Once upon a time, one founder got things badly wrong…
By Heidi Roizen (Operating Partner, DFJ)
This post originally appeared on Heidi’s blog.
This is a grim fairy tale about a mythical company and its mythical founder. While I concocted this story, I did so by drawing upon my sixteen years of experience as a venture capitalist, plus the fourteen years I spent before that as an entrepreneur. I’m going to use some pretty simple math and some pretty basic terms to create a really awful situation in the hopes that entrepreneurs reading this might avoid doing the same in the real world.
As I’ve seen over many years and many deals, in all but the most glorious outcomes, terms will matter way more than valuations, and way more than whatever your cap table says. And yet entrepreneurs – often with the encouragement of their stakeholders – optimize for the wrong things when they negotiate their financings.
This is my attempt to paint you a picture of why this is such a bad idea. The situation I present is fake, but the outcome is remarkably similar to those I’ve witnessed. Don’t let this happen to you.
A Grim(m) Tale
Let’s start with our entrepreneur, whom we’ll call Richard. He’s founded a breakthrough company. Let’s call it Pied Piper.
Richard attracts Peter, a newly-wealthy budding angel investor, who agrees to put in $1 million as a note with a $5 million cap and a 20% discount.
With his $1 million, Richard builds a small team of people, rents an Eichler in Palo Alto, and gets to work. Once he is able to demonstrate his product, he heads to Sand Hill Road. He’s in a hot space in a hot market. He nails his pitch, and the term sheets roll in.
Because Richard is extremely sensitive to dilution (after all, he’s seen The Social Network) he wants the highest valuation possible. (Early in my career, another venture capitalist called valuation ‘the grade at the top of the paper’ – and I’ve never forgotten that.) The highest valuation, $40 million pre-money, comes from an emerging venture fund, let’s call them BreakThroughVest (BTV). BTV is excited about this deal, but has ‘ownership requirements’ of at least 20%, so they insist that to support that valuation they need to invest $10 million. Plus, they want a senior liquidity preference of 1x to protect their downside since they feel the valuation is rich given the stage of the company.
Richard is thrilled with the valuation and the fresh capital for only 20% dilution. The prior investor, Peter, is stoked that he is getting his $1 million investment converted into roughly 20% of this super hot company, and now with the validation of an external term sheet he can mark his position up to $10 million, a 10X! This helps Peter validate his position as a savvy angel and solidify his syndicate following on AngelList.
Term sheet signed. Champagne popped. A few weeks later, funds wired.
With the $10 million, Richard rents space in SoMa on a seven-year lease, hires lots more people, and within a few months he is able to roll out the minimally viable product to test the market. Awash in the buzz of his fundraise, a feature in Re/code, and some early user traction, Pied Piper is perceived as the emerging leader in a nascent, winner-take-all market. While they are not yet monetizing their users, the adoption metrics are off the charts.
Pied Piper attracts the attention of a tech giant we’ll just call Hooli. Hooli’s consumer group wants access to Pied Piper’s data. With Hooli dollars behind Pied Piper, Pied Piper could inundate the market with consumer facing advertising to build their user base and upend competitors given the massive network effect of the product. Hooli approaches Richard with the idea of a large strategic round.
In the deal, Hooli would invest $200 million for equity while in return the two companies would enter into a business development agreement on the side in which Pied Piper guarantees to spend that money in a massive consumer campaign on Hooli’s ad platform. They float the magic “B” valuation. Richard goes to sleep dreaming of rainbows and unicorns.
Richard fantasizes about being named a member of the Unicorn Club by the press. His employees calculate the huge paper gains on their options – they will all be instant millionaires – and since no one is more than ¼ vested, they are all highly motivated to stay in spite of long, long work hours. BTV is thrilled with the 20x markup on Pied Piper, since they are about to hit their LPs up for a new fund.
The original investor, Peter, has achieved legendary status – his $1 million has turned into approximately $200 million on paper. He’s on the YC VIP sneak preview list, he’s been offered a spot on Shark Tank, and Ashton just called to try to get into his next deal.
Of course, that $200 million for 20% stake also comes in with a senior 1x liquidation preference in order for Hooli to create sufficient downside protection and thereby justify the $1 billion valuation to their board.
Richard, Peter and BTV all agree it is worth doing. With $200 million to spend on the most massive consumer-facing ad campaign in this sector’s history, the $1 billion valuation will seem low in retrospect.
Except, it doesn’t end up happening that way.
Plot Twist
The ads start running, but the conversion rate is low. Pied Piper shows Hooli the atrocious metrics and demands out of the advertising commitment, but Hooli won’t budge: Performance metrics were not pre-negotiated, and furthermore the ad group that recommended the investment did so in part to prop up their revenues with Pied Piper’s money ‘round-tripping’ into their coffers. The ad group is counting on that money to hit their annual numbers.
Pied Piper is forced to run the whole campaign, blowing through all $200 million. The good news: They increased their user base by 10x. The bad news: The resulting business model those users end up actually supporting equates to more of a ‘market valuation’ of $200 million. In more bad news, turns out Richard incorrectly estimated the cost of supporting those users, most of whom are taking advantage of the ‘free’ part of a freemium model. Support costs skyrocket.
Word about the poor conversion leaks out. The advertising stops when the money runs out. Growth slows to a trickle when the advertising stops. New investors sniff around, but with the preference overhang of $211 million, they are concerned about employees being buried under that structure and therefore being unmotivated to continue. They ask prior investors to recap, but the investors don’t want to give up their preferences: Pied Piper is now looking like it might be worth far less than the paper valuation, which means those preferences are very valuable as downside protection. Furthermore, BTV is out raising their fund, and the last thing they want to do is write down their 10x markup on the Pied Piper investment.
The board is now super unhappy about the massive miscalculation of support costs, awful user conversion, gargantuan ad overspend, the lack of growth the company is experiencing, and the departure of a few key employees who’ve seen this movie before and have done the ‘overhang math’. Richard as CEO is out of his element – the problems are huge and the company needs more money, which he is incapable of raising given his lack of experience navigating waters like these. Unfortunately, it is the CEO’s job to fix problems and raise money, and if he can’t do it, someone else has to. So the board (which now controls the company with 60% of the stock) votes to remove Richard as CEO.
They recruit an interim CEO (let’s call him George) to quickly take the helm. George says he’ll take the job on two conditions: One, that they create a 5% carve-out for him and the go-forward employees (he’s done the overhang math too) and two, that they extend the runway so he has time to either turn this thing around – or sell it.
The company is not profitable and the current investors are tapped out. “Let’s extend the runway using debt,” says BTV. Maybe things will improve with time – or at least perhaps they can get their fund closed before they have to take the write down.
They lean on their good friends at PierLast Venture Bank who cough up $15 million in debt, with a senior preference and a 2x guarantee. Onerous terms to be sure, but hard to get debt with a balance sheet like this. Unfortunately, Pied Piper is burning $2 million a month on office space, cloud services, customer support and expensive employees who are needed to build the next generation of the product.
Without support they’d have to shut down existing customers and revenue, yet without development of the new release that they hope will save the company, they will have nothing to sell. Since they can’t cut their way to glory, they have to simply hope they can grow into their valuation.
Time ticks by while the company plods forward with very slow growth. Market pressures force them to lower prices, pushing profitability off. A few key developers leave. Once again, they are facing the prospect of running out of money in 90 days. Current investors are worried. Not only do they not have funds to put into the deal, but once payroll is missed they could be personally liable for the damage. Not good.
Luckily, WhiteKnight, a public company with a complementary product and plenty of cash, offers to buy Pied Piper. The offer is $250 million. It’s not a billion – but it’s still a big, impressive number. It’s not that easy to create a company worth a quarter billion real dollars to someone else. That’s huge!
The venture debt provider PierLast is very nervous about Pied Piper’s balance sheet and looks to the VCs to either guarantee the loan or get the sale done. They want their $30 million. Hooli is likewise pushing to sell, after all they are guaranteed the first $200 million of any proceeds, after repayment of 2x debt to PierLast, while the company would have to be worth over a billion for them to see any further upside given that they only own 20%. Their calculus is that this is about as unlikely as seeing a real unicorn given the state of the company.
BTV, who no longer has any capital left to invest from their original fund, has recently closed their shiny new $300 million fund, so they decide it is time to take their chips off the table. They vote to sell too, getting their $10 million back. Peter, while sad about the outcome, has developed a huge syndication following on AngelList and has recently benefitted from an early acquisition that netted him $3 million on a $250k investment. Can’t win them all, but he’s at peace.
Even Richard votes yes to the sale: He still has a board seat but given the company’s lack of profitability and lack of any other sources of capital, turning down this deal would mean insolvency, missed payroll – and personal liability. George (the interim CEO) and the key go-forward employees demand their $12.5 million carve-out. Tack on more money for lawyers and ibankers, and…
Oh wait, that’s more than $250 million. Oops.
Ergo, Richard ends up with nothing.
So what can we learn from Richard’s grim fairy tale?
Terms Matter
Liquidation preferences, participation, ratchets – even the very term preferred shares (they are called ‘preferred’ for a reason) are things every entrepreneur needs to understand. Most terms are there because venture capitalists have created them, and they have created them because over time they have learned that terms are valuable ways to recover capital in downside outcomes and improve their share of the returns in moderate outcomes – which more than half the deals they do in normal markets will turn out to be.
There is nothing inherently evil about terms, they are a negotiation and part of standard procedure for high risk investing. But, for you the entrepreneur to be surprised after the fact about what the terms entitle the venture firm to is just bad business – on your part.
Cap Tables Don’t Tell the Real Story
For any private company with different classes of stock, the capitalization table is not-at-all the full picture of who gets what in an outcome.
In the above example, each of the three investors held 20% of the stock and Richard and crew held 40%, yet the outcome was vastly different because of those aforementioned pesky terms and preferences.
Before you close on any round, you should create a waterfall spreadsheet that shows what you and each other stakeholder would get in a range of exits – low, medium and high. What you will generally find is that, in high, everyone is happy. In low, no one is happy, and in medium (which is where most deals settle) you can either be penniless or “life-changingly” compensated, depending on how much money you raised and what terms you agreed to. It is simply foolish to sell part of the company you founded without understanding this fully.
This is why it is so crazy to me that many entrepreneurs today are focused on valuation – the grade at the top of the paper. They are willingly trading terms for a high number. Before you do so, run the math on the range of outcomes over multiple term and valuation scenarios, so you fully understand the tradeoffs you are making.
Venture Capital is not Free Money. It’s Debt. And Then Some.
People mistakenly think of an equity investment as ‘only’ equity dilution. After all, if you lose everything, your venture investor can’t come after you for your house like a bank lender could. However, most all venture transactions are done for preferred shares with a liquidation preference, which means all that venture money is guaranteed to be paid back first out of any proceeds before you get to make a dime.
The more money you raise, the higher that ‘overhang’ becomes. And interestingly, the higher the valuation, the higher the delta of value you need to create before the investor would rather hold on to the end instead of getting his or her money back (or a multiple thereof, as some terms dictate) in a premature sale if things are looking iffy. And what company doesn’t go through iffy times?
Stacked Preferences can Create Massive Problems Down the Line
This one is a hard to articulate in a blog post. Plus, I am a venture capitalist who on occasion puts said senior preferences in my term sheet. They exist for a reason – again often to do with the valuation and the risk/reward tradeoff the investor needs to make using the downside protection of a senior preference against the minimization of dilution the entrepreneur wants to achieve with a sky high valuation. They are not inherently bad.
But regardless of why they are there, the more diversity of value and terms in each round, the more you will create a situation where your investors (who are almost always also your voting board members) will have very different return profiles on the same offer. In the above example (and again I apologize for simplified math but it is directionally accurate) Hooli is getting their $200 million back on a $250 million acquisition. They own only 20% because of the high valuation they paid. So for them to instead double their return, the company would have to go public for $2 billion! This is a case of the bird in the hand being worth more than the two in the very distant bush.
Investors are Portfolio Managers: You are Not
You are betting usually 10 years of your life and all your available assets on your startup. Your investor is likely investing out of a fund where he or she will have 20-30 other positions. So in the simplest of terms, the outcome matters more to you than it does to them. As I noted above, when you have stacked preferences, each person at the table may be facing a vastly different outcome. But now layer onto that their fund or partner dynamics. Ever heard the expression, “lose the battle but win the war?” I’ve seen behavior that would seem crazy, until one considers what is going on in the background.
For example in the above, BTV is out raising a fund and depends on that 10X markup to validate their abilities as investors. Facing a write down, a fire sale – or an extension of runway using debt (and not incurring any accounting change) – which one do you think least impacts the most important thing they are doing right now? For our angel Peter, whose star has risen with this legendary markup, what value is there to him of taking a $1 million loss right now instead of just leaving a walking dead company out there and on his books (although this company is not technically walking dead because, since it is not profitable, it is not walking. But I digress.)
Most reputable investors do not engage in this sort of optics, and many of us who have been through the dot com bust are actually rather aggressive with our write downs to accurately reflect a sense of true value in our portfolios. Also, most investors who are also board members wear multiple hats and take their fiduciary responsibilities very seriously – I know I do. But, I bring up these behaviors because I’ve witnessed them more than once out there in the real world. As an entrepreneur, you should at least think through the motivations of others, both when you are structuring investments as well as when you are considering a sale. They will on occasion matter… a lot.
What to Do
Now that I’ve scared you, let me reiterate that most investors I deal with are great, ethical people. If I didn’t think of venture capital money as good for entrepreneurs on the whole, I wouldn’t be a venture capitalist. But we VCs do a lot more deals than you entrepreneurs do, and you need to go into them with your eyes open to the downside consequences of the terms you agree to.
Here’s what I recommend:
Focus on terms, not just valuation: Understand how they work. Read this book. Use a lawyer that does tech venture financings for a living, not your uncle who is a divorce attorney, so you are getting the best advice. Don’t completely delegate this because you need to understand it yourself.
Build a waterfall: Once you understand the terms being offered, build a waterfall spreadsheet so you can see exactly how each stakeholder will fare across the range of potential exit values (yes by stakeholder, not by class of stock: Investors often end up owning multiple classes, and likewise different people in the same class may have very different circumstances that will influence their behavior even in the same outcome.)
Don’t do bad business deals just to get investment capital: I know, duh, right? But I’ve seen otherwise brilliant entrepreneurs get entranced by these big number deals with big corporates, only to deeply regret them later when they cannot be unwound. My advice, separate the business development contract from the equity contract. Negotiate them individually. If the business development deal would not stand on its own merits, don’t do it.
Understand the motivations of others: This can be quite tricky, but I believe you should at least think through what might be the motivation of the others around the table. Is that junior partner going to get passed over for promotion if he writes down this deal? Is that other firm fundraising right now? If you don’t know, ask. I always aim to be transparent with the entrepreneurs I work with about what my and DFJ’s goals and constraints are, independent of my role as a director.
And finally…
Understand your own motivation: What are you doing this for? So you can see your face on the cover of Forbes? So you can have thousands of employees working for you? So you can be a member of the billion dollar Unicorn Club? Perhaps it is to do something you are personally excited about and in a reasonable amount of time, maybe take enough money off the table to live in a nice home, pay for your kid’s college and your retirement. I’m not saying one is more correct than the other, I’m just saying that your own goals will dictate whether you should even raise venture at all, how much to raise, and what to spend it on. If you raise $5 million and sell your company for $30 million, it will likely be a life-changing return for you. If you raise $30 million and then sell your company for $30 million, you’ll end up like Richard.
Photo credit: Marben Zu via Shutterstock.
