I am going to try to address a complex problem in a concise way.
Here is the big problem with investors – they dilute the founders’ ownership in the company. Is this actually a big problem? Well, that answer depends on your point of view.
Let’s cover some basics:
- It is impossible to issue stock to investors without existing shareholders (founders, employees and prior investors) being diluted.
- It is impossible to do a stock for stock business combination without existing shareholders being diluted. But now the diluted shareholders own a smaller piece of a larger pie hopefully.
- If you have issues with dilution then raising outside investment will give you heartburn every time. That is not a good situation to endure.
Given the basics, here is one key subjective data point that I always like to keep in mind: what exit value is going to make the founders happy?. The answer to this question is a function of (i) how much of the company do the founders own at time of exit and (ii) the exit value. For example, a company may sell for a relatively small amount, say $18 million. Are the founders happy? Well, if they own 50% of it they well might be. Typically, 50% ownership would mean that the company only has raised 1 or, at best, 2 rounds of equity funding. Alternatively, if the founders own only 15% then they might not be too happy with an $18 million exit. But they might be really happy with a $100 million exit.
Here is another basic truth: the more a company raises, particularly in tough times when projections are not being met, for example, the greater the likelihood of real tension between the investors and the founders. As investment dollars increase, founders ownership decreases. And if dollars are raised in challenging times then valuation and other terms will favor the investors compounding the tension. VCs deal with this situation most of the time. The “up and to the right” valuation scenario is not at all common (unfortunately!) or only comes after millions and millions of investment.
It is up to the investors and founders to acknowledge the tension, discuss it and come up with solutions that dissipate it. Often times, investors face situations where they must support a company that is going through growing pains. These are tough times for the investors and founders. It is up to the founders and investors to make sure that the founders stay motivated. But it is up to the founders to acknowledge the situation the company might be in, particularly if sub-optimal. There are ways to keep management teams motivated – additional stock option grants and management carve out plans are probably the 2 most common. But the investors and founders need to have direct face to face open and trustworthy discussion.
The motivations of founders and investors are highly predictable and usually aligned (maximize company value!), which should make the discussion easier. Luckily, the motivations are not political – I have been watching House of Cards recently…….
I have written quite a few posts on the topic of Boards of Directors. Just put in “board of directors” into the search bar. As a quick review, it is the Board of Directors or “Board” that literally by law makes all critical decisions for the company. The Board has to vote on issuing stock, approving the annual budget, setting the company’s strategy, changing the company’s by-laws and certificate of incorporation, selling the company, merging with another company, hiring officers like the CEO, shutting the company down, etc. The list goes on and on. Good corporate governance is critical at startups and other companies alike!
The importance of the Board is why institutional investors (like VCs) often get a seat on the Board after an investment. The Board discusses and agrees on strategy. Discussion is critical. But don’t be fooled, there is an element of control as investors want a say in critical decisions. This is pretty natural if you think about. VCs typically do not want to control the board vote, they just want a seat at the decision table.
When CVF invests we often take a board seat (probably 95% of the time) and when we don’t we take an observer seat (5% of the time). If the board is already large and we are coming into the company later in its stage of growth, then an observer seat might be fine.
One situation is really scary though. Sometimes at the seed stage, the company founder insists that he/she be the only board member and that once more financing is raised that the board composition will be normalized (code word for “adding more members”). From my perspective, this is typically a sign of paranoia.
I have now done 2 deals where there has been a lead investor (not CVF) who did not mind the “founder as sole board member” trap. We followed in line with the lead investor and went along with the structure. This was a HUGE mistake that I will never make again. Both companies have since failed for different reasons: one had no product market fit after 3 years of trying. And one gave up prematurely. Regardless, had there been an actual board of directors with 2 or 3 members I am pretty confident that the end result would have been better.
Once in a while I get the question “What do I need to know about investing in a startup?” The context is typically where Friend A has asked Friend B to invest in Friend A’s startup business. Then Friend B asks me the question. This happens multiple times a year.
It is a fair question. And one that is hard to answer definitively. But, here are some basic things that I would recommend to Friend B to start with:
- How much is Friend A looking to raise in total? Let’s pretend the target raise is $750,000.
- Is there a minimum amount needed to “close” the round of financing. This is a critical question. If Friend B wants to invest $25,000, then there better be some larger minimum amount going into to the company at the first closing. If Friend A took $25,000 from Friend B and nothing else, then Friend B has most likely just flushed $$ down the toilet. The company will be out of business as soon as the $25,000 is spent. So, in this made up scenario, Friend B should insist on a minimum closing amount that gives Friend A’s company at least 6 months (and ideally longer) of runway.
- Can Friend A produce a projection model? Does the projection model make sense? Does the projection model actually show how the funds being raised will be spent (in other words an understandable “use of proceeds”)? We all know that startup projections are essentially best guesses, but the model needs to tell a realistic narrative.
- Why type of legal entity does Friend A have set up? Typically will be either a corporation or LLC. BTW, I have a strong bias towards corporations when it comes to startups raising $$.
- What type of security is being sold? Typically will either be convertible debt or preferred stock (Series Seed or Series A). And does Friend B understand the terms of the security and the deal?
- Does Friend B know much about Friend A’s business and does Friend B truly trust Friend A?
- Finally, is Friend B ready to lose $25,000? Key question!
This is literally the tip of the iceberg. Please add your thoughts in the comments. Thanks.
First Round Capital just released its State of Startups 2016. It is chock full of interesting stuff! No need for me to recap it here. Just view it for yourself. Here is the link. Thanks!
PS: 2 prominent team members at First Round Capital are Cornellians (Bill Trenchard and Howard Morgan)!
Vanity Fair recently published a expose on Theranos. It is worth reading. Like a mini “page turner” novel.
It reminded me of one of my personal themes in investing: “if you don’t understand the technology then don’t invest.” The understanding can definitely be acquired. In fact, I rarely understand the technology when we first meet with a company. But over our months of due diligence the understanding grows. And sometimes my partners’ understanding is a good proxy. BTW, understanding does not mean being an expert.
So, how about these words that Vanity Fair wrote about Elizabeth Holmes, the CEO of Theranos: “She took the money on the condition that she would not divulge to investors how her technology actually worked, and that she had final say and control over every aspect of her company.” All I can say is OMG. Are you kidding me? Who would invest into a black hole and control freak? Not sure what else to say. Granted that this is all hearsay. I have no proof that this is what actually happened. All I will say is that if you get whiffs of this type of attitude you should run the other way. And now that I think about it more, we actually did get caught in a similar situation once, but by no means as blatant. It is not working out well!!
The Vanity Fair article also offered up an interesting synopsis of venture capital:
“It generally works like this: the venture capitalists (who are mostly white men) don’t really know what they’re doing with any certainty—it’s impossible, after all, to truly predict the next big thing—so they bet a little bit on every company that they can with the hope that one of them hits it big. The entrepreneurs (also mostly white men) often work on a lot of meaningless stuff, like using code to deliver frozen yogurt more expeditiously or apps that let you say “Yo!” (and only “Yo!”) to your friends. The entrepreneurs generally glorify their efforts by saying that their innovation could change the world, which tends to appease the venture capitalists, because they can also pretend they’re not there only to make money. And this also helps seduce the tech press (also largely comprised of white men), which is often ready to play a game of access in exchange for a few more page views of their story about the company that is trying to change the world by getting frozen yogurt to customers more expeditiously. The financial rewards speak for themselves. Silicon Valley, which is 50 square miles, has created more wealth than any place in human history. In the end, it isn’t in anyone’s interest to call bullshit.”
My reaction that synopsis, which definitely made me chuckle:
- The white men comments are true. Change is happening at a slow pace.
- Good VCs typically do know what they are doing, but some are so full of themselves that they come across as very pompous. But most VCs I deal with are good people with lots of brain power.
- Most companies I see are not working on meaningless stuff. But we focus on upstate NY!!
- There is nothing wrong with a “Change the World” CEO as long as they are realistic and focus on building a big company that will make money.
- VC is definitely about making money.
- It is in EVERYONE’S interest to call bullshit. Please do just that all the time!