Is the Reward Worth the Risk and Effort? Realign the Incentive Structure

Investors invest in a venture when the venture is investor ready, and then grow the venture to a point where it is acquisition ready, at which time the investors may exit. An entrepreneur with a creative deal structure that minimizes the risk of investment loss and maximizes the investor’s rate of return has a greater chance of getting funded. Investors, when structuring an investment in a new venture, consider whether the investment structure protects the investor in adverse performance conditions, whether the structure provides sufficient incentives to motivate the entrepreneur, and whether the structure enhances the likelihood of investment l iquidity. The investment loss can be minimized using stage financing, anti-dilution protection, liquidation preference, protective provisions, and board representation. Investors ensure a minimum rate of return by using priority-claim securities such as convertible notes and preferred stocks, securing a minimum percentage of equity in the venture, and structuring the investment return using priority payments such as dividends, interests, and royalties. Incentive mechanisms to motivate the entrepreneur and management and align their economic interests with those of the investors, include stock option plans, share buyback rights, time and performance vesting, and the threat of the investor’s ability to replace the management team.