Private venture investors embrace the notion of swapping liquidity and safety of principal in the pursuit of positive asymmetrical outcomes and the higher risk premium associated with venture capital. In spite of the certainty of uncertain outcomes, the venture investor accepts these risks as the apropos quid pro quo toward achieving high double-digit and triple-digit IRRs on investment.
But venture investors too willingly accept the notion that their investment outcomes will be the result of a binary set of events–characterized either by loss of capital or an attractive multiple on exit as the result of an IPO, sale, merger, or other change-of-control transaction.
These investors can become more effective fiduciaries of their capital by demanding investment terms that broaden the variety of each investment's potential returns. I refer to this as increasing an investment's "optionality" beyond a binary set of boom or bust outcomes.
Among the most frustrating venture investment experience is the non-outcome outcome. In an earlier column we described this sort of venture purgatory as "My Grandkids' Company"–a private company that is successful but there is no exit in sight. (Perhaps your grandchildren's inheritance?) You were prescient enough to back an early-stage venture that is now successful yet all you have to show for it is an annual K-1. This is where investment term sheet mechanisms that enhance the investor's optionality really come in handy.
Demand a Put Option
I have become a strong proponent of requiring that venture investors demand a "put right" (or, put option) as a contingency to committing venture capital to an angel round or early-stage equity financing. A well-conceived put option may impact your grandkid's inheritance.
Typically, a venture investor's exercise of a "put" would require the company to repurchase its equity securities at fair market value. Investor put rights have been around venture transactions for years for the express purpose of providing a way out of an investment with no liquidity event in near site. Because of the terms by which they have generally been structured, however, they have been rarely exercised.
That's because if the company appears to be on the right track, investors are more likely to let their fortunes play out. On the other hand, if the company is not performing to plan, it is not likely to be able to afford to honor the investor's put–rendering the option worthless.
