In our practice, start-ups occupy a special position. We see many enthusiastic young entrepreneurs who are encouraged to develop their innovative ideas into full-fledged products or services. However, the innovative nature also entails relatively low success rates. Statistics on failures among start-ups range between 75% and 90%, while the truly successful start-ups are as rare as the unicorns/unicorns they are proverbially named after.
The low success rate of start-ups leads to cautious behavior among the investors (also called business angels or informal investors) who provide early stage venture capital or private equity. On the one hand, those investors very much want to be involved in the scarce start-ups that do eventually succeed, because their investment there can yield tremendous returns. At the same time, the investors want to limit their losses among the multitude of participations that do not make it. To achieve this, they place conditions on their financing. These have to strengthen upside potential on the one hand, and reduce downside risk on the other. Meanwhile, they must come up with an attractive proposal to avoid the start-up's founder opting for another investor.
A proven method for investors is to make a participation proposal to the founder with a relatively high (so-called pre-money) valuation of the start-up. With that high valuation, they send a positive signal to the founder that, after all, he/she has already created something very valuable. From that pre-money valuation, they then calculate back what percentage of shares the investor acquires in exchange for his financial injection. At the same time, the investor negotiates anti-dilution clauses and liquidation preference to protect him if the future of the start-up company is less favorable than hoped.
An anti-dilution clause described as "full ratchet" is intended to ensure that in a future round of financing under less favorable circumstances, the dilution is passed entirely to the founder. This leaves the relative equity interest of the financial investor intact. An alternative such as the weighted-average anti-dilution clause works out more favorably for the founder.
The liquidation preference comes into play in the unlikely event that the company, as an investment, ultimately fails to become a resounding success but is instead liquidated for a relatively low amount. In such a case, the liquidation preference ensures that the vast majority of the lower proceeds goes to the investor. Many young entrepreneurs have been disappointed to find that they are sidelined when the proceeds are distributed.
Start-ups with a golden idea should therefore be on their guard: A seemingly very attractive proposal from a business angel or informal investor may contain particularly detrimental details. The remedy for this: Make sure you receive a participation proposal from several parties so that you build up a negotiating position. And make sure you are well advised.