Addressing the Dreaded Lifestyle Outcome

Bill Payne , Angel Investor , Frontier Angel Fund

18 May 2015

Three outcomes dominate exits of angel-funded companies:

• Dead bugs – Startups that go out of business, returning less-than-invested capital to angels (usually zero).
• Positive exits – Companies that liquidate with capital gains to investors, usually via a cash sale to a larger company.  While IPOs are possible, they are very rare for angel-funded companies.  The exits can range from simply return of capital to wildly exiting multiples.
• The living dead – These companies continue indefinitely to operate with internally generated cash without pursuing an exit.  By intention or due to market forces, these entrepreneurs turn what at first appeared to be a high-growth opportunity into a lifestyle company, that is, a company that meets payroll for all employees but does not demonstrate sufficient upside potential to attract buyers.  Such companies are going sideways and, as such, offer no opportunities to angels to harvest their investment – not even to write off their investment.  There are also examples of entrepreneurs who “get comfortable” with the income provided by their startup companies and simply choose not to pursue an exit.

What can investors do to protect themselves against the dreaded lifestyle outcome?

There are at least two investment terms that can be negotiated in advance of closing an angel round that help mitigate the “living dead” outcome:

Redemption:  This common deal term requires the entrepreneur/company to repurchase investor shares if an exit does not occur within a reasonable period of time, providing some upside to the investors via a small multiple of capital invested or with interest added to the capital, as if the capital infusion were debt.  Here is how redemption rights are defined in the model term sheet of the National Venture Capital Association for a Series A Preferred round:

Unless prohibited by (state) law governing distributions to stockholders, the Series A Preferred shall be redeemable at the option of holders of at least [__]% of the Series A Preferred commencing any time after[________] at a price equal to the Original Purchase Price [plus all accrued but unpaid dividends].  Redemption shall occur in three equal annual portions.  Upon a redemption request from the holders of the required percentage of the Series A Preferred, all Series A Preferred shares shall be redeemed [(except for any Series A holders who affirmatively opt-out)].

In footnotes, NVCA adds:  “Redemption rights allow Investors to force the Company to redeem their shares at cost (and sometimes investors may also request a small guaranteed rate of return, in the form of a dividend).  In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company.”  It is also clear that in certain states and under certain conditions, redemption may not be enforceable.  Nonetheless, redemption rights clearly specify the exits intentions of the investors.

Shared Governance:   This concept is one in which neither the founders nor the investors have voting control of the Board of Directors.  Here is how the Model Term Sheet for Alliance of Angels describes an appropriate Board of Directors:

The holders of a majority of the Series A Preferred shall be entitled to elect one member of the board of directors, who shall initially be ________.  At the time of the closing of this financing, the board of directors shall be 5 members: 1 from management, 1 from Series A, and 3 independent directors acceptable to both common and Series A directors.

Clearly, any board of five directors in which neither the founders nor the investors have three voting members would satisfy this concept.  Appropriate make-up might be two founders, two investors and one independent agreed upon by the other four or even one founders, two investors and two agreed upon by the other three.

Since the Board of Directors selects the CEO, shared governance, as described above, general provides sufficient leverage for investors to guide the company towards an appropriate exit in a reasonable period of time.

Five-director Boards with shared governance are rather common among angel-funded startups and are generally considered better practice.  Redemption rights, while less common in Silicon Valley than elsewhere in the US, are excellent leverage for investors to keep the management of angel-funded companies driving towards exits.

This post originally appeared in the ACA Blog. 

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