It's easy to be seduced by the headline grabbing valuations of companies- especially in the technology space- at the moment. An Entrepreneur's head can be turned thinking of the end game and how they can raise money at the top end of normal.

Raising investment is horribly time consuming. It's also a journey with a number of traps along the way for the unsuspecting Entrepreneur, which is why so few make it to a successful exit at all. The bottom line is that six out of ten Founders of VC backed businesses will no longer be with their companies within 3 years of raising investment.

My first fund raising experience was back in 1990, and it was, shall we say, an illuminating experience.

I learnt the hard way that an ocean lies between an investor saying -' I really like this idea' - to actually securing the money.

Raising investment is a big distraction for your business. It's such a distraction that there is a real danger by the time you are closing your first offer of investment you will have run out of cash. VC investors are particularly attuned to that which means only one outcome- the deal being done on their terms and not yours.

And that's the start of a subtle, but fundamental shift in the terms of your relationship. Up until this point it seemed that you were both on the same side of the table- sharing the ideas, plans, and hopes for the business.

Not anymore.

The subtle shift I just talked about? You, the Entrepreneur fully expects there will be challenges ahead- but hey you believe in the dream right? You can and will weather the storm with the backing of your Board and your new shareholders. Ultimately you will still go on to build a successful business - one in which everyone will exit from in a few years either by IPO or a full blown liquidity event.

But here's the difference. You expect it to happen- your VC investor hopes it will happen, but they don't really expect it to.

VC investors come in all shapes and sizes- they operate on one core principle -what's in it for them. Investors want you to sell out. As soon as possible. For as much as possible. They have no desire to own part of your company forever. Investors are very focused on the company, not you. They're not interested in having you take out your original investment or paying you a large salary as profits go up.

So to ensure they get the best deal possible for them at exit here is what they will look for:

• Liquidation preferences
• Inflated option pools
• Board seat numbers
• Reps and warranties
• Service contracts

All of the above should make you say ' hold on- I'm signing up to what?'

When I did the first investment with a VC this is how it worked out. I raised £ 3.5 million at a £ 7 million pre-money valuation leading to a £ 10.5 million post money valuation.

The VC owned around 25% of the company and the founders owned 75%.

Happy days- so I thought.

The VC investor was insistent on us having an option pool - no problem there. I knew for example I was going to have to hire say a CEO to replace me at some point, to reward the existing CTO, take on a VP of marketing, and definitely a CFO and a Sales Director. I figured that 20% should be more than adequate to bring on the best people I could find.

But here's the catch. The VC wanted the options included before they would fund . So now that I had committed to a 20% option pool post funding, then I needed at least a 25% option pool pre funding (because the pool got diluted by 25% when the VC invested their money). So suddenly 100% of my company was down to 80% before the VC had invested.

Here's how it would work out if you had committed to a similar deal.

The VC’s investment still buys them 25% of your company – but guess what? - It’s you who has diluted to 60% ownership rather than 75%. Which means your true 'pre money valuation' is a lot less than you thought. It's the start of the gradual takeover of your business.

The second most important economic term in the term sheet other than price is the liquidation preference. What it means is how the net proceeds from a sale or dissolution of the company will be distributed.

Investors will always want to get their money out of the company before founders, which in the case where the company is sold for a low price is fair. You will find that this is pretty much negotiable with almost all VC's.

However - and this is the catch- not all liquidation preferences are equal . For example some can have a “multiple” on top of them such as a 2x liquidation preference, which means that investors get 2x their money before founders get anything. In an early round of investment this can often be higher. In our situation it was 3x. So as a Founder you will not see a bean until your investors have taken out 2/3 times their original investment. Negotiate hard on that.

And finally is 'reps and warrants'. Not unreasonably an investor expects you to take responsibility for what the brochure says, and more explicitly what you have represented in your financial forecasts. And if what you have said isn't quite as was advertised the investor can make you pay, either through cash or worse through the clawing back by the investor of your equity.

And this is where it gets interesting. Its one thing to be able to confidently warrant that your product is for example your own developed technology and that there are no IPR issues, it’s quite another having to warrant that your financial forecasts will be achieved.

In our situation we ended up warranting on both. You can probably guess the rest- within 2 years my co-founders and I were down to less than 10% of the company.

You see when VC's invest they are making a bet- a bet that the person who brings them a business idea is going to carry the torch for that idea as long as it takes, that the idea will get passed on, and that the business will make it across the finish line.

Make sure you still own part of that torch.

Tags: Entrepreneur

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