Both investors and entrepreneurs need equal motivation

The economic clauses on the term sheet have long-term implications to the motivation both of investors and of owners.

What motivates an entrepreneur to seek investment in their business model? The prevailing motivation is pride of ownership. To see one’s idea made a reality and to witness others enjoy the fruit of one’s idea. To have created something new in the world. These are the prevailing motivations. Closely tied to pride of ownership is capital ownership, or the realization of one’s effort in financial gain. An entrepreneur who creates and yet receives no gain from her creation takes victory with bitterness. Ownership implies a direct benefit to a company’s success or failure, otherwise it is an empty term.

What motivates an investor to supply funds to an entrepreneur? The ultimate motivation is also pride of ownership, though the investor begins at the intent to receive financial gain and thus ends in a similar place to the entrepreneur, except for personal pride in the invention. As both entrepreneur and investor share a similar motivation, the term sheet must reflect ownership from both parties for motivation to persist.

Foolish investors and foolish entrepreneurs think only of their ownership.

A foolish entrepreneur may only accept seed investors who agree to a pay-to-play provision in the term sheet. This might be a wise safeguard at a later investment stage, but this provision hurts early investors who give charitably what they can afford at the time. If grandma signs up with this clause, her investment will surely revert to common stock if a second investment round occurs, since she gave all her savings to help jump-start the business.

A foolish investor consumes all the economic success of the entrepreneur and her employee’s efforts. Afraid to risk his money on the entrepreneur, the foolish investor dooms the company to failure from the beginning by removing all inventive to succeed from the entrepreneur and her management. If the investor requires participating stock and a majority share in the equity, the possibility that common stock will see any return is slim, and even explosive growth gouges a considerable share from the owner and management in a liquidity event. Without the hope of future gain, there’s little incentive for expert talent to remain at the startup long enough to vest their stock or to labor for a profitable company.

A wise partnership between investor and entrepreneur requires equal motivation. If either walks away from a contract with a lopsided share of the company’s success, they may well be walking away from any hope of success. If I am ever in the situation where my or a friend’s business model requires investment to realize, I will encourage equality. The entrepreneur needs investors who are willing to accept some risk on the business model and have personal interest in the long-term success of the company. Likewise, the investor needs entrepreneurs who have reasonable hope of gain that’s based on an accurate assessment of the terms and not legal misdirection. When multiple rounds of investment may be required, or even considered, I will also encourage both parties to consider the impact their first round will have on future rounds. Attributes like participating preferred stock and pay-to-play provisions rarely disappear once they’ve been introduced, which will have a snowball effect on future investment rounds.

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