There is no sure-fire way to prevent failure, but one can always fail smarter. Entrepreneurs fail smarter by understanding the basics of their term sheet, understanding how much capital is needed, and having an exit plan.
Term sheets. In the exhilaration of securing capital, many first-time entrepreneurs fail to read, and understand, the language around liquidation. All smart entrepreneurs know to seek legal counsel prior to signing off on a term sheet. However, even those who do understand the terms, tend to visualize a profitable exit; in which even the least entrepreneur-friendly terms are digestible. Unfortunately, not all companies liquidate at a profit. In the event that there is a fire sale, entrepreneurs can feel a deeper burn if they neglect to properly negotiate the language in their term sheet.
A common mistake first time entrepreneurs make is failing to fully understand the events that could potentially occur during the sale of their company.
Liquidation Preference. Liquidation preference dictates how the proceeds of a sale will be distributed.
“In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).”
Tip: Most investors will request a liquidation preference of 1x. If your liquidation preference is substantially higher, this is a red flag.
Participation. An entrepreneur needs to understand participation. There are three varieties: Full participation, capped participation and non-participating.
Fully participating stock will share in the liquidation proceeds on a pro rata basis with common, after payment of the liquidation preference.
Capped participation indicates that the stock will share in the liquidation proceeds on a pro rata basis until a certain multiple return is reached. Non-participating would not participate at all.
Tip: Some investors will request fully participating stock. Be mindful of how this will affect your proceeds during the liquidation.
Redemption Clause. The redemption clause puts a finite number of years on the investment’s life. This is enacted to protect the investor and provide a guaranteed exit.
“Redemption at Option of Investors: At the election of the holders of at least majority of the Series A Preferred, the Company shall redeem the outstanding Series A Preferred in three annual installments beginning on the [fifth] anniversary of the Closing. Such redemptions shall be at a purchase price equal to [x] times the Original Purchase Price plus declared and unpaid dividends.”
Tip: Most investors do not enforce redemption, however, it is used in some term sheets. Discuss this with your investor and understand the ramifications.
It’s important to work with an attorney who will educate you on these terms and make certain that you understand what you are signing.
Not understanding these basic terms could leave a first-time entrepreneur in for a shock when it comes time to wind down their company.
Capital. Most entrepreneurs dread building and maintaining financial models. Unfortunately, the number one reason companies fail is that they run out of capital. Know your numbers.
All first time entrepreneurs should have a general understanding of their revenue model (how money is coming into the company) and their financial model (how money flows through the company).
When entrepreneurs take the time to create a financial model and track their cash flow, they are in a better position to detect a crisis and re-position for a downturn. This will assist them if they need to pivot or exit the company.
Entrepreneurs can protect themselves in a future crisis by establishing limits. For instance, entrepreneurs can set a baseline of capital (3 months worth of salary, operating expenses, and legal expense) as the point in time that they need to seriously consider winding down and looking for a buyer.
Tip: Budget for a worst-case scenario. Most entrepreneurs build out a financial plan based on one scenario only. This creates a blind spot for operations.
Exit. Another mistake entrepreneurs make is failing to attach an exit strategy to the worst-case scenario. They typically have an exit strategy based on their best case. For example, if we reach $100 million in annual sales, we could potentially sell to these top five companies.
Entrepreneurs who fail to create a worst-case exit strategy miss out on opportunities for asset sales, liquidations, and other sales strategies that are employed when a company is failing.
Tip: Prepare for the worst and you will come out on top of any exit.
This post originally appeared on Atelier Advisors. Lili Balfour is the founder and CEO of the SoMa-based financial advisory firm, Atelier Advisors, creator of Lean Finance for Startups and Finance Boot Camp for Entrepreneurs. All AlleyWatch readers are automatically eligible for a 50% discount on either of the courses using the preceding links.