So let me first start this off with this: good VCs are not out to screw people over--founder or otherwise. Being a good, trustworthy person is incredibly good for business. Conversely, being untrustworthy and screwing people over (founder, engineers, etc.) is extremely bad for business in addition to being morally reprehensible.
Why? 3 reasons:
- It's a small world. The venture community and successful startup founder community (really tech as a whole) is super small, and word will travel quickly if you're a d***.
- Nobody wants to work with a d***. Venture is an extremely competitive industry, partricularly at an early stage. If you're doing well for your stage you're going to have a lot of optionality in who you take money from. And if you know Investor X screwed over someone in their last fund, why would you take money from them?
- Everybody wants to work with someone good. Venture is a game of expected value, and success requires you to build and maintain positive relationships over 10+ year periods of times in order to build enough rapport to get the best teams to take your money. Screwing things over or even making costly mistakes is a great way to make sure that never happens.
Now that we got that out of the way, the asymmetric information barrier between founders/CEOs and VCs can lead to problems. There are few legal and strategic things you need to be mindful of when taking funding:
- Participating Preferred: Participating Preferred refers to a situation where an investor has assured themselves a certain payout amount in the case of a liquidation event.VCs employ participating preferred to provide downside protection for "risky" investments. Remember, a VC is really just a fund manager. For them to execute investments they need to ensure said investment makes sense for the risk preferences of their investors (i.e.: LPs or Limited Partners).It works like this. Let's say you invest $5M in a super risky company at a $20M pre-money valuation with 2x cap participating preferred wired into the deal. You own post-funding 20% of the company ($5M / [$20M+5M] = 1/5 = 20%).Now let's say that the company gets sold for $100M. If you were just a preferred stock holder you could take back your initial investment or take out your percentage ownership out of that $100M. Given that 20% of $100M is $20M, you're probably going to want to take out your percentage.But things are very different with your participating preferred. The terms of your participating preferred stock ensure that you will get 2x your initial investment back plus your percentage ownership of the company's stock before common stock shareholders (i.e.: employees) are paid out. This means that of that $100M sale, you're walking away with $28M= $10M (2x your initial $5M investment), plus 20% of the remaining proceeds (20% of $90M = $18M)
Why it's so important to understand how participating preferred works is that it ultimately limits the amount of a payout that common stock holders get. This means that if you have VCs with too high participating preferred, the payout that normal employees get from an exit can be dramatically reduced.
Good VCs will work with you to understand the situation behind their use of participating preferred, and even better lawyers will help you negotiate terms at least mutually beneficial (and ideally more beneficial to you) for the transaction.
- Warrant Rights: Sometimes investors (particularly angel investors) will request warrants to purchase future stock in your company at a later time at a fixed valuation--usually coinciding with a subsequent round.This is beneficial to investors because if you raise money in a subsequent round at a much higher valuation, this allows the investor to increase their ownership percentage to offset their dilution from that financing.Complex warrants can make the waterfall of money from a liquidation event (M&A, IPO) very complicated and deter future investors of investing in your company. They're not deal-breakers, but raising money is always stressful and it's always good to make sure everyone around the table is happy.Also, speaking as someone who's been an associate, complex warrant agreements make the dreaded waterfall analysis an absolute nightmare for analysis.This is what a normal waterfall looks like:
If you add in warrants, you can dramatically complicate investor ownership, shares outstanding, overall financial returns--really everything on this list. This is a summarized model of a lot of already complex stuff, and adding wacky warrant agreements will make it look something like this to your deal's associate and your own FP&A staff:
Save your sanity. Save an associate. Be really careful about your warrants.
- Your Valuation: Possibly one of the simplest parts of financing is also one of the most sensitive and strategic aspects to your future exit. You need to be really careful about your company's valuation, lest you jeopardize your ability to raise future rounds from good investors. I bring this up because VCs nowadays have a tendency to over-aggressively price valuations (so-called "paying up"). There's a lot of stories out there about founding teams getting a pre-emptive term sheet during financing from a VC who's willing to give them a sky high valuation in order to win the lead investor position right off the bat. High valuations aren't necessarily bad. As someone who now works on the other side of the fence and owns stock in his startup, I for one like the idea of my company having a high valuation because it means my ownership is worth more.But if you have a valuation that has no financial precedence (e.g.: your TEV/REV multiple calculating such valuation has no basis on the public market or in M&A transactions), or it's set so aggressively that it's impossible for you to fulfill the growth implied with such a valuation, you run the risk of making it extremely difficult to raise a subsequent round of funding.Valuations with no precedence in early stage companies has been a big contributor to both the Series A Crunch and (especially) the less-discussed Series B Crunch. Consequently, it's killed a lot of high growth startups who rely on venture financing to "grow" into revenue and find later that they can't get enough money to cover their day to day expenses.Being rich is the bees knees. But you don't get there by arbitrarily pumping your valuation, or allowing someone else to arbitrarily pump it for you, because at the end of the day money in unliquidated stock isn't really money.
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