And how their preferred shares allows them to kabash your celebration
In your seed round, you raised $5 million on a $20 million valuation. Not bad. But just a start. Because if things go well, the company will be worth at least 10x as much 5–7 years from now. And that’s what investors are betting on.
But you’ve developed some critical technology that’s attracting attention in the industry. GiantCo, a faded dinosaur desperate for growth reaches out. They make an offer to buy the business for $30M. Woohoo!
This is not a firesale, not an acquire-hire. This is a 50% increase in the valuation from only a year ago. It’s an attractive offer.
A deal with GiantCo relieves you of the challenge of raising another round of funding, and another and another. Getting your product to market will be simplified by the thousands of salespeople at that industry giant, and the tens of millions GiantCo spends on marketing. This is everything you want, tied into a neat bow.
Assuming there weren’t any earlier raises to complicate this simple example, at the time of the offer, seed investors own 20% of the stock of the business (5/(20+5)). Let’s say 10% of the stock has been issued in employee options that will immediately vest on acquisition.
That leaves you and your co-founder with 35% each. On a $30M payout, you and your cofounder each take home $10.5M. Time to break out the champagne.
Barely able to contain your glee, visions of Ferraris dancing in your head, you take the offer to the board expecting a standing ovation. Instead the investors on the board shake their head and say NFW. “What the hell are you thinking?”
What the Hell Are You Thinking???
As an angel investor, if I’m able to get a 50% return in one year, that’s a nice win. For my $100K investment, I can take the $50K winnings and buy my wife a top-of-the line Honda CR-V, then reinvest the original $100K into the next startup. Not the 10x I was hoping for, but not bad.
However, as the manager of an angel fund that invested in 10 startups, that 1.5x return isn’t great. Members who put $100K each into the fund get $15K back. Hardly an impressive win, though at the moment, nobody will complain about getting any cash return at all, no matter how small.
For a venture fund, though, it’s a problem, because the fund is closed. They put in $4M. They get $6M back. Sounds like a win, but it isn’t.
Their $100M fund that invested in 20 startups has to reach $250M within 7 years. That $6M return doesn’t move the needle.
Sure, if every one of the 20 investments in the fund returned 1.5x in a year, that would be great. But that’s not what happens. Instead, 10 of those startups will fail outright. Another 8 will return 1x or less. That leaves 2 to carry the load of reaching the $250M goal.
Within a year or so, half the startups are struggling. Hopefully, a few in the portfolio are doing well. Those are the ones we’re counting on to be our big winners. And that includes your startup.
So when you come back to investors and tell them of your great success with a 50% gain, don’t be surprised if we don’t share your joy. We’re looking for your startup to grow into a 50x winner, not 50%.
But Founders Hold More Than 50% of the Shares, Right?
You and your cofounder still hold 70% of the shares. In terms of voting rights, you have 80%. You have two of the three votes on the board. You have the votes to accept the offer, right?
Wrong. Completely wrong.
This is why investors insist on preferred shares rather than common stock.
There really isn’t much difference between preferred and common stock in a startup except for a two key details: liquidation preferences and the right to vote independently as a separate class on key decision such as acquisition of the business.
That means preferred shareholders as a separate group have to approve of the transaction. If you have multiple classes of preferred shares, i.e. Series Seed, Series A, Series B, etc., each class has to vote yes. In other words, each class has veto rights on any acquisition of the business. Even if early seed-stage investors are happy with a 5x return on their investment, Series B investors might kabosh a 1.25x return to them.
In a situation like this where the company is doing well and has a good chance to reach a much larger acquisition in the future, venture investors will vote no. Sorry. They didn’t invest in your startup for a 1.5x return. It’s 10x or bust.
What’s Next for You?
Your $21M payday is put on hold. The appointment at the Ferrari dealer is cancelled. You can use the time instead to shop at Target to stock up on instant ramen to carry you through the next 5 years.
GiantCo is told to come back later when they’re prepared to pay $1B. In the meantime, they’re invited to invest that $30M in your next funding round.
Then it’s back to the grind for you. Now it’s clear that investors not only don’t care about a $30M exit, but are adamantly opposed to it. The game was always to reach $100M in revenues and get acquired by GiantCo for $1B. Until then, it’s time to execute.
That’s the venture game, and when you take their bet, you’re playing by their rules.
What If?
What if you hadn’t taken venture capital? What if instead of raising $5M, you’d bootstrapped the business?
It might’ve taken longer to reach the point where GiantCo would offer you $30M. Instead of a year, it might’ve taken two or three. Still, 3 years of work for life-changing money? That’s a deal I’d take.
If you need that $5M investment to build equipment, you might not have any choice other than venture capital. Or maybe you do. Maybe GiantCo will lend you access to their production line in return for preferential pricing. Or perhaps a government grant would fund part of it. By being scrappy, creative, and opportunistic, there can be ways of getting what you need.
I’m not saying venture capital is bad. If you’re building a rocket ship, it’s the rocket fuel you need. If you’re building a Toyota Camry, though, bad things happen if you put rocket fuel in the tank.
Once you start down the venture path and take that first check, there’s no turning back. It’s a one way decision — reach orbit or explode. Even when it could’ve meant a $20M payday to you, if it doesn’t fit the needs of venture investors, you don’t get to make the choice.
So as you decide how to build and fund your business, make sure you understand the implications of what you’re getting into, from that first check all the way to the exit.
If you’re looking for alternatives to venture funding but need more capital than you can bootstrap, take a look at operational capital as an alternative to venture capital.
