New businesses are started every day around the world. Some businesses will become hugely successful (i.e. Twitter, Google, Amazon, Facebook), others, not so much. Many start-up businesses seek funding to help grow their business. The source of start-up funds often comes from a venture capitalist, also known as a VC. Angel investors are similar to venture capitalists, but they usually provide seed-stage funding (less than $1,000,000). Often, angel investors are high net worth individuals with excess liquid capital they want to invest. As this blog post is being written (May 2015), the amount of angel investment money and venture capital money available to fund new ventures has never been higher. However, it still remains very difficult for many start up companies to raise money from angel investors and VC’s for reasons beyond the scope of this blog post.
When founders and VC’s choose to work with each other, some people, (myself included), believe it is similar to a marriage, with one major exception. Investors almost always expect their investment relationship in the companies they finance (known as their “portfolio companies”) to eventually end. VC’s properly prepare an exit strategy from day one.
Unlike a marriage, nearly every single investor has the primary goal of someday exiting the company they once funded. For many reasons, some investors remain on the board of directors of their portfolio companies even after the company has gone public or has been acquired.
Certain provisions contained in a VC’s term sheet act like a prenuptial agreement for investors. A term sheet controls the economics of the investment deal when the relationship between the portfolio company and the investor ends. In many ways, prenuptial agreements act in the same manner as a term sheet.
In very basic terms, before money changes hands between the investor (VC or angel) and the founders of a company, a document known as a term sheet must be negotiated and signed by both. The term sheet is a critical document for both the founder and the potential investor. The term sheet controls the economics of the deal and often, control of the company. Basically, the term sheet sets forth the economic terms when the company experiences a liquidity event. The term sheet establishes who is entitled to how much money when the company is acquired, merged, issues an initial public offering (IPO), or the company is otherwise liquidated. Modern day investors could not function without a term sheet.
In the technology sector, it is not unusual for some investors to earn 25 to 50 times back on their initial investment if a company they funded becomes successful. If you were an early investor in Google or Facebook, that could translate into hundreds of millions of dollars in profit. The term sheet becomes critical when valuing the everyone’s share of the company.
What does a term sheet have in common with a prenuptial agreement?
Venture capitalists and angel investors make investments with the expectation they will eventually exit. In contrast, people do not marry each other with the expectation that they will eventually divorce. However, statistics tell us about 50% of first time marriages in the United States end in divorce. The divorce rate is even higher for second and third marriages.
Given the high likelihood of divorce, having a prenuptial agreement in place is simply a good economic decision. For high net worth individuals, it can save tens of thousands of dollars, (or more) in legal fees and costs in the event your marriage ends.
At first, it may seem difficult to approach the subject of entering into a prenuptial agreement. In reality, many people are surprised to discover the idea is welcomed and even embraced by their significant other.