What are some creative ways to incentivize startup teams through deal structuring?

1 Milestone-based financing

Milestone-based financing is a common way to link the funding rounds to the achievement of specific goals by the startup, such as product development, customer acquisition, revenue growth, or profitability. By doing so, the investors can reduce their risk and uncertainty, while the founders can demonstrate their progress and increase their valuation. Milestone-based financing can also motivate the startup team to focus on the most important aspects of their business and avoid distractions or scope creep.

2 Equity vesting and clawbacks

Equity vesting and clawbacks are mechanisms that ensure that the founders and key employees remain committed to the startup and do not leave prematurely or underperform. Equity vesting means that the founders and employees receive their shares gradually over a period of time, usually four years, with a one-year cliff. This means that they have to stay with the startup for at least one year to receive any equity, and then they receive a portion of their equity every month or quarter thereafter. Equity clawbacks mean that the investors can reclaim some or all of the equity from the founders or employees if they breach certain agreements, such as non-compete, non-disclosure, or non-solicitation clauses.

3 Participating preferred stock

Participating preferred stock is a type of equity that gives the investors both a preference and a participation in the exit proceeds of the startup. A preference means that the investors get their money back before the common shareholders, usually with a fixed or variable multiple. A participation means that the investors also get a share of the remaining proceeds after the preference, usually proportional to their ownership. Participating preferred stock can incentivize the startup team to aim for a higher exit valuation, as they will benefit from the upside along with the investors. However, it can also create a misalignment of interests if the investors have a high preference or participation rate, as they will have less incentive to accept a lower exit offer that may still be favorable for the founders.

4 Anti-dilution protection

Anti-dilution protection is a clause that protects the investors from losing their ownership percentage in the startup if the startup raises a subsequent round of funding at a lower valuation than the previous round. This is also known as a down round. Anti-dilution protection can take different forms, such as full ratchet, weighted average, or pay-to-play. Full ratchet means that the investors can convert their shares to the same price as the new investors in the down round, effectively increasing their share count and diluting the founders and other shareholders. Weighted average means that the investors can convert their shares to a price that reflects the average of the old and new prices, depending on the amount of new shares issued. Pay-to-play means that the investors have to participate in the down round to maintain their anti-dilution protection, otherwise they lose it or have their shares converted to common stock. Anti-dilution protection can incentivize the startup team to avoid down rounds and maintain or increase their valuation, as they will face severe dilution and loss of control if they fail to do so.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?