I had a great lunch with a VC in NYC who I have known for a number of years. He and I were involved in a fantastic company that went on to be one of the biggest wins in both of our careers. During the lunch, we spent a lot of time discussing the current venture market conditions – trying to better understand each other’s take. It got me thinking about the roles of term sheet structures and financial engineering in start-up funding:
I have spoken many times to other investors (angels and VCs), about that fact that I do not believe that at the seed stage, investors can financially engineer a win. Basically, I do not think that the extraneous terms that can be put on a relatively clean deal (rachet clauses, multiple liquidation preferences, etc) can materially impact your outcome if the start-up you are investing in is successful.
However, I firmly believe that you can financially engineer a loss at the seed stage. Here are three common ways that this happens:
1) Too complicated of a term sheet for the size of the round:
Explanation: This was something that we saw a lot of in 2008 and 2009 when the seed funding environment was 1/50th of the size and raising $500k was incredibly challenging for even the most promising start-ups (yes there was a time when not all YC companies got funded within weeks after demo day). Many seed investors – and we were guilty too – thought that they could pile on protective provisions, etc. into companies in the hopes that financing risk would be mitigated.
Result: Companies who would close small rounds of financing ended up with enormous legal bills that they were then forced to pay. In the most extreme case, I was on the board of a company that raised $400k and ended up with a $100k legal bill (for the record, this was a friends company, and I invested on a straight convertible note with no discount or cap). By the time the legal bill was paid, and the company was ready to start building, cash had run out and the CEOs attention went off the business and back to fundraising. The spiral never ended and the difficult term sheet resulted in a further incurrence of crazy legal bills every time a round was raised.
2) Entrepreneurs who don’t fully understand their economics or don’t like their economics
Explanation: At times, the terms of a deal can be clear as day for the lawyers and investors, but the entrepreneurs don’t quite understand them. Or worse, the entrepreneur understands the terms, but had no other option and took a deal he didn’t want. Either way, this will generally result in an entrepreneur who feels “taken to the mat”.
Result: This can be a tricky situation, because I know that as a seed investor, I am trying to align incentives as best as possible with an entrepreneur while getting the best deal that I can (within reason). There are three things that I due before I finalize a term sheet or an investment that I lead: 1) I send the entrepreneur a waterfall analysis of the deal or an email that says “Hey man, this is a great deal for both of us – if we can get to the next inflection point, I think that you can retain XX% of your business”. We now both have an aligned goal on the financing front to strive towards. 2) I make sure that the entrepreneur is represented by a good group of lawyers who understand venture financings and can coach the entrepreneur on what is a “market” rate deal. While Uncle Morton the tax attorney might be the cheaper option, he probably isn’t going to understand the nuance of the venture industry. 3) Make sure that the entrepreneur understands that if they hit the ball out of the park with this investment round, one of two things can happen: they can raise additional capital at a substantial uptick limiting dilution or they can come to the board and ask for an option grant as part of a new compensation package. I have seen and been involved with both (and in the best scenario, both for the same company!).
3) Cluttering the cap table with pile-on rounds of financing or crazy note structure
Explanation: This is something that you will begin to see a lot more of as bridge financing begins to intensify alongside the Series A squeeze. Basically, this occurs when entrepreneurs are in need of interim investment rounds because they cannot raise the next round of investment. Investors want more compensation then a simple convertible note with discount, while entrepreneurs believe that they have built enterprise value above the last round of financing. Thus, the Series A-2 (then the A-3, A-4…), which has a different price but a similar structure to the previous round. A similar situation can come up in/around an M&A transaction when investors want to be compensated for risk, but entrepreneurs don’t want to give up equity. You end up with crazy note structures where there are 2x or even 3x liquidation preferences on the notes.
Result: Trust me on this one – I know is from experience and it SUCKS! – these types of financings can bite you just when you don’t want/need any problems. Take for instance, an M&A transaction. Most due diligence is around market, technology, team, etc and is done early in the process. Business leaders buy off on an acquisition and it goes to the CFO or corp dev. Then the cap table comes out… now, you have the business team excited about your company, but a CFO who needs a PhD in Applied Mathmatics to unwind your financing. It can take days/weeks of time. At best, the CFO understands what is going on and accepts the companies financing structure for what it is – at worst, the CFO sees this as a red flag and the deal falls apart. For investors, I would urge you to move to a note with cap structure for bridge-like financing. For entrepreneurs, it is important to take stock in where you really are as a business and figure out if it makes more sense just opening up the last round of financing – realizing that new investors are getting a great deal. By the way, when investors feel like they are getting in on a great deal, they tend to be more excited about the investment, willing to make connections, do heavy lifting and tell their friends!
Overall, I prefer very clean and simple deal terms that have alignment throughout the process. In every case, the investor has to give a little and the entrepreneur has to give a little. And, hopefully, in the end, you build a company with immense market and enterprise value, you sell or IPO for something in the $B range and the difference between participation and non-participation on your $3m Series A is completely meaningless!