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 🙂
I remember well the fights with my parents over tidying up my room. I mean, is that really necessary? Organised things are for dumbs, smart guys can navigate in chaos!
Over time, I found out I can avoid this boring task when there is nothing to clean. Everything can be put back to place after I stop using it. And this simple principle works great everywhere. When I do it right at first, I don’t have to get back to them.
It’s even more important in business. Your goal is to build a successful business, and you may want to have an option to sell it in the future. It won’t help if you know, how to navigate the chaos. The investor wants to be able to navigate it itself. Each missing contract, IP or makeshift arrangements will be grounds to hammer the price down. And cleaning the mess during the due diligence is nerve wracking and sometimes even impossible.
Do I know, where and how all my contracts are organised? Do I have that code from a friend covered with IP assignment? Is my accounting showing real accruals and aging of A/R? … Anywhere where I can be tempted to cut a corner and have a temporarily easier way, I should ask myself – if I was an investor, what would I say to this? Well, I rather work overtime to do it right. Because cleaning sucks.