The Startup Checklist

22Survive the Term Sheet Negotiation and Investor Due Diligence

In Chapter 19, we noted that one of the principal roles of the lead investor was to negotiate the terms of an investment with the founder of the startup. In theory, the terms could be “Here's a million dollars to use; if the company becomes a big success, please give it back to us.” Unfortunately, that's not the way it works.

The Different Types of Equity Investments

When a corporation is established, its ownership is divided into pieces called shares of common stock, as discussed in Chapter 9. That's what you as a founder have, which is why it's also known as founders' stock.

There is a different kind of stock that investors can choose to purchase, called preferred stock. While the name makes it seem preferable to common stock, preferred is not inherently better; it's just different. Here's why:

When the time comes to turn the value of the company into cash (during an exit), that cash may be more or less than the value that you and the investors agreed the company was worth at the time of the original investment. That is where the difference between the two types of stock is critical.

Preferred stock is paid out first before any common stock is paid—but it gets back only the amount that was paid for it (plus perhaps some dividends, which for this purpose act like interest). In contrast, common stock gets paid out only after all the preferred has been satisfied—but it gets its proportionate share of all the remaining ...