The last 5-10 years have been an extraordinary time for early stage tech founders to raise money. But easy access to capital has ingrained some bad habits among founders. There has always been the risk of over-funding your company or not being able to find a funder for your next round, but now it’s far more common to see founders blithely accepting deal terms that could kill their businesses — or at least their ownership of them.
Ironically, this is a problem for both successful startups as well as those that are struggling: Competitive founders of rocket ships aiming at a unicorn-filled fairyland often accept onerous terms precisely to secure a higher valuation, and struggling startups end up signing deals with less scrupulous third-tier firms or strategic corporate investors who haven’t bought into the Y Combinator playbook.
Despite all the educational blog posts and videos available to founders, there is still an information asymmetry between investors. You’ll find that pitfalls abound as you progress down the funding path.
How founders get stuck
Lending money is an inherently risky business, yet most of us work under the assumption that there is a wide gap between assets like sovereign debt and junk bonds. You’d expect to see a risk curve that starts shallow at T-Bills (which are as close to riskless as can be), that then curves dramatically upwards to junk bonds (which offer more reward to compensate for the riskiness of the bet). Blue-chip corporate bonds and parastatal organizations would fit somewhere between the two. The truth is that the curve is much flatter than you think.
I’m an early stage VC, but also serve as a non-executive director of RMB, the investment banking arm of FirstRand, a South African institution that manages more than $75 billion of assets; I’ve seen how the other side works. J.P. Morgan famously said he’d lend to anyone of character, but for today’s later-stage investors, collateral is key.
Late-stage startup investment is much closer to a personal home mortgage than most founders think.
Why? People who successfully bet on risky financial instruments ensure their deals leave them owning the underlying assets. Just ask any real estate developer. They ensure there is collateral on the loan, they insist on warrants and covenants.
First-time founders don’t necessarily understand that it’s just the same in the startup world. At the seed stage, the downside risk is so small that investors can write off small failures as the cost of doing business. At the later stages, liquidation preferences, covenants and board control shift the balance of power.
Late-stage startup investment is much closer to a personal home mortgage than most founders think. With a mortgage, you don’t buy a house. In reality, you’re placing a 20 percent down payment and living for the next 30 years in a home the bank owns. The same is true of startups.
At this point, it’s important for a founder to know that their role changes fundamentally. You go from being the CEO of a company you own to the mortgage holder of a company that the VCs are letting you run — as long as you’re performing. There is always the risk that a founder will fail as a CEO, but smart investors ensure that they capture the salvage value — which may be worthless at the get-go, but increases over time.
Fidelity doesn’t give a fig about founder-friendly financing norms
The rules change as you raise money from larger institutional funds. Gone are the days of SAFE docs, which bend the power to the entrepreneur. At later stages you’ll be negotiating terms with veterans who stubbornly hold onto things like liquidity preferences. As many unicorns have found out, to their embarrassment, larger financial institutions have no compunction about writing down the value of a struggling frustratingly-slow-to-be-listed portfolio company. Startups rarely face this kind of drama, but there are many smaller ways they can be tripped up.
I recently helped one of our founders complete a later-stage deal. The deal was a huge win for everyone involved, but it nearly died during negotiation. The valuation went up. The terms were fair. But the new investor demanded a 1x liquidation preference. Unfortunately, the lead of the previous round had negotiated a 2x and was loathe to relinquish it.
Even though he was a pen stroke away from both paper and cash gains, he understandably didn’t want to give up the 2x preference that protected his downside (which he had been granted only a year before). We ended up working out a deal between the steadfast financiers, but it came at the cost of new accommodations, which could create new challenges down the road.
Please balance opportunism and strategy
Why care? Stories about founders being pushed out of their startups are as old as Apple. Everyone who starts a company knows it’s a possibility. But I think most founders underestimate the likelihood that it could happen to them.
I expect we’ll soon see a rash of this kind of activity in the industry. Have you ever wondered how a startup gets a massive round of capital at an exorbitant valuation when their fundamentals don’t seem to merit it? Simple: They’ve mortgaged their future.
Promising businesses that are being managed poorly by founding CEOs will find themselves under new, VC-appointed leadership. Others will be sold off, leaving late-stage investors whole while founders and earlier investors are wiped out.
If you’ve already raised a big round, all you can do is try to manage your business to plan, and try to make the results work.
More often than not, you’re going to be at a disadvantage in negotiation.
If you’re at the earlier stages, forewarned is forearmed. If you’re offered a clean round at a lower valuation, versus a term sheet with a more enticing topline number but scary downside clauses, closely consider the former. Don’t hamstring your future self to prevent a few points of dilution.
You’ll be tempted by offers from these later-stage funders that pit your interests against your earlier investors. Feel free to take them, but if you find yourself struggling, there will be few around the table offering support.
Above all, don’t try to outfox the funder and her lawyers. I wish it was as simple as suggesting you spend an hour in a deep dive with your lawyer learning to understand these terms. It would be the best $1,000 you’d ever spend. But founders are at a deep disadvantage. Investors use financial terms to protect their interests in so many ways, every day, that they’ve got an unfair advantage. It’s highly unlikely that you will be able to pick up all the intricacies and nuances of complex deal terms in a crash-course format.
More often than not, you’re going to be at a disadvantage in negotiation. You need to invest in top-notch legal counsel, and hope your earlier investors are more aligned with you than the later-stage investors. Otherwise, you may be kicked out of the house that you built.