The venture capital (VC) firm Aerovent Capital is considering a $100 million investment in the startup company Earth Escape. The Founder of Earth Escape and Aerovent Capital must negotiate the terms of the investment. Both parties are concerned with structuring a deal that protects their substantive investment interests and with creating a positive foundation for their potential collaboration.

The negotiable terms of the investment include: venture capital (VC) equity percentage, dividends, number of VC-appointed board members, and a CEO replacement provision.

Confidential Instructions for Aerovent Capital

Scenario:

You are a general partner for Aerovent Capital, a venture capital (VC) firm that focuses on investing in early stage, high-growth companies in the aerospace industry. Aerovent Capital prides itself on the very active role it assumes with its portfolio companies to help build them into successful, industry leaders. You have worked with Aerovent for over fifteen years and have become one of the most senior partners in the firm.

The current deal you are considering is a $100 million investment in a company called Earth Escape. As the lead partner for this investment opportunity, you have met with the founder several times and are ready to discuss terms. During this negotiation, you will discuss the most significant terms of the potential investment. If this negotiation is successful, the agreed-upon terms will provide the basis for a detailed term sheet to be signed later this week. You are extremely excited about becoming an investor in Earth Escape, but you also realize that convincing the founder of your desired terms while nurturing such a nascent relationship may be quite a challenge.

Aerovent Capital's Investment Philosophy:

Aerovent Capital focuses on leveraging its industry expertise by acting as lead investor and "partner" to early stage companies. Aerovent strives to provide much more than just a capital infusion to its portfolio companies. The firm seeks to add value to its portfolio companies by recruiting outstanding board members and top management, recommending company strategy based on its industry expertise, providing access to its network of industry professionals, and eventually helping the company find a buyer or go public. Aerovent hopes to attract the best entrepreneurs in the aerospace industry by marketing itself as an investment partner that makes industry-revolutionizing success possible. As a representative of such a firm, you consider developing well-functioning relationships with your portfolio companies one of your greatest responsibilities.

Background on Potential Investment:

Earth Escape was founded four years ago with the intent of revolutionizing the space tourism industry. The founder, with whom you are negotiating, is an accomplished management and engineering R&D (research and development) professional with over 25 years' experience in the aerospace industry, specializing in launch vehicle development. The founder is also Earth Escape's current Chief Executive Officer (CEO).

The company's mission is to make suborbital space flight an economically feasible option for the general public. Earth Escape is well on its way to accomplishing such a task. The company has privately developed a new reusable launch vehicle (RLV) based on its own proprietary technology. The launch vehicle is capable of taking off from a standard airport runway, exiting the earth's atmosphere and entering outer space for approximately twenty minutes at a peak altitude of over 100 miles above the earth's surface, and returning to the same runway, with a round-trip time of only two hours.

Earth Escape claims that the RLV is ten times as safe as any spacecraft to date and is far less expensive to produce and maintain. By drastically reducing the safety and financial concerns of space flight, Earth Escape intends to exponentially increase the number of private citizens taking commercial space tours each year for the next decade. The tours will offer anyone with the desire and financial means the opportunity to experience the weightlessness of outer space, and to view the grandeur of the earth from a distance previously reserved for only a select few astronauts.

Earth Escape has spent approximately $23 million, primarily funded through personal contacts of the founder, over the past four years to develop its proprietary RLV. To date, the company's single test-RLV has made fifteen tours of space, catering to extremely wealthy and eccentric individuals. The company currently employs 35 individuals, but intends to grow quickly. Earth Escape is currently seeking funding of $100 million to produce a fleet of six RLVs and to develop the company infrastructure necessary to begin servicing the general public.

Expectations and Concerns:

You are very optimistic for the potential of this investment, but you realize the challenges that lie ahead. On the positive side, at this point you believe Earth Escape has all the characteristics of an investment home run. Based on your experience and instincts, you think that Earth Escape could become the dominant industry leader for public space travel. You believe the space tourism market is ripe for a growth explosion if a company such as Earth Escape can reduce the cost and safety issues currently restraining the market.

You are most concerned with the risks of the complicated and emergent technology. Earth Escape seems quite confident that its proprietary design will make safety issues a minor point. However, you realize the devastating effect even one non-routine flight resulting in a casualty might have on the company's credibility. Furthermore, you must account for the risk of pioneering a young market, relying on a few key individuals from Earth Escape, responding to new competitors in the future, and dealing with potentially illiquid securities when you hope to exit the deal. Accordingly, you hope to set up the terms of the Earth Escape investment so that you protect yourself from as much risk as possible and generously compensate yourself and your firm in the event that the investment is successful.

Aerovent Capital's Process Interests:

As the first negotiation of substantive terms with the founder, this discussion could set the tone for the rest of your potential relationship. You hope to convince the founder through your actions that Aerovent will strive to act as more of a partner than just as a financial investor. Your process goals are to establish an open flow of communication based on mutual respect and to actively consider the founder's interests throughout the entire negotiation. It is clear that you cannot control all of the founder's perceptions of the process, but you hope to convince the founder that your requested terms are equitable to both parties and that partnering with Aerovent Capital will result in the best possible working relationship with a venture capital firm. It is your hope that you can achieve such process goals while agreeing to an investment structure that is highly lucrative for Aerovent Capital.

In order for this process to succeed, Earth Escape must come out of the negotiation, not just willing to partner with Aerovent, but also trusting you. You know that it is critical to make sure that Earth Escape feels respected and that the process was fair. Further, you need to reassure Earth Escape that you understand the company's interests and that you both share a commitment to working productively together in the future.

Negotiable Terms for the Venture Capitalist

The following confidential information regards the negotiable terms you will discuss with the founder. You may negotiate the terms in any order.

1. VC Equity Percentage

You will receive equity in Earth Escape for your $100 million investment. One of your most basic interests in this negotiation is to receive as great an equity percentage as possible. In your previous meeting with the founder you both agreed that a $100 million investment is the appropriate amount to help Earth Escape reach the next stage of its development, a cash flow positive business running a small fleet of suborbital RLVs. To determine the approximate percentage of equity your investment is worth, you have considered your valuation of Earth Escape. The equity percentage and valuation are related such that the higher the valuation you attach to the company, the smaller the equity percentage you will receive for the fixed $100 million investment.

Determining the value of a company in its early stages can be a subjective analysis. With Aerovent Capital you have found that detailed financial projections of startup companies are of secondary value to experience and recommendations from industry contacts and consultants. By forecasting a range of values for Earth Escape five years from now and discounting them to the present, you think that Earth Escape deserves a post-investment valuation between $150 and $200 million. These valuations suggest that you should receive between 50% and 67% of the company equity for your $100 million investment, but you would be eager to receive even more. You justify the higher equity percentage by considering your desired risk/reward ratio. The unproven management team, uncertain future of the public space travel market, unrefined technology, and potentially illiquid nature of the investment all support your receiving a large portion of the company to offset the high risk factors.

One other significant consideration you should make during the negotiation of your equity percentage is who will have the majority of shareholder control. As a legal matter, though a corporation is run by its board of directors, a majority shareholder has the ability to take control of the company. Thus, if Earth Escape begins to fail, there is an importance difference in the influence Aerovent Capital would have over the company if it owns 51% versus 49% of the equity. You want to make it clear to the founder that you do not intend, nor desire, to control the future of Earth Escape through shareholder influence. However, having a shareholder majority offers you significantly more security in the event that the company begins to fail and Aerovent must take on a more active role.

Therefore, you have a strong incentive to settle on an equity percentage significantly over 50% by establishing a low valuation based on your idea of fair compensation for the substantial risk involved in the venture. If you are unable to achieve this, you will need significant concessions in other areas.

2. Dividends

You may also negotiate the right to receive dividends on your equity share. Potential dividends will not be paid in cash. Rather, they shall accrue until a liquidation event and be paid in equity, commonly referred to as payment in kind. You normally negotiate dividends as a percentage per annum of the original VC owned equity. Your primary interest in agreeing to dividends is to increase your equity share and thus, your upside potential. From your experience, the industry average, when dividends are issued, is 8% per annum. You value receiving dividends rather highly because you realize the substantial increase in your final equity stake a moderate compounding dividend can produce over a number of years. You would like to receive as high a dividend as possible without damaging the relationship.

3. VC Appointed Board Members

Achieving adequate representation on Earth Escape's board of directors is critically important to your investment. Not only does it offer you influence over the company's strategy, but it is one of the principle ways you hope to add value to the company. The board of directors has many responsibilities that effect the future of a company, such as setting strategic goals, reviewing management's performance, approving major financial transactions, etc.

You are negotiating the number of directors that Aerovent Capital may appoint to the board. The board currently consists of three members: the founder and two independent directors selected by the founder. You emphatically want to appoint at least one member to the board, but the more you appoint the more influence you would have over Earth Escape. If the founder is receptive to Aerovent appointing multiple board members, you would like to appoint as many as possible for the benefit of the company and your investment.

4. CEO Replacement Provision

Though the founder is critical to the success of the company, as the company expands you think it would benefit everyone involved if the founder served on the board of directors and Earth Escape hired a professional CEO. The founder has acted as CEO since the company's inception and has done an excellent job to date considering that running an entire company is a markedly new experience for a former R&D manager. However, the CEO is one of the top variables in a company and the attributes that make a CEO successful in an entrepreneurial company can be drastically different from those that make a CEO successful in a mature company. Personally, you would like to bring in a professional CEO immediately to begin implementing the next major stage of growth for Earth Escape. However, your previous discussions made it clear that the founder is adamant about remaining CEO, and you believe the deal will not proceed if you request an immediate replacement.

To protect your investment interests and allow the founder a chance to retain the CEO title, you have suggested the use of performance benchmarks. If an agreed upon annual benchmark is not met, Aerovent Capital will have the right to immediately replace the CEO with no further negotiation. Vesting of the founder's stock would not be affected by a CEO replacement if the founder continued to work for the company as a member of the board of directors, which you sincerely hope would be the result.

For this term you are negotiating the performance benchmarks that will be used to determine if the CEO should be replaced. You have suggested that the benchmarks be the very revenue projections that the founder presented to you in your first meeting. The founder presented three potential scenarios categorized as conservative projections, moderate projections, and aggressive projections. The scenarios detailed annual revenue projections for the next five years.

You are most interested in agreeing to the aggressive projections because the founder will likely not be able to meet them year after year, in which case Aerovent would have the option of replacing the founder as CEO. If the founder is capable of meeting the aggressive projections, so much the better for your investment. The moderate projections would be acceptable, but you are extremely hesitant to accept the conservative projections as benchmarks. If only the conservative projections are met, you will not achieve your required rate of return on the investment.

1. VC Equity Percentage

Aerovent Capital will receive equity in Earth Escape for the $100 million investment. You would like to give as small an equity percentage to the VC as possible. In your previous meeting with the VC, you both agreed that a $100 million investment is the appropriate amount to help Earth Escape reach the next stage of its development. To determine an approximate percentage of the equity the VC deserves you have considered your valuation of Earth Escape. The equity percentage and valuation are related such that the higher the valuation you attach to the company, the smaller the equity percentage the VC deserves for the fixed $100 million investment.

You have used a number of techniques to objectively value Earth Escape. From a variety of detailed revenue projections and comparisons to other aerospace companies, you have concluded that Earth Escape deserves a post-investment valuation between $250 and $300 million. In which case, Aerovent Capital would receive between 33% and 40% of the company for its $100 million investment. Your analysis has shown situations in which the company could be valued even more aggressively. Overall, you think an equity percentage between 33% and 40% more than fairly compensates Aerovent because the firm could easily earn a multiple of ten return on its investment in five years if the company develops as planned. Furthermore, the company has already grown through its most vulnerable stage by developing a launch vehicle that has proven to surpass all industry standards. Now, it is just a matter of implementing the business plan.

Though you may be willing to negotiate a higher VC percentage than 40% in exchange for other terms in your favor, you do not want to give up shareholder control of your company. Earth Escape's bylaws detail that for governance issues requiring a shareholder vote, a simple shareholder majority is required for approval. You have built Earth Escape from the ground up and you strongly oppose giving control to a VC at this point in the company's development. Therefore, you are extremely hesitant to accept any term sheet that gives the VC 50% or more of the company's equity. The lower the VC equity percentage you can negotiate without damaging the future relationship the better.

2. Dividends

You have already established with Aerovent Capital that paying cash dividends while trying to grow an early stage company is unreasonable. However, the option of granting dividends payable in equity (commonly referred to as payment in kind) that accrue until a liquidation event still remains. You think that Aerovent should be satisfied with its basic equity percentage and concentrate more on increasing the value of Earth Escape for all its investors.

Furthermore, overcompensating the VC with equity may misalign incentives with the other stockholders. If Aerovent receives too much of Earth Escape's equity, it will actually be a detriment to Aerovent because the employees and other stock holders of Earth Escape will be overly diluted and their incentives diminished. If you choose to grant dividends, negotiate them as a percentage per annum of the original VC owned equity and aim to keep them as minimal as possible.

3. VC Appointed Board Members

You are negotiating the number of members that Aerovent Capital may appoint to Earth Escape's board of directors. The board currently consists of three members: yourself and two independent directors. When founding the company, you beseeched two aerospace executives you had met during your career to join Earth Escape. They agreed and brought a wealth of diverse, strategic knowledge to the young company.

The board of directors has many responsibilities that affect the future of your company, such as setting strategic goals, reviewing management's performance, approving major financial transactions, etc. You have always intended to keep the board a manageable size and have no interest in dealing with a large, unwieldy board.

Aerovent may not be aware that you would actually prefer Aerovent to have at least some board representation. A single board member appointed by Aerovent would be a great conduit to the firm and broaden the board's perspective. You would even accept two VC appointed members, but you cannot accept the VC appointing three members and controlling half the board. You also recognize that if you receive financing in the future from another VC firm, that firm will also likely expect board representation. Therefore, you have decided that you will not accept any agreement that grants Aerovent more than two board seats.

4. CEO Replacement Provision

Apparently Aerovent has some concern with you retaining your title of CEO. You think this is ridiculous and personally offensive. You have done an excellent job running the company to this point and have held numerous management positions overseeing R&D projects during your corporate career. Indeed, you finally left your last job so you could run your own company, and who better to oversee Earth Escape than the individual that understands the technology and market more intimately than anyone else. You have also pointed out that you are not a serial entrepreneur that will start another company in a few years. This is your one shot at running a company.

During your last meeting with the VC, this issue was definitely a point of conflict. To compromise on the issue, the VC has suggested that you remain CEO of Earth Escape on a conditional basis contingent on the company meeting annual performance benchmarks over the next five years. If an agreed upon annual benchmark is not met, Aerovent Capital will have the right to immediately replace you as CEO with no further negotiation. They have suggested that, in such a case, you could serve on the board of directors and continue to work with the company.

For this term, you are negotiating the annual performance benchmarks that will be used to determine if you are replaced. The VC has suggested that the benchmarks be the very revenue projections that you presented to the firm in your first meeting with them. You presented three potential scenarios categorized as conservative projections, moderate projections, and aggressive projections. The scenarios detailed annual revenue projections for the next five years.

You prefer no CEO replacement provision whatsoever, but the conservative projections as benchmarks might be acceptable. You are uneasy agreeing to even the moderate projections though, because you know all the projections you made were admittedly aggressive. You were advised that venture capitalists love to see impressive numbers that border on unrealistic. Furthermore, a CEO cannot control all the factors that affect a company, and you do not think you should be replaced as CEO if certain market forces or unavoidable delays cause revenue to be slightly below target levels for one year. You see accepting the aggressive projections as basically submitting to resign as CEO because unless everything progresses flawlessly over the next five years, Earth Escape will likely fall short.

Can you help me negotiate a middle ground deal for this prompt?