How Lead Investors Can Affect Earlier Investors 

by Kera DeMars

When you invest into a seed-stage company, there's a decent chance that company will raise a Series A.

And Series A investments come with a Lead Investor.

As an early-stage investor, that lead investor's term sheet will impact you and your shares.

There are a lot of ways a lead can affect you. But for your sanity (and my fingertips) this article will just cover the 3 things we think are most relevant. 

1. Board Seats

Investors at the seed level don't usually ask for seats on the board of their portfolio companies. The check size is typically too small to warrant such a valuable asset.

But Series A investors have more leverage. 

And sometimes the lead investor will require a seat on the board in order for a deal go to through.

What's so great about being on the board?

Being on a company's board gives you more power than simply being an investor.

For example, a board can:

  • veto the CEO's decisions 
  • fire the CEO
  • dilute everyone's equity

Let's say a CEO decides to give herself a raise... to $700k a year. The board can reverse this decision if they feel it's unreasonable.

Let's say a CEO is a bully whose behavior is causing high employee turnover. The board can remove the CEO from the company.

Let's say the company is trying to attract top talent. The board can create a new option pool for employees, diluting down all the other investors.

Takeaway: it's in your best interest to help your portfolio companies connect with Series A investors that are good humans.

 

2. Pro Rata Rights

Pro rata rights give early-stage investors the right to invest in future rounds at the same level (percentage) of ownership.

For example, let's say you invest $1m into a company valued at $10m.

You own 10% of that company.

Then the founder decides to raise a $10m Series A.

Pro rata rights are typically designed to give you the right to invest another $1m into this round, giving you 10% ownership of the shares available in the Series A.

Pro rata rights is established through legal documentation, like a side letter, during your initial investment. It's meant to prevent early stage investors from being heavily diluted as a company continues to raise funding.

But sometimes a lead investor will poop all over your pro rata rights.

If a promising founder is raising her Series A, her lead investor might want to block all other investors from participating in the round... regardless of any legal documentation.

This puts the founder in a tough spot. If they say no, the deal could fall apart. But if they say yes, their early believers get shafted.

If this happens, you as the early investor have 3 options:

A. You could sue.

But keep in mind you'd be bringing the Series A deal to a dead halt. And you're going up against a big firm with tons of resources. And your reputation will take a big hit.

B. You could withdraw your pro rata rights.

But you could be leaving millions of dollars (or more) on the table if the company does well.

C. You could ask the founder to fight for you.

This only works if you have a great relationship with the founder. 

Takeaway: It's in your best interest to develop a great relationship with your portfolio companies.

 

3. Liquidation Preferences

When a company is acquired, how much does everyone get paid, and in what order?

This process is referred to as "liquidation preferences". 

Most of the time the liquidation preferences are 1x.

Which means that, in the event of an exit, the first thing that happens is everyone gets their money back. Then the rest of the returns are distributed in the same order as the first round.

Let's break that down.

The last investor in will get paid first. This is because the last investor likely put in the largest check.

So, if the last investor put in $25m, that firm will get their $25m back.

Then the second to last investor gets paid back.

Then the investor before that gets paid back. And so on until all the investors have been paid back.

And THEN the rest of the profits are distributed in the same order. Founders and employees are paid last.

But sometimes a lead investor will sneak a 2x or 3x liquidation preference into their term sheet. Meaning the $25m investor will get $50m or $75m before anyone else gets a dime.

Takeaway: it's in everyone's best interest for the founders to be keenly aware of what is in their term sheet.

 

What can you do?

If your portfolio company is raising their Series A, it's certainly a reason to celebrate.

But it also helps to educate yourself before making a big investment. 

If pro rata rights, or a seat on the board, or liquidation preferences are important to you... be sure to put together a side letter with your SAFE.

Asking for those things retroactively will probably not work out well.

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