In the startup community often people associate raising capital with success. I get it. It (kind of) makes sense. You see a company raise a big round of money, they must be successful. Right? Well not always…. Here’s 10 startups that raised a bunch of funding and all went belly up in 2017.
Which is why it was so refreshing to hear Matt Barrie from Freelancer speak at last weekend’s Startcon Conference. I have heard Matt speak once of twice before and while he has always had a deep understanding of the subject matter, he absolutely knocked this presentation out of the park.
The passion he spoke with, the cases he references and his commitment to making sure that founders in the room wouldn’t fall into easy traps was evident.
In fact, I would go as far as saying this was “THE” stand out presentation of Startcon 2017.
So what wisdom did Matt have to share…..
Customers are your best source of funding
First and foremost Matt outlined how sales to your customers is the best form of funding for your business.
Selling products or services and then using that money to fund your growth is non-dilutive. You get to retain control over your company and once you achieve break-even (or better yet profitability) then you are in the driver’s seat when it comes to raising money.
But not all businesses can scale fast enough off of customer sales. So if you need to raise money what should you look out for.
Raising VC Funding – Things To Look Out For
Liquidation Preferences are a form of protection for investors. Essentially a liquidation preference means that in the event of a liquidation event (either welcomed or forced) they are the first equity stockholders to receive a return on their capital.
Typically an investor will require a minimum of a 1x Liquidation Preference. This makes sense and is fair. Say an investor has put $100,000 into your company, a 1x Liquidation Preference means that if the company is sold/liquidation they get their money back first. That happens whether the company sells for $100,000 (leaving you with nothing) or $10,000,000.
Everything above and beyond their initial investment can then be split based on the percentage ownership or not. Depending on the details of the investment that $100,000 can either be counted as part of their overall split of the sales proceeds (straight or non-participating) or be separate (participating preferred). More info on this can be found here.
To decode this a little let’s say an investor put in their $100,000 and owned 10% of the company. If that company sold for $10,000,000, in the case of participating preferred they would first of all get their $100,000 back. Then on top of that they would get 10% of the remaining $9,900,000 or $990,000, for a total of $1,090,000.
If they had straight/non-participating preferred stock they would have only received $1,000,000 or $90,000 less.
2x or 3x Liquidation Preference
So far this all seems straightforward and relatively fair, although you could make an argument either way when it comes to participating/non-participating. When this can potentially present a trap is when the liquidation preference is greater than 1x. For example 2 or 3x.
Often a larger liquidation preference can be used to “bridge the gap” when negotiating a company valuation. For example as a startup you may have previously raised at a $10 million valuation. Things haven’t gone so well and you desperately want to avoid a downround. Instead of raising at $10m or less which would cause all kinds of issues for your cap table you manage to find an investor who will give you a $12 million valuation but they want a 2x liquidation preference.
This essentially means that in the event of a liquidation event they get 2x of their money back before anyone else, or double their investment. Now let’s say they put in $4 million into that round. Now if you sell for anything less than $8 million you (and your previous investors) get nothing.
By taking a deal with a liquidation preference you are essentially banking on achieving a significantly better outcome for the company. Let’s look at this with some numbers.
Liquidation Preference Examples
For the sake of simplicity we will assume your first group of investors put in $2 million at the $10 million pre-money valuation.
Your new investor comes in and negotiates a 2x liquidation preference and puts another $4 million into the company at a $12 million pre so they end up with ~21.7% of the equity in the company.
Now lets assume things still don’t really work out but you somehow many to get a trade sale for $12 million. Sounds kind of okay right?
Well not really. Investor number 2 has a 2x liquidation preference so walks away with $8 million straight off the top. Your original investors put in $ 2million, but only have 1x liquidation preference so they take their $2 million.
There’s now $2million left. But it still needs to be split. Your investors combine own ~35%, but hey you still walk out with more than $1 million. Years of work brings a reward but nowhere near what you expected.
Let’s say things were a little worse, but perhaps you had some IP or tech that was valuable to another player. They come in the low ball you for $8 million. What happens in this instance?
Well investor number 2 walks away with the $8 million. You and your earlier investors get nothing.
Of course no one is really going to complain if you go on to great success and sell for $100 million, $500 million or a billion plus, but just be wary of what liquidation preferences can mean in the event of a less than ideal sale event.
One of the takeaway quotes from Matt Barrie’s presentation was that boards have one job:
“To hire and fire the company founder”
The moment you lose control of the board, you lose control of your company. As a result you need to be aware of investors that demand greater board control that their equity ownership in the company would usually translate to.
Why, because let’s say you have a five person board. The VC is investing in your comapny for a 20% ownership but require 2 board seats. The other 2 can be nominated by you and the third is independent. On the surface it sounds fair. But chances are the investor will be the one who recommends the third because they know someone who would be really good. In the event of a tough situation who do you think that independent will side with? You or the VC they have known and done business with for year?
Matt Barrie has a 3 person board to this day and recommend you stick to either 3 or 5 people at most.
Other clauses to be wary for is anything that gives the investor or board veto over and above what you would normally expect. For example Matt shared a term sheet that requested veto power over any written agreement! You can’t run a business effectively like that.
Full Ratchet Anti Dilution
Yes, investors are out to make money. And yes they should be rewarded for their success. But investors are also investing in an early stage company so need to be prepare to accept some of the risk of doing so.
Full ratchet anti dilution can absolutely destroy your ownership in your company in the event of a down-round. Essentially full ratchet anti dilution means that if your company ever issues shares at a lower cost that the VC invested at, the company will automatically issue more shares to the VC to bring their invest to the share price of the down round.
For example, and to keep maths simple, say the VC invested $10m for 33% of the company at a $30 million post-money valuation. Say the share price is $10 per share, for 1 million shares. Now say the company fails to hit their targets and takes a bit of a hit. They go out and raise more money at $5 a share. Well now investor 1 gets issued new shares as well to bring their average price down to $5 as well, significantly diluting you in the process. Here’s a real life example involving Square to see how this can work in practice.
Not All Investors Are Bad
Now not all investors are bad apples. In fact there were come great presentations by investors at Startcon. What Matt Barrie’s presentation really says to me however is the following:
- Try and fund your business via sales to your customers.
- In the event that you need to raise funding don’t just accept the first cheque. Make sure the terms are fair and reasonable given the risk taken by all of the parties.
- Don’t try and raise at a valuation you can’t justify. You only set yourself up for a trap later.
- The headline valuation of the company often masks a lot of what goes on behind the scenes. So when you hear about Unicorns and hundred million dollar rounds just member it might not always be a straight forward deal.
Also published on Medium.