13.3 Risk mitigation techniques in deal structuring
3 min read•august 9, 2024
Venture capital and private equity firms use various techniques to mitigate risk when structuring deals. These methods help protect their investments and align interests with founders. From to , investors carefully assess and monitor their portfolio companies.
Deal terms like and offer flexibility and downside protection. Investor protections such as board seats and ensure ongoing involvement. These strategies work together to manage risk and maximize potential returns in high-stakes investments.
Deal Terms
Due Diligence and Staged Financing
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- Due diligence involves comprehensive investigation of potential investment
- Includes financial, legal, operational, and market analysis
- Helps identify risks and opportunities before committing capital
- Staged financing allows investors to provide capital in multiple rounds
- Subsequent funding contingent on meeting predetermined milestones
- Reduces risk by allowing investors to exit if company underperforms
- Incentivizes founders to achieve key objectives for continued support
Convertible Securities and Anti-Dilution Provisions
- Convertible securities offer flexibility in investment structure
- Can convert to equity at predetermined events (IPO, future funding rounds)
- Provides downside protection while maintaining upside potential
- Common types include and (Simple Agreement for Future Equity)
- protect investors from value dilution
- adjusts conversion price to lowest subsequent round price
- considers size of dilutive issuance in adjustment
- includes all outstanding securities in calculation
- only includes preferred stock in calculation
Liquidation Preferences
- Liquidation preferences determine order and amount of payout in liquidation event
- guarantees return of initial investment
- allows share in remaining proceeds after initial return
- sets upper limit on additional proceeds received
- offer higher guaranteed return (2x, 3x initial investment)
- Seniority in liquidation preferences establishes hierarchy among investor classes
Investor Protections
Vesting Schedules and Board Representation
- align founder incentives with long-term company success
- Typical structure: 4-year vesting with 1-year cliff
- requires minimum tenure before any equity vests
- may occur in change of control events
- gives investors direct influence on company decisions
- Investors may negotiate for specific number of board seats
- Observer rights allow investors to attend board meetings without voting power
- Independent directors often added to balance founder and investor interests
Information Rights and Protective Provisions
- Information rights ensure investors receive regular financial and operational updates
- May include monthly, quarterly, and annual financial statements
- Access to cap table, business plans, and strategic documents
- Protective provisions give investors veto power over certain company actions
- Common protective provisions include:
- Issuance of new securities
- Changes to articles of incorporation
- Sale or merger of the company
- Increase in option pool
- Incurring significant debt
- Major decisions require approval from specified percentage of preferred shareholders
Drag-Along and Tag-Along Rights
- allow majority shareholders to force minority holders to join in sale
- Ensures ability to sell entire company without minority holdouts
- Often requires approval from board and specified percentage of preferred shareholders
- (co-sale rights) allow minority shareholders to join in sale
- Protects minority investors from being left out of favorable exit opportunities
- Typically triggered when founders or major shareholders sell significant portion of stock
- allows investors to maintain ownership percentage in future rounds
- gives company or existing investors priority to purchase shares before external sale
Key Terms to Review (24)
Accelerated vesting: Accelerated vesting refers to the process in which an employee's rights to stock options or benefits are moved forward, allowing them to gain ownership of these benefits sooner than originally scheduled. This is often a strategic move used in deal structuring to mitigate risks, particularly during significant events like company mergers or acquisitions. By accelerating the vesting schedule, companies can ensure key employees remain motivated and aligned with the new strategic direction post-event.
Anti-dilution provisions: Anti-dilution provisions are contractual agreements that protect investors from a decrease in their ownership percentage or value of shares due to future financing rounds at a lower valuation. These provisions are designed to maintain the economic value of an investor's stake in a company, especially when new shares are issued at a price that is less than what earlier investors paid. They serve as a critical component of deal structuring by ensuring that investors are not unfairly disadvantaged in subsequent funding rounds.
Board Representation: Board representation refers to the presence of investors or their appointed representatives on a company's board of directors, allowing them to influence strategic decisions and governance. This concept is crucial for ensuring that investors have a voice in the management of their investments, facilitating communication between the company and its stakeholders, and aligning the interests of both parties. Having board representation also enhances accountability, as it enables investors to monitor company performance and support post-investment value creation efforts.
Broad-based weighted average: A broad-based weighted average is a calculation used to adjust the conversion price of preferred shares to common shares in a way that considers the total number of outstanding shares. This method ensures that all existing shareholders, especially common shareholders, are fairly treated during equity financing rounds by minimizing dilution effects. It provides a more equitable approach compared to narrow-based formulas by factoring in a larger pool of shares.
Capped participation: Capped participation is a mechanism used in investment deals that limits the amount of returns an investor can receive from a specific investment while still allowing them to participate in the upside to a certain degree. This technique is often employed to align interests between investors and management, providing an incentive for performance while protecting against excessive returns for investors at the expense of the company’s growth.
Cliff period: A cliff period is a specific time frame in which an employee, typically in a startup or venture-backed company, must remain with the organization before any equity or stock options vest. This period acts as an incentive for the employee to stay and contribute to the company's success, while also providing a risk mitigation strategy for investors and employers by ensuring that key personnel are committed during critical phases of growth.
Convertible Notes: Convertible notes are short-term debt instruments that convert into equity, typically during a future financing round. They allow investors to loan money to a startup with the expectation that the loan will be converted into shares of stock at a later date, often at a discount or with a valuation cap, which helps mitigate risk for both the investor and the startup.
Convertible securities: Convertible securities are financial instruments, typically bonds or preferred shares, that can be converted into a predetermined number of common shares of the issuing company at the holder's discretion. This feature allows investors to potentially benefit from equity appreciation while also receiving fixed income from the security, making them an attractive option for risk mitigation in deal structuring.
Drag-Along Rights: Drag-along rights are contractual agreements that allow majority shareholders or investors to force minority shareholders to sell their shares in the event of a sale of the company. This mechanism is crucial in venture capital deals as it ensures that potential buyers can acquire 100% ownership, making the company more attractive for acquisition and facilitating smoother transactions.
Due Diligence: Due diligence is the process of thorough investigation and evaluation of a potential investment opportunity, aimed at uncovering relevant facts and risks before finalizing a deal. It is essential in ensuring that investors make informed decisions by validating assumptions, assessing financial health, and understanding operational aspects of the target company.
Full ratchet anti-dilution: Full ratchet anti-dilution is a protective mechanism for investors that adjusts the price per share of their existing investment to match the lower price of shares issued in subsequent funding rounds. This type of anti-dilution provision ensures that if a startup raises capital at a valuation lower than what earlier investors paid, those investors will have their share prices adjusted downward, effectively preserving their ownership percentage. It connects to the overall deal structure by safeguarding investor interests and can influence negotiation dynamics in term sheets.
Information Rights: Information rights refer to the legal and contractual entitlements that investors, particularly venture capitalists, have to access information about a company's financial performance, strategic direction, and operational status. These rights are crucial for investors to monitor their investments effectively and to protect their interests as they navigate various aspects of the deal-making process, governance, and risk management.
Liquidation Preferences: Liquidation preferences refer to the terms that specify the order and amount that investors receive in the event of a company's liquidation or sale. This financial mechanism helps protect investors by ensuring they are compensated before common shareholders during a liquidation event, thereby reducing their risk exposure. Understanding these preferences is essential for both venture capitalists and entrepreneurs when structuring deals, as it influences investor behavior and expectations in scenarios like mergers or bankruptcies.
Multiple liquidation preferences: Multiple liquidation preferences refer to a financial mechanism used in venture capital and private equity investments, where investors receive a return on their investment that is a multiple of their original investment upon a liquidity event, such as a sale or IPO. This structure helps mitigate risks for investors by ensuring they are compensated first and at a guaranteed return rate before other stakeholders receive any proceeds, creating a layer of protection in deal structuring.
Narrow-based weighted average: A narrow-based weighted average is a method of calculating the average price of a company's shares, where only the most recent stock prices are considered, and given more weight than older prices. This approach is particularly useful in assessing the value of shares during significant transactions, such as mergers or acquisitions, as it reflects the current market sentiment more accurately. By focusing on recent valuations, it can help mitigate risks associated with sudden changes in the market or company performance.
Non-participating liquidation preference: Non-participating liquidation preference is a financial term that describes a provision in investment agreements, where investors receive their initial investment amount back in the event of a liquidation event, without participating in any additional proceeds beyond that. This mechanism is crucial for protecting investor capital and minimizing risk, as it ensures that investors get their money back before any remaining assets are distributed to other shareholders.
Participating Liquidation Preference: Participating liquidation preference is a financial term that refers to a type of provision in investment agreements allowing investors to receive their original investment back upon a liquidation event, plus a share of any remaining proceeds, as if they were common shareholders. This mechanism protects investors by ensuring they can recoup their capital while also benefiting from any upside in the company’s valuation during an exit. It serves as a risk mitigation technique, giving investors a more favorable position in scenarios where the company is sold or liquidated.
Pro-rata participation: Pro-rata participation refers to the right of investors to maintain their ownership percentage in a company during subsequent funding rounds by purchasing additional shares proportionate to their existing stake. This concept is crucial for investors as it helps them avoid dilution of their ownership and ensures they can continue benefiting from the growth potential of the business. By allowing investors to participate in future funding rounds, pro-rata participation serves as a risk mitigation technique that strengthens investor confidence and aligns their interests with the company’s long-term success.
Right of First Refusal: The right of first refusal (ROFR) is a contractual agreement that gives an individual or entity the first opportunity to purchase an asset before the owner sells it to someone else. This term is commonly seen in venture capital deals, where investors may want to maintain control over their investment by having the first chance to buy additional shares or interests in a company. It acts as a protective measure for investors, ensuring they can increase their stake without competition from outside buyers.
Safes: A SAFE, or Simple Agreement for Future Equity, is an investment contract used by startups to raise capital in exchange for future equity. It allows investors to convert their investment into shares of the company during a future financing round, typically at a discounted rate compared to the price paid by new investors. This mechanism reduces the immediate need for valuation, making it easier for both startups and investors to negotiate terms and expedite funding.
Staged Financing: Staged financing is an investment strategy where funds are provided in multiple rounds, contingent on the achievement of specific milestones by a startup or project. This approach not only allows investors to monitor progress and adjust their commitments but also minimizes risk by ensuring that additional capital is only allocated when predetermined goals are met.
Tag-along rights: Tag-along rights are contractual agreements that allow minority shareholders to sell their shares alongside majority shareholders if the latter decide to sell their stake in a company. This provision protects minority investors by ensuring they have the opportunity to participate in a liquidity event, thus mitigating the risk of being left with an illiquid investment. It plays a crucial role in negotiations and deal structuring, as it influences the dynamics of ownership transfer, terms within term sheets, governance provisions, and risk management strategies during investment exits.
Vesting Schedules: Vesting schedules are structured timelines that determine when an individual gains full ownership of certain benefits, typically equity or stock options, granted by an employer or investor. These schedules serve to align the interests of stakeholders, encouraging commitment and retention over time by providing incentives that are gradually unlocked based on performance or duration of service.
Weighted average anti-dilution: Weighted average anti-dilution is a provision designed to protect investors from dilution of their ownership percentage in a company during future financing rounds. This mechanism adjusts the conversion price of preferred shares based on the price of new shares issued, effectively allowing existing investors to maintain their equity value as new shares are sold at lower prices. This concept not only plays a crucial role in negotiating term sheets but also serves as a key risk mitigation technique in deal structuring.