One of the most pronounced misalignments between investors and entrepreneurs is around the concept of “optionality.” I’m not talking about stock options, but the freedom to choose from a variety of different strategic and tactical options when running your startup.
I learned, the hard way, that the founder has to create his/her own optionality or your startup is at the whim of your investors. The more shots on goal you have, the more likely you’ll be successful. Paradoxically, more funding means fewer shots, and less optionality for you.
When you first start the company founders have ultimate optionality. You can hire who you want, and pivot a hundred times until you’ve found the right business opportunity. You can even decide to walk away if it doesn’t feel right.
As a former startup founder I noticed that as my companies raised multiple rounds of funding the investors gained options, while mine narrowed. The balance shifts. You can’t fire your investors, but they can fire you. With every dollar a startup takes, investors are buying explicit and implicit options in your company and, at times, it seems investors maintain all the options.
For example, if you’re fortunate enough to take $20 million in venture capital at a $100 million valuation, you can no longer sell the company for $80 million even if it’s a windfall for management.
Optionality also presents in more prosaic ways. You’ll need board of director approval for pretty much all senior level hires or major purchases. While there’s good reason for this, namely good fiduciary control, it can become cumbersome. Most boards will generally follow management’s recommendations, but you are in a position of asking for permission, not proactively deciding.
Running Out of Options
Optionality is worst when things aren’t going great. Consider a business that’s going sideways. Revenue is growing, but not at a rocket-ship pace, and the company is in need of capital to continue operating.
Unless you can get a new investor to set the price of the round, existing investors have enormous leverage (or optionality). They can decide to make a bridge investment, entirely at their option. Some funds will increase the valuation in recognition of progress the company has made. Others will use the opportunity to buy more of the company in a down or flat round. Or they may decide not to follow-on at all, sending a disastrous signal to market.
How to Maintain Optionality
So how does the entrepreneur manage to gain optionality while still subject to the venture capital markets? Here are some of your levers:
Managing the burn
The ultimate form of re-acquiring maximum optionality for the entrepreneur is to reach profitability. For early-stage tech companies, that may be a long way away, but you can control your burn rate.
Burn rates don’t grow linearly; they tend to grow geometrically. This is because when you hire your first VP of anything, he/she often will want to hire a director who at some point will want an analyst.
Budgets go up as more people are there to spend them. The most effective way to manage the burn is to set hard caps on numbers of staff, spend that gives you ample buffer between fundraising. The more dependent on the capital markets you are, the fewer degrees of freedom you have.
Managing the board/investors
Managing a board full of strong personalities can be tricky. But it’s important to build strong, individual relationships with each member of your board.
Get to know them socially, ideally even their spouses and families. They are your partners, just like your co-founders. Provide regular updates so they feel engaged and mentally and emotionally invested in the company beyond their financial commitment.
I recommend that founders bring on an independent board member who can contribute significantly to the company, but also can be a friend and supporter to management. If the board and investor group feel closer to each other than the founders, there is a greater likelihood of group-think. This can be harmful when you need one investor to step up in times of, say, a bridge note or when you have to make a controversial decision and need a base of support.
Stay close to prospective investors/buyers
The adage “keep your friends close and your enemies closer” echoes true in the startup world. Bringing optionality to your company is about creating a network or ecosystem around you beyond those that are directly affiliated with the company.
Shrewd founders know the key players at potential acquirers. They’re not actively selling the company, but, as with fundraising, it pays to have relationships going in so that if the company does begin a sales process, it is easier to generate multiple offers.
We tell most of our founders that you’re always fundraising. Keeping warm relationships with prospective investors is also beneficial in that it gives you an alternative to inside rounds, or at the very least can help increase an outside round. There are times where friendly investors will provide a term sheet at a higher valuation as a show of support, even if they know full well that you’re unlikely to take it.
I used highly curated distribution lists for company news at my startups. I had a broad list in which I’d share general company news (always listed recipients as BCC). I’d often include prospective acquirers on that list, but made sure to avoid any specific details about the company.
That note would also get sent to candidates we were pursuing and other VCs we might want to approach in the future. The much more specific (and more frequent) email update when to shareholders, employees and key partners.
Venture debt
When used rationally and conservatively, venture debt provides an alternative source of capital. While some board members may argue that debt is bad for the venture, it enables the founder to open up the dialogue about equity.
It provides a foil. For example, I’ve heard founders say “You’re either a buyer or seller; if you’re not willing to provide equity capital, I’m going to take on debt.”
Raise money when you don’t need it
One of the most effective times to raise money is when you need it least. The founders who wait until there is only a few months of cash left in the bank inevitably find themselves in a weak position and with limited optionality. The best time to raise money is on the heels of momentum, such as a strong sales quarter, or when you closed a marquee customer.
Advocate for yourself.
Like the fundraising process, the perception of leverage and optionality is often driven as much by confidence as business metrics. Ultimately without the company founders, the value of the startup is surely zero. At the right moments, seek opportunities to engage the discussion about re-ups, or increases in options.
The best time for this is when the business has had some success and the founders are nearing the end of their vesting schedule. Sometimes the right move is to take money off the table so everyone is aligned around playing for a bigger exit opportunity. Running a startup is among the hardest jobs on the planet so when things are going well, don’t be afraid to take a little credit.
In the end, most investors don’t want to exercise too much judgment over their options. They want to be led, rather than lead. Options are viewed primarily as downside protection; levers to be pulled only in case of emergency. As a company founder, don’t forget you need your own levers, too.