From the August 2010 issue of Investment Advisor • Subscribe!

Venture Populist: Terms of Engagement for Private Venture Advisors

Angel and venture investors often have the option to determine to what extent they intend to contribute professionally to their new portfolio holding. Investment advisors that allocate client capital to private investments lend their business skills, resources, and Rolodex to the venture as well, helping the company solve problems, prioritize objectives, build great teams, and even seek out strategic partners and potential customers.

This makes private venture investment a unique asset class for advisors, because they are more than passive investors. Rather, they can choose to add value and influence the outcome of their investment in the same manner that advisors' efforts ultimately contribute to the return of their client's investment or retirement portfolios. The discretion to engage with the entrepreneur and contribute to the enterprise is a facet of private venture investing that attracts family offices and wealth managers.

Equally compelling to advisors is the ability to influence the terms of engagement for their client's capital in a manner that increases the opportunity for a favorable investment outcome. Unlike conventional public investment vehicles, and most alternative products, the investment terms for private venture investments are often negotiable depending on the size of the contemplated investment, stage of the company, and financing history.

Evaluate, Negotiate, Allocate

Between due diligence and the investment decision is the opportunity to have a material impact on a private investment outcome. It surprises me when angel participants, particularly lead investors in a seed round, simply accept the offering terms of a private venture without fully leveraging their currency to negotiate. Startup capital for new ventures is scarce relative to the go-go days of the 1990s. It tilts the advantage in favor of capital and provides angel investors with an opportunity to materially improve their position.

Angel round investors are a special breed. They take on startups at the riskier seed stage (in pursuit of higher-multiple exits) at a point where venture capital firms will typically not engage. VCs and institutional investors are more apt to see some evidence of progress with a startup, whether in regards to financing, product development, or a proven business model or market. Yet that does not prevent VCs from coming to the table with their own terms for a series 'A' financing. Too often, however, angels let the entrepreneur's counsel set the terms for the seed and bridge financing rounds.

So which provisions in an angel investor's term sheet are negotiable? All of them. I am humored by entrepreneurs who describe their terms as being "market." There is no market without the angel's capital and that means that valuation, liquidation preference, anti-dilution protection, dividends, various protective provisions, board composition, and even the vesting of the founders' stock should be subject to negotiation.

Each of these terms may have a critical influence on the outcome of an early-stage investment, but valuation is arguably the most difficult for angel investors to negotiate, as there is little meaningful company history to value, rather merely a vision around an idea, a market and a management team, and perhaps a business plan.

The "market" (for angel investors and entrepreneurs) has responded to this issue by relying upon convertible notes to fund seed stage companies. Rather than dickering endlessly about the present value of a future uncertainty, angels and entrepreneurs agree to lend their capital to the new venture in the form of a note (often secured with some form of collateral and offering a dividend) and agree to convert their debt to equity at the price set in the subsequent round of financing. The theory is that at that point, more will be known about the business, market, competition, and opportunity, thus making it easier to agree on a valuation.

Consequently, convertible notes have become the primary template for seeding young companies and providing bridge financing from the concept stage to a larger, perhaps institutional, financing round.

Getting Help; Exploiting the Opportunity

Advisors should engage the growing universe of online content that speaks to best practices for investors in private early-stage ventures. Among them, venturepopulist.com (disclosure, this is my own site) is the only free online resource that specifically provides investment advisors, wealth managers, and family offices education and counsel on general matters pertaining to private venture investments. Additionally, advisors should engage a securities attorney with ample experience in private venture financings to advise on each term sheet negotiation.

Advisors that allocate to private investments on behalf of their clients have a unique opportunity to positively influence the investment outcome. I would argue that it is also their obligation to exploit that opportunity.

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