Been there, done it. I took investors into my company and awarded them with extensive rights without much thinking about it. I trusted their talk about how they had the same interest with me, how they would never block anything, and how it all was a pure formality. Bullshit. Quid pro quo. High valuations mean high risks and more extensive veto rights.
I’ll tell you a couple of stories.
Story 1. Mall.cz. A major global financial crisis occurred in 2008, and moreover, we screwed SAP implementation. The investors said, “Do not expect any more funding from us. You’re on your own.” Well, we would have expected our partners to stay with us in good and bad … but at least, they would not torpedo our efforts to save the business. Us, founders, had to once again bet everything on the company, we pledged our houses … and saved the company. It grew again, yet we still needed more cash. One of our investors was willing to support us again. The second investor, however, said that not only he would not invest any more money (he lost his biggest LP due to the crisis), but that his stake shall not be diluted should anyone else invest! “We have a veto right to any funding, so unless you guys keep our stake at where it is now, we will not give you our consent.” That was obviously unacceptable for our lead investor who said they would rather let us go bankrupt than succumb to such a blackmail.
Story 2. A global startup success story, a company most of you know. At the beginning, they took money from an investor who got a blocking right to everything. Moreover, he always had ill manners. In the board discussions, he would attack the founder with open vulgarisms. There were several exit talks of the company to big multi-billion players. And now imagine a stakeholder who says to the prospective buyers: “Boys, I have the rights to block it all, so you shall give me more money than to the founders, otherwise go home.” No kidding. As a result, no exit discussions ever progressed.
Veto rights are a standard part of most investment contracts. The investor gets the right to veto any important decisions, for example any other funding, M&A, but often also ordinary business decisions such as senior hires and their compensation packages. On the one hand, no problem with that, he has more experience, so can help avoid fatal errors. But there is also the flip-side. To understand the risks, it helps to know, how an ordinary investment manager job actually looks like. In the vast majority of cases such a wealthy-looking guy is not an entrepreneur like you. He often is just a corporate soldier. A person who works for his salary, and, similarly as in a corporation, his main interest is not to make bold decisions, but not to make mistakes. He fears to be fired. And what is the best strategy to not make mistakes? To assume no responsibility, to decide nothing. So, it is quite common for an entrepreneur to send a so-called “consent letter” to hire a super-employee with whom he felt in love. (By the way, just the constant stress to exactly fulfill all your obligations of the hundred-page investment contract … but that’s elaborated on elsewhere). And after a few iterations, a month went by and although the investor (or his legal department) finally releases the written consent, the love is lost and the guy is already employed somewhere else. Or, you arrange to acquire your competitor, agree on everything, pay due diligence process, prepare contracts, etc., the investor will “support you” all the time (“Great idea, we shall formally approve it after everything is ready”), yet when there’s the time, he doesn’t have the balls and you will not get the approval. True story.
One does not read these things in the PR texts about successful investments and it’s easy to listen to the Sirens. They always sing beautifully, wearing golden robes and waving big valuations. However, it is extremely important for you to have investors on your side, your blood, your values, same motivations. They shall be with you in good and bad and have the balls to make courageous decisions. Veto rights in the contract and their potential unscrupulous enforcement are far more important for the future of your company than if the investor has 12% or 18% stake in your company.
Disclaimer: Of course, not all investors are alike. Many are not corporate soldiers, many can assume risks and have genuine interest to help you. And also it would be naive to think someone would bet on you big bucks without any veto rights. The point of this article is, that founders tend to be blindfolded with the valuation… whilst there are much more important things to look for.
Founders often focus their company presentations on product and detailed elaborations on why is their product superior to that of their competitors. However it is not so important to have the best product on the market, what is critical, is the ability to persuade the market to buy it. Sometimes the market falls for the best product, but that’s almost an exception. Otherwise we would not use Microsoft Windows, successor of MS DOS, which was far from being the best product on the market. And McDonald’s products are also far from any culinary experience.
It is therefore quite surprising, that only a small number of company founders can clearly articulate, how they plan to launch their product on the market and sell a reasonable volume of it. Everyone knows that business is – like it or hate it – about making money, and it is not a beauty contest. So the plan must not be focused on how to make the best product, but how to persuade enough customers to spend money on it, and by doing that, how to secure sufficient funding for the company operations (so called “business model”). The model must not be immediately profitable, because short term the funding can be provided by investors, but even they will want a return on their investment eventually and business, that is not sustainable, will hardly find a buyer.
Long ago even door-to-door groceries were profitable. But a lot changed and labor costs are now the most expensive technology of ’em all. 25 years ago the average salary of a coder was $2,000 per month and a big disk storage costed $8,000. Nowadays it is exactly the opposite. The market has divided into B2C, where each product must be sold with minimum portion of labor costs, and B2B, where it still can pay to send a sales person to a client. And even in B2B the lower limit of a contract goes up. A $100,000 contract is no longer attractive if is negotiated over three iterations with complete technical team in Kuala Lumpur. So even B2B delivery is shifting to B2C automated model. Specifically how to get the product on the market with reasonable costs and reasonable margins, is the go-to-market Strategy. It is much more important, than having a product with a few more features over your competitors. It is an art … and even the best product on the market will fail, if the go-to-market strategy is wrong.
Valuation. The magic word supposedly related to the current price tag of a company. Is it so, though?
I remember it as it was yesterday. In 2007, in my own startup, we received a Term Sheet with stellar valuation. It was so high, that we were blindfolded for the other “legal language”, such as … liquidation preference. “That’s not important, we’re not gonna liquidate our company and even if it does go down the tubes, two times zero is zero anyway,” I recall us thinking.
Liquidation preference is, however, related to any “liquidation event”, which – surprise, surprise – includes exit of the business as well. Then those stakeholders with higher liquidation preference are higher in so called “liquidation waterfall” and are entitled to get not just what their then-current shareholding is, but what their liquidation preference says. Only after they are fully satisfied, remaining proceeds are distributed to others.
Not long ago I’ve seen a startup signing a Term Sheet with $5 investment at a whopping $50m post money valuation. Competitive bids came at around $30m. The catch was, that there was “participating 3x liquidation preference” fine print in the seemingly better Term Sheet. The “participating” word is even another slyness. It means that after such investor gets his 3x investment, he still participates on the pro-rata distribution. With the more usual and fair “non-participating”, the investor can choose to get either liquidation preference, or pro-rata distribution. So, in practical terms, what can happen:
The company gets sold at $100m: Investor gets his 3×5=$15m a then 10% of $85m, i.e. total of $23,5m (23.5%) for his 10% stake. Compared to the investor, who’d invest at $30m without these “features” (who’d get 5/30*100=$16.7m), he receives 40% more, although his stake was 66% smaller (!). And now imagine things do not go so well and the company gets only sold at $15m: The 10% investor gets everything and founders get nothing.
Do you still consider the valuation as the most important part of a term sheet?
In the coming weeks we will elaborate on other twists relating to high valuations. Have you heard of full-ratchet anti-dillution protection? Or the lock up your company would face if things do not go so well and you would need to raise a downround? Or consequences of different conversion times of convertible notes? We’ve been there and learned the hard way. We are aware that we won’t be liked by other investors, as we are uncovering their dirty practices. But we are and always will be on the founders side.
Stay tuned 🙂