise in the many types of capital formation activities, including entity and structure choices, fundraising processes, and securities compliance.