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Risks and Rewards in the Search for VC Funding

August 7, 2018

 

 

When an entrepreneur takes the initial steps towards starting a new business, one of the first questions that will come up is the capital structure of the business -- in fact, every great idea needs an initial source of capital before it becomes a great business. For many years, venture capital has made itself the apparent cornerstone of the fundraising story for startups in the United States -- to the point that such nuggets of investor jargon as “Series A,” “Down Round,” and “Fully Diluted Shares” have entered the public lexicon on television shows like ABC’s Shark Tank and HBO’s Silicon Valley. Of course awareness does not equal understanding, and likewise an overall increase exposure to industry terminology does not necessarily mean the average founder has been adequately educated on the risks and benefits of raising a venture round and we should not expect them to. Rarely is the visionary biomedical engineer, software designer, or fashion icon the same type to pursue a schooling in investment, and many of the entrepreneurs I’ve personally worked with are unsure of what to expect from venture capital. They ask questions like: “What is the right time to start looking for a seed round?”; “How much equity will the VCs want in my company?”; or “Are X and Y standard items on the term sheet?” Leaving these questions unanswered can result in a murky understanding of the decision at hand, and can ultimately hurt the company and its founders when they become aware of what they have agreed to. The purpose of this article, then, is to bring to light some of the most common examples of hidden risks that come with the process of raising venture funding, and provide information to arm entrepreneurs as they enter negotiation. Finally, I will conclude with the arguments in favor of venture capital -- not least that many of the largest companies of the modern era springboarded to success from bets made by venture capitalists.

 

 

Poor Alignment of Goals

 

What makes the VC model work is return on investment -- with the VC firm’s ideal scenario being to enter at a low valuation and with a comparatively large stake in the company for these shares to appreciate in value year-over-year while avoiding dilution (or decline in percentage stake held in the business).Then to finally exit via an IPO, purchase by a larger firm, or Private Equity buyout. Although the time to exit has been increasing in recent years, the average is still sitting at about 5.9 years as of this time last year, or 8.1 for IPOs (per Pitchbook). Clearly, this is a model that favors rapidly growing companies -- a prospect which may or may not align with your own vision as a founder. In cases where an activist VC controls a majority of board seats this can lead to one or more founders being fired from their leadership positions or the entire direction of the company being altered. In the worst cases, the influence of ROI-hungry investors can incentivize patterns of growth and value creation that are unsustainable in the long-term but give a boost to the company’s valuation in the short term. In a pre-money scenario, this same tendency leads investors to undervalue firms, requiring founders to give up more of their stake in order to obtain the nominal investment they are seeking.

 

Information Asymmetry & Term Sheet Clauses

 

Something else to keep in mind when approaching VCs is that they are incredibly focused on managing risk. Investing during the early stages of a startup is incredibly risky -- most VC funds project that no more than 15% of funded companies will go on to be winners -- and even with extensive evaluation of pitch decks, interviews with founders, reviews of company financials, and other due diligence there exists an enormous amount of information asymmetry between the founders and the investors looking to sink money into the company. The primary method by which VCs manage this asymmetry is to counter with their own asymmetry -- namely through the term sheet, a document which delineates the amount of money invested, timing of the investment, number of shares purchased, as well as other terms and conditions to be met per the binding final agreement which precedes the disbursement of capital. Often, these documents contain dozens of subtle clauses intended to gain an advantage from a founder’s lack of legal and investment experience.

 

Two common types of clauses that can pose a significant risk to founders are Liquidation Preferences and Ratchet Clauses. Liquidation Preferences are a tool that investors use to both minimize losses and maximize gains in the case of a “liquidation event” -- a term that varies in its exact definition but generally refers to an event where the company is either sold or files for bankruptcy. The preference itself is executed through the creation of one or more classes of preferred stock, and sometimes includes a multiplier attached to the payout on preferred shares. In some circumstances this is nothing more than an attempt to recoup the initial investment in the case of disaster, but often it is used as a lever to increase returns at exit. Consider these two possibilities of the following scenario: A VC invests $1 million in a firm, $500,000 of this in exchange for 25% of common stock, and $500,000 in exchange for shares of preferred stock with 1.5x liquidation preference. If the company sells for $5 million, the investor receives $2.375 million (1.5 x $1 million plus 25% of the remaining $3.5 million) -- despite the fact that the firm only grew by 100%, the VC’s investment grew by 137%, and the founder’s share appreciates by only 75%. Alternatively, if the company sells for $1.25 million, the results are even worse for the founders -- with the VCs taking $875,000 (1.5 x $500,000 plus 25% of the remaining $500,000) for a 12.5% loss while the founders experience a loss of 75%. Through this mechanism, the investor sees outsized benefits in good times, and diminished losses in bad times, while hiding this fact between the lines of the contract.

 

On the other hand, Ratchet Clauses are contract terms that are, at least on their surface, intended as a defence against anti-dilution for early investors in the case of subsequent fundraising rounds, vesting of employee stock options, or conversion of debt to equity. In its most simplistic form, the “full ratchet” converts the early investor’s initial investment at the lowest subsequent share price issued later on, no matter to whom it is granted. For example if investor A initially purchases 100 shares for $500 ($5 per share) with full ratchet, and investor B subsequently purchases 150 shares for $600 ($4 per share), per the contract terms investor A must be granted 25 shares in addition to his original 100 to effectively equalize the price paid by the two investors; this has the effect of allowing investor A to maintain the value of his stake while eroding the value of those owned by the founders, as well as any prior investors. This effect may be masked if the company is experiencing significant growth, as the nominal value of the founder’s shares will continue to increase despite losing relative value as more shares are issued.

 

When founders realize too late that they have agreed to terms like these, they often feel they have been cheated, and this feeling is understandable, but whether or not it is justified is harder to say. Should we not expect investors to act in their own best interest and in the best interest of their firms? They do not exist to give charity to entrepreneurs but to generate profits for the LPs that have invested in their fund, and so it is not surprising that they are tough negotiators. In fact many would say that VC firms present an opportunity that is not offered anywhere else, and help lead companies toward success.

 

The Promise of Success

 

Alternatively, perhaps founders are blinded by the validation offered by getting a fund to commit. Closing on a round of investment is inherently exciting -- to that point, many Silicon Valley firms are known to host extravagant celebrations following a big raise. This is understandable -- for founders, it is vindicating, a sign of their successful leadership up to that point, and often comes hand in hand with a hefty valuation. In our view, while this is a major step on the path towards building a thriving business yet to many entrepreneurs see fundraising and high valuations as goals in and of themselves when they are not.

 

The firms that last are those that successfully create value for their consumers as well as for their investors, whereas early valuations are primarily built on the expectation that these will come later. In reality, a plurality of firms fail to raise a Series A after obtaining an initial Seed Round; a study following 1,098 tech firms that raised seed rounds in the U.S. from 2008-2010 found that nearly half (46%) of these firms did not go on to raise another round, with the majority of these having attempted and failed, while others were spun off or sold at a loss or a modest return. Further rounds mirror this trend of spin-off and low returns -- while the study does not speak to the number of firms who attempted and failed to raise the initial round. Ironically, an often-cited reason why startups such as those in the study ultimately fail, is that they invest so much time and energy marketing themselves to investors and raising the next round, they neglect to find traction with customers and fail to hit growth targets.

 

Why have these results failed to become accepted by the startup community at large? Partially responsible is the wealth of good PR and attention bestowed upon VCs in response to what amounts to relatively few big successes. Not only, as we have already mentioned, does the average funded firm fail to become a rockstar, but the typical VC fund fails to outperform the yield on exchange-traded index funds. In the face of such statistics, it is not outlandish to think there may be a better way to succeed at the early stage. At the very least, founders would do well to be selective about the investors they choose to partner with.

 

A Note on Negotiations

 

As we have noted, there are many ways in which negotiations with VCs can lead to a situation that is less than advantageous for the founder. When we look at a large field of founders and the deals they have made there are several key criteria that separate those with unfavorable contracts from those who have come out of negotiations unscathed.

 

Best practices:

  • Begin the fundraising process earlier rather than later

  • Talk to many VC firms rather than fewer

  • Invest in legal counsel to assist in drawing up contracts

  • Embrace the possibility of avoiding VC funding altogether

  • The first piece of advice to start the fundraising process early requires clarification. We do not advocate pitching on a business that is little more than an idea.

  • Businesses should first:

  • Identify a target market

  • Establish initial traction with customers

  • Show a steady pattern of growth

  • Begin to generate predictable monthly revenue

Once they have done the above it may be time to think about looking for funding in order to achieve a more rapid level of expansion. The reason behind this is the process of closing on a round of funding can take 12 weeks or more, and the last thing any entrepreneur should do is to go after a raise out of desperation for cash. This can make the entrepreneur appear weak in negotiations, and drive them to accept a deal that is less favorable than what they would have accepted otherwise; when short-term thinking takes over, long-term strategy is inevitably compromised. Accordingly, it is wise to keep an eye on the cash runway and think about some sort of financing well ahead of that 12-week time frame.

 

The next item step, to talk to many VC firms rather than fewer serves a dual purpose. The first goes back to a classic negotiating tactic: leveraging alternatives to the choice at hand. If a firm is in talks with many investors, suddenly the investors are in competition with each other to win the firm’s favor rather than in competition with the firm to get the better end of the deal, and they may make more concessions (assuming the firm in question is a promising investment). The second purpose emerges out of this competition: the more funds a firm talks to, the easier it becomes to differentiate what each of the funds offer in addition to the money -- mentorship, professional networks, and reputational benefits are some examples.

 

Our third piece of advice to shop for a lawyer prior to signing a contract -- goes without saying. Though legal fees can be frightening for an entrepreneur with limited cash resources, there is simply no substitute for going into a meeting with VCs informed on the legal implications of the term sheet. Trustworthy legal counsel can help avoid missteps that otherwise could have cost the founder the security of their position and board seats, their stake in the company, and their reward at exit.

 

Finally, a founder must enter negotiations comfortable with the fact that they may ultimately forgo VC funding entirely in favor of other forms of financing or bootstrapping. This includes cases where the company actually receives an offer from one or more VC. Not every deal has the potential to be a good deal -- especially when a firm has only one offer, investors have little reason to give concessions. Though it can be hard to accept -- especially when the firm has sunk costs associated with the round -- a founder must reject funding when the price, in terms of control or shares, is too high.

 

The Brighter Side of VC Funding

 

The above analysis has looked into the shadier facets of venture capital; but of course, as with everything, this is not a complete picture. In fact, many founders have had wonderful experiences with their investors. Indeed, there are plenty of VCs out there that are well aligned with the founders in whom they invest, both in strategy and in ambition, and serve as mentors rather than hostile activists. They don’t draw up terms and conditions with the intent to deceive or mislead; they are honest about the difficulty of achieving success and the consequences of failure; and they serve to come to a consensus with negotiations that is tough but nevertheless fair. Moreover, good investors will understand skepticism of the VC institution, particularly those known for making more predatory deals.

 

At its best, venture capital can bring into the company much more than an influx of cash. VC partners and the directors they appoint can provide invaluable mentorship and advice drawing from their years of experience working with and investing in companies, and help to avoid strategy missteps that especially younger or less experienced founders may not see coming. Additionally, when a VC firm decides to invest, they are implicitly also expressing their confidence that your company will succeed -- at least from an outside view. The reputational benefits of winning a contract with a well-known VC firm can often bring a new level of awareness to the company and serve as a boom to public relations. Finally, partnership with a VC often opens the door for strategic partnerships that would not be available otherwise; the VC often serves as a connection between their portfolio firms, as well as in the larger business community -- and they have every incentive to do this if it presents an opportunity for the firm to grow and thus for their investment to appreciate.

 

To conclude, venture capital investment comes with many hidden risks that founders would do well to be informed about; such is true for any method of raising money in the midst of uncertainty. The inherent danger lies not in the mere idea of working with VCs, but in a lack of the necessary information required for a founder or a team of founders to maintain integrity and control through one or many rounds of fundraising. This is easier said than done, of course, but in the end it can be a challenge whose rewards are well worth the effort.

 

  1. Clark, Kate. “VC investment-to-exit ratio in the US at record high”, Pitchbook.com, 28 July 2017.

  2. Dean, Tomer. “The meeting that showed me the truth about VCs” TechCrunch. 1 Jun 2017.

  3. “Venture Capital Funnel Shows Odds of Becoming a Unicorn Are Less than 1%” CBInsights. 29 March, 2017.

  4. Mulcahy, Diane. “Six Myths About Venture Capitalists” Harvard Business Review. May 2013.

 

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