Editor’s note: Tomio Geron is head of content at startup Exitround. This is part of a series of posts on the tech M&A market. Follow him on Twitter @tomiogeron.
For one founder who recently sold his startup, it was the culmination of a long journey. At the same time, the founder, who spoke to me on the condition of anonymity, had problems during the acquisition process, feeling bullied by a venture investor.
The investor argued against a sale of the startup, and then after agreeing to the sale, proceeded to call the buyer and yell about terms of the deal. The investor also pushed for certain terms that the founder felt were unfair and benefited the investor.
The founder was pleased with the outcome but felt powerless to stop this investor from essentially steamrolling the process.
“They didn’t want to sell because, for them, the deal was too small,” the founder says. “Eventually our investors inserted themselves into the negotiations. They actually screwed things up for us because they demanded more and actually offended the buyers.”
This type of story rarely gets publicly told in Silicon Valley, since founders and investors don’t want to reveal how the sausage is made in negotiations — and more importantly don’t want to criticize each other in public and break Silicon Valley’s unspoken rule of positivity. But because of how venture capital is structured (more on this below), and because of the many startups that will need to sell without being able to raise more funding in the current environment, these types of situations are bound to come up.
Negotiating with a buyer is a challenge for founders in an acquisition. But negotiating with one’s own side — the investors — can be just as difficult, if not more so. These disagreements typically arise when startups get an offer to sell and the founders and venture investors disagree about what to do. These offers, even if relatively small in Silicon Valley terms — say $10 million or $20 million — can be “life-changing” for founders. But for venture investors, particularly with big funds ($300 million, $400 million or even $1 billion), smaller exits are not appealing. To explain why, we need to look at how traditional venture funds are structured.
VCs typically want a good venture fund to make 3-5x their money. In other words, a fund with $250 million invested would have to return $750 million to $1.25 billion from the fund’s companies that are acquired, IPO, or are otherwise sold off in some form. A 4x return would net about a 2.5x distribution to the fund’s limited partners after fees to the general partners. So VCs depend on massive “home run” exits. For a $250 million fund, VCs would require at least three to four exits of $1 billion or 10 exits of $400 million. (This assumes a VC fund would get 20 percent of the exit price.)
As a result, smaller sub-$100 million exits aren’t that attractive to most large VCs, particularly if they have made a large investment. Many would rather not sell, and instead they roll the dice and hope for a larger outcome. “VCs often look at return on their money as opposed to IRR (as a metric). The fact that they made 4x (return) on $5 million over nine months on a $500 million fund: who cares?” says Villi Iltchev, EVP of corporate development at LifeLock.
To be clear, I’m not saying that all VCs are mistreating startups or behaving badly. I’m not even arguing that the investors’ actions described above are necessarily wrong. (Though it does explain why some founders privately complain about VCs.) And of course, unlike the investor described above, many investors do let their founders make the call on acquisition offers without pressuring them at all.
So while many VCs don’t like to talk about it, their immediate economic interests can diverge from their startups, particularly in smaller acquisitions, Iltchev says. “For founders, especially those who are not independently wealthy, their tolerance for risk is usually lower. VCs are in the business of managing risk on a portfolio basis. For founders an exit can be a once in a lifetime chance to change their life for their family. For investors the same transactions may be immaterial.”
This isn’t to say VCs (or founders) are necessarily at fault. The different economic interests are inherently part of the venture model. Other structures may evolve but this is now the dominant model. That certain investors don’t adhere to these fund economics and let founders make their own decisions is a credit to them and their long-term thinking to try to keep founders coming back to them for future investments.
There are also things that venture firms have done to better align interests of founders and investors. Founders Fund created Series FF stock, which gives founders more flexibility to sell shares. And many venture firms now allow founders to take a small percentage of “money off the table” in a secondary transaction to reduce the financial need for founders to sell early.
Of course, not all investors have the same interests. The larger a VC fund, and the more of their money they have invested in a company, the less likely they are to like a smaller exit. Smaller seed investors or micro-VC funds, which are proliferating, don’t need billion-dollar exits to return their funds, so they are happier with smaller exits — what Dave McClure calls a “Moneyball” model. This makes sense, since about 88 percent of tech acquisitions in the last five years with announced prices were less than $100 million, according to Capital IQ. Also, sites like AngelList and FundersClub enable more individuals to invest, and these individuals typically don’t push for massive exits.
Despite the potential conflict of interest I’ve described (i.e. founders want to sell but investors don’t), some venture investors will help negotiate a deal. Particularly for younger, less experienced founders, investors will get actively involved. And some smaller angels or micro-VC investors have less incentive to oppose smaller acquisitions so there can be less of a conflict. For example, seed stage investor Manu Kumar, founder of K9 Ventures, has negotiated acquisitions for a number of his startups.
For founders it can be difficult to disagree with an investor on a sale. In particular, first-time founders often feel indebted to investors for taking a chance on them. So to turn around and say, “No we don’t agree with you,” can be hard to do.
Many VCs have rights they can use to try to block an acquisition. But most rarely use them, particularly if a founder makes a good case for a deal as the best possible outcome for a company. VCs do not want to be known as “not founder friendly,” even if they hate a deal and feel it is unfair. But they’ll complain privately. Like the anonymous founder mentioned above, Iltchev has received calls and been yelled at by investors who are unhappy with a deal.
For buyers, of course, it’s complicated when sellers and investors aren’t on the same page. Buyers don’t want to negotiate with multiple parties in the same company. On the other hand, if a VC is calling a buyer, that can mean the founder has already decided to take the deal. “If the investor is calling me to negotiate terms, it is probably because they have already lost the battle with the founder and they are just trying to beat me up,” Iltchev says.
At top Silicon Valley buyers, it is standard to treat investors well, even if they don’t technically have to. For example in an acqui-hire — where a buyer just wants the team but not the product or IP — a buyer could just hire a startup team and not pay the investors anything. But most big Silicon Valley buyers want to stay on good terms with investors — who, after all, send them companies to buy — so they will try to make investors happy by paying back their original investment, if not more. (Non-Silicon Valley buyers do not necessarily play by these rules.)
I will be extremely cautious before ever accepting VC investment again and would only do it on my terms.
The anonymous founder mentioned above, reflecting on the experience, says, “My advice would be to make sure you have someone who will stick with you not just when things are going well, but during the inevitable struggle that all startups face. It’s fine to have a strong investor who pushes you and fights for what they think is best for the company, but hopefully it’s not just what’s best for them. That said, I will be extremely cautious before ever accepting VC investment again and would only do it on my terms.”
For founders the best way to avoid these problems is to choose the right investor. Vet your investors and have honest conversations before they invest. Ask them what their return profile is and what kind of exit they’re expecting for your company, says Ursheet Parikh, former CEO of StorSimple, which was acquired by Microsoft, and a new partner at Mayfield Fund.
“Some investors may not appreciate you talking to any large companies early because they are concerned that these strategic buyers may either be a distraction or try to buy you early on the cheap,” he says.
That’ll give you an idea of what you are expected to deliver and whether you’re ready to accept that money and the strings attached. And have an honest conversation with the investor about what would happen if you disagreed with him or her on an acquisition offer. The more honest and transparent they are with you the better. Ultimately the more you prepare while choosing your investor, the better position you’ll be in when acquisition offers come in.
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