"What are the terms?

"What Are the Terms? Part One: A Preferred Return"
by Joe Hadzima (This article originally appeared in the "Starting Up" column of the Boston Business Journal.) Several entrepreneurs and privateinvestors have asked me to do a Starting Up co lumn on "non-price" investment terms. Many entrepreneurs I know have gone into at least a mild panic when they see the typical five-page termsheet. Theyhave become somewhat paranoid and have started envisioning thousands of hidden traps in all of the financial and legal verbiage. They usually re-enter a form of reality after I explain what the termsmean and what the investor is trying to accomplish. I like to group the terms of a typical professional venture capital termsheet into four broad categories rather than tackle the terms one by one.Entrepreneurs have told me that this categorization has helped them see the big picture as they try to fathom the complexities of the deal. These categories are: (1) A Preferred Return; (2) Protection ofValuation and Position, re: Future Money; (3) Management of the Investment; and (4) Exit Strategies. A Preferred Return. Investors usually feel that their payment of cash is more "tangible" than theentrepreneur's promises of greatness. As a result, rightly or wrongly, investors, especially venture capital investors, want their return to come before that of the entrepreneur. Although there arevariations among venture fund groups based on tax and institutional issues, the typical investment instrument is convertible preferred stock. Dividends. The holder of a preferred stock is entitled toreceive dividends before dividends are paid on the common stock. This might not seem to be an issue with a high-growth, nondividend- paying entrepreneurial company. However, dividends do come into play ifthey are cumulative. In many preferred stock instruments, if the company can't or doesn't pay a dividend then the amount of the stated dividend accumulates and has to be paid in full before...