This has happened to me several times now. I’ve found an amazing lack of caring when it comes to negotiating terms amongst supposedly experienced investors. This is both among angels and venture firms. It doesn’t happen every time, but it happens enough. I have also found that people who put the most money in have the most to lose, but yet don’t step up to lead a negotiation on terms.
Why would this happen even with seemingly experienced individuals who have put up a large sum of cash for investment? Here are some reasons I’ve seen:
1. There is inherent trust in the entrepreneur. This occurs most in rounds with family and friends. Experienced individuals who jump into these rounds may not negotiate over terms and just sign whatever paperwork comes their way, on the assumption that the entrepreneur won’t ever do anything to screw them.
2. Some investors have lots of money, but don’t have enough knowledge on financing terms and their future implications. In my own experience, the only way I have learned (and that learning is burned into me) is to have done lots of deals and continually do them. Most angels don’t invest that often and it’s easy to forget how terms can affect their investment.
3. Some investors simply don’t care. They just put money up for investment and they are totally passive, and are happy to be part of the deal and gain some sort of return later. They don’t care about the details at all.
With 3, I believe that even at large sums of money, and this can be upwards of 500k-1MM dollars, this still is a drop in the bucket for their entire holdings and thus can afford to not care about the details.
Also, I think that for many investors, they are just doing it as a hobby and they are not serious about it. Thus, their level of care drops considerably on the details.
4. I have also seen investors simply avoid confrontation. They don’t want to get into an argument over terms, so they don’t start.
5. Some investors don’t want to spend lawyer fees to deal with the terms. They don’t want to spend anything extra and just want it done.
6. There is also something more serious, which is that if you lead, you could take on extra liability in case something in the terms causes the entire deal to go sour at some point. I’ve heard of cases where you could get sued for that. So investors get cold feet and avoid leading.
On some deals, I have pushed back on the terms because they weren’t to my liking. I do that even when I go in at my very low investment level, and I am never large enough to be a traditional lead investor. Entrepreneurs often counter that their most experienced investor is OK with the terms and thus the terms must be acceptable. In fact, because the other investors have not spoken up, the terms get accepted by default.
I have to say that this is frustrating. I have met only one other investor who invests at my level and ALWAYS speaks up about the terms. Everyone else just follows whatever is happening and assumes someone else is dealing with the details.
The problem with the terms is that, unless a lead investor produces a term sheet, you’re almost always given a term sheet that is company friendly. It will always favor the company and provides zero protection for investors from negative events.
My message to entrepreneurs is this:
You’re probably doing the right thing from a negotiation standpoint in starting out with a document that favors you totally. But I would truly warn you against making the assumption that since an experienced investor(s) have reviewed it, that it is truly an acceptable document. As discussed before, there are myriad of reasons why an investor, or group of investors, are OK with what you produced. But bear in mind, that if you as an entrepreneur truly want to take care of your investors, then you should query your lawyer on why an investor might object to the terms set forth in the document that he gives you, so that you understand why we would have issues and the ramifications for us in the extreme cases.
By the way, a lawyer will ALWAYS produce documents that favor you initially. It’s their job. If they are being a proper lawyer they will always seek to protect you and the company first UNLESS you specifically ask for a document that is more balanced. Also, NOTHING IS STANDARD. No matter what anyone tells you, it’s true. In every deal I’ve worked on, the terms are always slightly different.
My message to investors:
First, following on the very last comment previous, NOTHING IS STANDARD. Don’t believe it if someone hands you a term sheet and they say it’s standard, in hopes that you will believe them and just accept it blindly. I’ve worked on many deals now and they are all different in small and large ways, with many of the entrepreneurs and their lawyers leading the discussion with “it’s standard”.
Second, hire a good lawyer and spend the money to have someone review the terms and explain to you the potential up and downsides of the terms. Too many horror stories abound where there was insufficient protection for investors and we’ve gotten squeezed out company ownership, cheating us of larger returns. As an early stage investor, we put up cash at the earliest stage and take the highest risk and it is my belief that we should be compensated for taking that risk early on. Without us, the entrepreneur would never have gotten anywhere.
Third, CARE ABOUT THE TERMS. Make sure someone good is negotiating on your behalf. Never assume that someone else is going to do it. If you’re unwilling to do the negotiation, then at least make sure that there is someone who will do the negotiation. READ THE TERMS. Understand their implications to you and your money.
Fourth, we’d all like to work off of trust and a handshake, but I’ve already seen how friends can turn on friends in a business situation. It happens way too much for my taste. Thus, if we have a trusting business relationship, then there should be no problem putting that down in the terms. Be alert for when an entrepreneur gets upset at you implying that their trust is not good enough because you want it written down – to me, it’s a sign of trouble. It’s a psychological tactic to get at your good, trusting nature so that you won’t require him to write it down. Don’t fall for that. Walk away from the deal.
Last, do not be afraid to speak up regarding the terms either to the entrepreneur or to the lead investor. It’s your money so take care of it! Besides, you never know if the entrepreneur might actually change something based on what you say; it’s happened twice to me now where I’m on great terms with the entrepreneur and just asked nicely if we could make a change, and they did it.