In my experience, many first-time entrepreneurs seem to misunderstand or confuse the concept of “economics” versus “control” in terms of issuing equity. The book Venture Deals is an excellent resource and strongly recommended for those preparing or evaluating a term sheet. The book is very comprehensive and can take some time to digest, however, the underlying principles can be distilled into the following:
(i) Every equity instrument consists of two components that are of value to the investor, namely “economics” and “control”.
(ii) “Economics” represents the investor’s ability to generate a return on investment. Generally, this includes the cost of the investment, as well as the percentage of ownership. Howevever, there can be other complex economic terms to an equity instrument. For example, many term sheets include an anti-dilution provision to protect the investor’s pro-rata share in the event the company subsequently issues shares at a lower valuation and lower price. In addition, convertible preferred shares often include a liquidation preference to be enacted upon sale of the company, or some other liquidation event. So, economics goes beyond “issuing n% of the company for $x”.
(iii) “Control” represents the investor’s ability to influence the decisions of the corporation. It is important to note that control of a corporation ultimately resides with the Board of Directors, and a shareholder can only exercise influence to the extent that they can appoint or elect members of the Board. The control provisions of a term sheet can be very complicated, and Board governance models can vary widely depending on the corporation, so, every situation is unique.
(iv) It follows from the previous point that x% economic interest does not necessarily translate to x% control. For example, an investor might be issued 10% of the outstanding common shares of the corporation in the form of Class B non-voting common shares. In this case, the economic interest is 10%, but they have no representation on the Board of Directors. Similarly, suppose an investor owns 45% of the voting shares but none other shareholder own in excess of 5%. Although the investor owns a minority interest, unanimous opposition would be required to prevent them from achieving control. (NB: I like to refer to this as the ‘Dragon’s Den’ error. Dragon’s Den is a popular show in Canada where new ventures ask a panel of wealthy business people for an investment. Often, the supposedly astute investors ask for 51% ownership so they can exercise control, which, as demonstrated, is not the case.)
(v) Economics and control, although separate components of an equity instrument, are symbiotic. The greater the economic interest belonging to an investor, the greater the incentive for them to be involved in the affairs of the business, and the larger the desired control. Given that life science ventures generally require large capital investments, it is reasonable to expect giving up significant chunks of both equity and control to investors. So, when it comes to preparing a term sheet, it is important to arrive not only at a fair valuation, but also a fair system of representation.
Hopefully this article clarified any misunderstanding that might exist regarding the issuance of equity instruments. As I have mentioned to many people, the finance principles applicable to start-ups can be initially confusing, however, once understood, they are quite intuitive and easy to remember.