The Ins and Outs of Venture Capital
Raising venture capital funds is an exciting and often necessary step for your start-up. It’s also fraught with potential pitfalls that could cost you your company. The third article in our venture capital series examines key terms used in investment deals and offers valuable insights into the venture capital business model.
by Helge Seetzen
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.
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.
Anti-Dilution Preferences: 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. (For more about seed rounds and series rounds, see “Raising Capital for Technology Ventures,” Sep./Oct. 2013.) 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
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.
Liquidation Preference: 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
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. (See the sidebar, “Venture Capital Goals and Compensation.) 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
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. (A related issue is that of founding valuation: See the sidebar, “A Common Founding Valuation Misconception.”) 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. •
2If 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.
3If none of these words make any sense to you, I recommend reading Brad Feld’s very good explanation here: http://www.feld.com/wp/archives/2005/03/term-sheet-anti-dilution.html
4Such 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 (see the sidebar on venture capital compensation).
5Acquirers 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.
6In 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.
7I 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.
8If 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: http://www.kauffman.org/research-and-policy/we-have-met-the-enemy-and-he-is-us.aspx