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Thursday, September 9, 2010

Don't do "mandatory redemptions" in seed deals...

I had a conversation with one of our BAN company founders last night (I have a very understanding spouse) about term sheets and our preferred structure.  He was really asking about convertible debt vs. preferred equity, but we ended up talking more about share redemption requirements or puts and related change of control provisions.

We have had this discussion several times in our BAN meetings and my opinion is fairly clear...don't put mandatory redemptions and change of control provisions in seed stage deals.

Why?  Because it is a seed deal and they are inherently more fluid than later stage deals, so the flexibility is helpful.  Also, we are talking about $300-400k (not $3-30mm), usually in increments of $10-25k per investor, so it is almost always in everyone's best interest to have the founders tackle whatever obstructions may arise and have the investors "keep their day job."

As an investor, I would much rather focus on doing good due diligence and valuing the deal properly for the risk  involved (which btw explains part of why I prefer preferred stock deals rather than debt that punts valuation to the next round) than trying to force a deal to work that has developed issues.  Furthermore, if a deal is so sideways at the pre-revenue/seed level that someone else needs to come in and rescue it from the founders, then it is probably headed for the scrap pile anyway.

But, this is not just a theory that reduces the investor's risk of throwing good money after bad, I think experience is showing that by focusing on due diligence and hammering out the details rather than trying to contractually bind a minimum return, our BAN deals have a much higher chance of success both short term and long.

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