Thus far in this Venture Capital series, we have covered the fundamental three “P’s” of building a technology venture: people, product, and pesos. But the last often comes with a bit more paperwork than the first two. In this article, we will look at common structures for venture capital deals, the motivations of the players involved in venture funding, and some of the pitfalls that could destroy your company (or your stake in it) if you are not careful.
At the highest level, an investment deal is an exchange of ownership for money. The previous article in this series, “Raising Capital for Technology Ventures” in the September/ October 2013 issue, discussed some of the valuation mechanics, but as a reminder, an investment deal sets the amount of capital to be invested and the pre-investment valuation for your company (often called “pre-money”). The sum of the two gives the post-money valuation of the company and effectively the post-money ownership. For example, a pre-money valuation of $4 million with an investment of $2 million means that the new investors will own one-third of the company after closing. Sounds simple, right? If only it weren’t for those pesky terms …
Entire books have been written about investment terms, but we will try to cover at least some of the key ones, as well as some of the tricks used in the inherently asymmetric game of term sheet negotiation.1 To start with, most investments these days are made in exchange for so-called preferred shares. As the name implies, these have some characteristics that make them preferable to common shares, which are generally the type of share capital held by founders, employees, and inventors.2 Those preferences can vary greatly, but we will cover at least some of the more common types:
Straight vs. Convertible
Later-stage venture investments are almost always straight purchases of shares for money. But early on it is often difficult to accurately value a company. Convertible debentures, a form of debt that later converts into shares, are a way to solve this problem by deferring the valuation discussion to the next round of financing. The money invested through the convertible debenture is available to the company immediately, but the investors only receive their shares when the next round closes (usually on the terms of the next round with some discount on the new valuation to reward them for investing early). Convertible debentures also usually have a time limit and convert at some fixed share price, usually low, if the deadline is missed.
Emilie, our intrepid entrepreneur, sets out to build her display company — SuperTech, Inc. She partners with John and Steve on equal terms (300K shares each) and reserves 10% of the company for employees (100K shares). After some initial efforts, they convince an angel investor to provide $300K in seed capital on a convertible debenture with a 25% discount to the next round.
ContributorSharesOwnership Founders & Employees1,000,000 Common100%
Interest and Dividends
Some preferred share deals include a required minimum dividend (e.g., each year the company has to pay out $1 per share to the holders of the preferred shares). For convertible debentures, this usually takes the form of annual interest on the debt instead. In both cases, the amount might have to be paid out or just accrued for conversion into more preferred shares. Unless the amounts are exorbitant, these clauses are generally not a problem — just take the expected cash drain into account when budgeting your operations.
Enter the Venture Capital Investor
Emilie’s convertible debenture carries a 10% annual interest that accrues. As luck, at the author’s wishes, would have it, she raised her second round of financing exactly one year after the convertible debenture at a valuation of $4 per share ($4 million pre-money valuation). The second round with a venture capital investor brings $2 million into the company in exchange for 500K preferred shares ($2 million divided by $4/share). The debenture holders have invested $300K plus $30K in accrued interest and get 25%, so they receive 110K preferred shares ($330K divided by the discounted $3/share).
A variety of preferences deal with anti-dilution. This can take the form of straight share capital adjustments, warrants, or similar mechanisms, but all boil down to keeping the investor whole if the company has misjudged a particular financing valuation. A common scenario is an optimistically priced seed round followed by a series A round that adjusts the valuation of the company back down to market prices. In that scenario, anti-dilution preferences would retroactively give the seed investors more equity at the expense of common shareholders (e.g., founders, employees, etc.). Anti-dilution formulas are usually benign, broad-based, and weighted-average, but some clauses, such as full ratchets, can get nasty.3
The Fine Print Rears Its Head
Over the next 2 years, Emilie’s business hits a few snags. None are fatal, but she probably was a bit too aggressive with her $4 million pre-money valuation of the last round. Either that or Steve just isn’t selling enough! She goes back to her VC investors to see if they might be willing to put in some more money, even at a lower valuation, to keep the company afloat. The investors seem amenable to investing another $1 million at a pre-money valuation of $2 million. This is not an optimal outcome, but Emilie, John, and Steve are willing to accept the loss of another third of their company as the price of keeping it alive.
That’s when their lawyer explains the anti-dilution clause of their original deal. The new valuation is lower than the previously raised amount, causing the full ratchet iterative anti-dilution calculation to converge on a price of $0 per share and thus handing the VC investor 100% of Emilie’s company regardless of how much he actually invests. Game over.
Special Consent Requirements
Preferred shares often come with additional control benefits, such as the ability to force the appointment of seats on the Board of Directors or veto certain business decisions. Within reason, those are benign preferences that serve as an exaggerated minority protection. Note that the biggest control benefit often does not appear explicitly in the term sheet: Most companies have bylaws or shareholder agreements stipulating that each class of shares must vote independently for major decisions in the company such as an acquisition, new financing, or change of business strategy. So even if your new investors own only 10% of your company, but 100% of those 10% are preferred class shares, the investors might very well be able to dictate company decisions simply by holding their share class hostage for all major decisions.
Almost Saved by the Sale
Emilie starts to panic as soon as her lawyer is done with the explanation of anti-dilution. The choices seem horrible: the only way to keep the company alive is to effectively lose her ownership in it. The only option out of this mess seems to be the sale of the business. The team members cut their salaries, tell their families good bye for now, and plunge into the crazy whirlwind of startup acquisitions. After several months, they have an offer from MegaCorp, Inc., to buy SuperTech, Inc., for $5 million. Proudly, Emilie goes to her board and explains the last-minute rescue deal. It turns out that the VCs do not like the deal and instead advocate a re-launch plan with new leadership and new financing (wiping out both Emilie’s job and ownership). Fortunately, Emilie and her fellow founders still have majority control of the company so this cannot happen — right? In fact, accepting the acquisition offer requires a shareholder vote with both the common shareholders (which Emilie wins easily) and the preferred shareholders (in which Emilie and her friends do not get to participate). Motion denied.
Liquidation preferences function like a LIFO buffer — last in, first out — for investor’s cash ahead of all other shareholders during an exit, public offering, or similar liquidity event. A basic 1× liquidation preference is practically the default for all venture financings these days, ensuring that investors get their money back first. Some investors push for higher multipliers or so-called participating liquidation preferences, which can make things rapidly more difficult. The latter ensures that the investors first get their money back at some multiple and then participate in the remaining cash according to their ownership of the company — a structure usually reserved for the desperate or innocent entrepreneur.4
Modest Payout, Major Lessons
In desperation, Emilie turns to the original angel investor, Jenny, and explains all her troubles. Jenny is by far the smallest shareholder of SuperTech, Inc., so legally she doesn’t carry much weight. But she has done a number of deals together with the VC and has a lot of stature in the local investment community. Using that leverage, Jenny is able to work out a deal where the founders cancel 100K shares each, but the MegaCorp deal can go ahead. The final ownership distribution still leaves Emilie with 15% of the company and the team collectively with 53%.
There is, however, that little line about a 2× participating liquidation preference in the investment agreement. After another trip to the lawyers, the situation doesn’t look quite as rosy. The holders of preferred shares have collectively invested $2.3 million, so the first $4.6 million of the MegaCorp purchase price is theirs. The remaining $400K is then split between all shareholders.
The VC has turned its $2 million investment to a bit over $4 million, a solid 108% return. Jenny, our angel, also made the same return on her $300K (though Emilie does not feel so bad about that). When all the dust has settled, Emilie gets a check for 60K (15% of $400K) — not much for 3 years of hard work, but it comes with a lot of lessons learned about life and investment terms! Now, MegaCorp is talking about something called “earn out”.5
As the story of poor Emilie hopefully illustrates, understanding these investment terms is critical. First-time founders would be well advised to have advisors (or co-founders) who have been through the cycle a few times, especially if the amounts involved are dazzling. Of course, venture capitalists are not inherently evil — I am essentially one myself, though my company invests on common shares — but the incentive model and economics of venture investing mean that Emilie’s story is not particularly uncommon. These investment terms of engagement essentially give savvy investors a high degree of downside protection at the expense of other shareholders. Usually, none of this matters if the company consistently grows, but such terms can trigger very dramatic changes to the wealth distribution in the company as soon as key milestones are missed (and usually do not allow for any recovery later on).
So you have raised money, avoided the worst of the financial terms, and even built a nice little venture with growth momentum. Now what? The first thing to remember is that nobody gets rich from receiving shares. The concept of shares is probably the source of the biggest misunderstanding in the entrepreneurial community and the root of countless frustrations in start-up board rooms across the world. Let me repeat this: getting lots of shares will not make you rich. Why is that?
Shares, like all other considerations in a business, are given in exchange for something of comparable value. As a founder, that’s usually your time and possibly your reputation. As an investor, the exchange is more straightforward — for cash. As an inventor, it will be for the value of your contributed intellectual property. And so forth. Any such exchange is highly unlikely to yield significant wealth for anybody involved regardless of when or how you do it. As a founder you will get a lot of shares; as a later-stage employee you will get fewer shares, but ultimately you are still trading beans for carrots at market prices. Even if you somehow manage to trick the other side into giving you a bit more value in the exchange, say, by elevating your reputation or the value of your idea, it is virtually impossible to turn that into significant wealth gain — especially since the monetization of such wealth will ultimately require several other seasoned valuators to buy into your price.6 The inability to understand the exchange nature of equity has led to some odd behaviors — such as companies creating millions of penny shares instead of thousands of dollar shares so that people feel like they “own” more.
Emilie’s example shows that share ownership itself, and the manipulation of valuation, rarely help very much. Few ventures have happy outcomes if they continue to raise money at flat or nearly flat valuations. Instead, each round of financing is an opportunity to generate wealth, even if it will be illiquid for a while. Most successes follow a fairly steady climb of valuation until they finally hit the cash-out jackpot during an initial public offering or acquisition.
So, if not by amassing shares, how does one get rich as an entrepreneur? The key is to increase share value — make those shares worth more after you receive them. Increasing your number of shares tenfold is virtually impossible in a fair exchange, but multiplying their value 10 times can be done. It will require significant growth of your business, careful husbanding of resources, development of innovative products or services, and, above all, a good eye for opportunities that maximize value increase. And therein lies the magic of entrepreneurship.
As a corporate employee, your compensation is largely decoupled from the value of your work product. If you invent the next big thing, you might get a 20% increase during a promotion, but your company will gain millions or billions in value. Not so for the entrepreneur. If you raise money at a $1 million valuation and then use that money to achieve a new valuation of $10 million, you have just created a massive amount of wealth — for yourself and your other shareholders. The next article in this series will discuss ways to monetize your hard-earned equity through exits, licensing, and public offerings.
A Common Founding Valuation Misconception
There is a commonly held but incorrect belief that “founding” somehow creates value. A common example is the lone engineer who leaves his $100K/year employment to start a new venture for which he approaches angels for an investment against a valuation of $1 million. Magically, so the mistaken belief goes, $1 million of free value has been created by declaring the business “founded.” Not so. Assuming that the founder commits to working on the venture for free for a year, the value of the venture is essentially $100K (the approximate fair market value of the engineer’s future contribution). Having spent $500 to incorporate an entity does not make anything more valuable.
This, of course, does not mean that founders should not receive significant rewards in the company, just that “founding” itself does not create value. Assembling a team, inventing concepts, building product, and making sales — these things all create value. If our lone engineer goes out for a year and does all of these things, then his venture might very well be worth $1 million. It could also be worth nothing — the engineer has effectively invested his $100K in fair market value compensation and now rides the same uncapped rollercoaster of valuation from $0 to millions based purely on the value of the venture with no consideration for the amount sunk into getting it to that point.
Apart from making for amusing anecdotes in discussions with first-time entrepreneurs, this has some serious consequences:
(a) Accelerator (or other “pre-activity”) investments are often made at very low effective valuations precisely because the founder contribution is limited to future work at fair market value (e.g., Ycombinator, grandfather of all Accelerators, invests in teams of 2–4 people at an effective valuation of ~$200K, which is very closely comparable to the combined earning power of most of those people during the 3–9 months that they will not be drawing pay).
(b) Founders who leave ventures early really should have reverse vesting mechanism in their share allocation to largely remove them from the capital table of the company (similar to and ideally on the same terms of other employees who leave early). Anything else ascribes a magic power to the “first guys” and will create nothing but morale problems for the remaining people (who then have to work extra hard just to make the quitter rich).
© Major contributors joining during the same “valuation stage” as the founders should get founder-like equity grants (e.g., joining a venture a few weeks after it was “founded” should not magically lower your equity stake by 10× compared to founders of similar function).
Of course, this does not mean that the ownership gap between founders and other employees can’t still be huge. Contributors who join at future valuation stages will, and should, have major reductions in comparable equity. Similarly, people who invest little in the form of lower salary or similar risk contributions generally will not receive much of a stake in the new venture regardless of their time of arrival.
Venture Capital Goals and Compensation
Unlike angels or other direct investors, venture capitalists do not invest their own money. Instead, they are paid to manage the capital of others, their so-called Limited Partners (LPs). Like all human beings, VCs act upon incentives, but those are subtly different from the straightforward goals of direct investors. The latter, including the actual LPs of VC funds, want to invest money and get more money back in return. That’s not entirely the case for their fund-managing VCs, though. Most VCs are paid using the “2 and 20” model, which provides an annual management fee of 2% of the total capital as well as 20% of any carried interest (return on invested capital after return of the principal investment). While this sounds straightforward, it introduces two fundamental alignment conflicts involving the VCs, their LPs, and effectively, the entrepreneur:
(a) Downside Misalignment: The management fee covers the operating cost of the fund, but also generally provides the fund managers with high compensation — regardless of whether the fund performs or not. A traditional $200 million fund running for 10 years will pay out a solid $40 million to the 3–8 fund managers even if the entire $160 million of invested capital goes down the drain.7 This creates what, thanks to the recent Wall Street debacle, we now know as a “moral hazard.”
(b) Upside Misalignment: As bad as the moral hazard of downside protection is, it pales in comparison to the impact of upside misalignment. Even though the fund managers’ participation in the upside by 20% appears to nicely align their success to that of the entrepreneur and LP, it creates a curious disconnect: Imagine two $10 million investment opportunities available to a VC. One is guaranteed to double your money in a year. The other has a 10% chance of yielding $150 million during the same year. From the perspective of any rational investor, including the LPs and entrepreneur, the first option is preferable with an expected exit value of $20 million vs. $15 million for the second. Unfortunately, VC math is different. The first opportunity will yield $2 million for the fund manager (20% × $10 million in gained interest). The second will yield $28 million if it works (20% × $140 million) and $0 if it doesn’t for an expected value of $2.8 million ($2.8 million × 10% probability). In other words, the VC is encouraged to make bad investments by virtue of its compensation structure.
Combined, these two elements of the VC compensation structure encourage VC fund managers to push their companies toward high-risk avenues — often up to and beyond the point of reasonable risk taking for their LPs and entrepreneurs. A viable counter argument might be that a venture capital firm could somehow increase the probability of the big wins occurring so that its LPs and entrepreneurs might still benefit from the skewed compensation model. Unfortunately, that doesn’t seem supported by market observation: for almost 20 years, the VC industry has consistently returned less money to its LPs than much safer asset classes such as blue chip stock indices.8 This by no means implies that taking venture capital is fundamentally wrong for a new venture — in fact, it is often the only viable option — but it is important to understand the biases introduced by venture capital and incorporate those into your strategic planning.
1. Asymmetric because the investor is usually a financial professional who has made dozens if not hundreds of investments, whereas the entrepreneur is usually a technologist or business builder raising money for the first or second time in her life.
2. If your investor is the rare kind that still takes common shares then you can pretty much ignore the rest of this section and count your blessings.
3. If none of these words make any sense to you, I recommend reading Brad Feld’s very good explanation here.
4. Such a participating liquidation preference with a multiple is often used as a mechanism to force entrepreneurs to pursue high-risk strategies even against their economic interest
5. Acquirers often add requirements to a deal that key contributors, like Emilie, have to remain on-staff for 2–4 years to actually get their payout. This is frequently done by locking up their payout or converting it into vesting options of the acquirer. Emilie’s troubles might not be over yet.
6. In other words, even if you manage to convince an innocent angel investor that you invented the LCD in 2013 and thus your company should be worth $100 million, it is unlikely that any acquirer will ever actually pay that $100 million in the future — thus leaving you with the satisfaction of having tricked the angel but not much else.
7. I will ignore more advanced elements of VC compensation such as the distinction between committed and invested capital, hurdle adjustments, stacking of parallel funds, and so forth — these structures are complicated enough as it is.
8. If you are curious about this situation, I recommend reading the Kauffmann Foundation study titled “We Have Met the Enemy … And He is Us,” released in 2012, which describes the authors’ last 20 years as a major LP and concludes with the observation that the abysmal returns are a direct consequence of the alignment problems outlined in this sidebar.