Clean up your own shite. Ok. I know that the tone of the title and post will seem a bit aggressive for a post from a venture capitalist on fund raising. It’s meant to be a bit provocative but the reality is that I give this advice to entrepreneurs all the the time and I usually leave the “e” off of the end. I learned all of this myself on your side of the table raising money at my first company. I normally offer this advice in the capacity of really wanting to help entrepreneurs so please bear with me. If you want to raise venture capital more easily the advice could be quite practical and counter-intuitive.
It is 2010. Many companies that are raising B or C venture capital rounds right now raised their initial money in 2005-2008. That means that they likely raised money at a particularly high price relative to 2010 prices. It’s a bit like if you bought a $1 million home in 2007 and want to sell it for $1 million today. Good luck. Dealing with an artificially high price can make fund raising hard.
In addition, these companies probably raised too much money as was common in this era. Let’s say the company had raised $15 million. That means that the likely have a minimum of $15 million in liquidation preferences. It will usually be higher because the liquidation preference has a dividend so if the deal is long in the tooth assume that the liquidation preference might be $20-22 million.
Liquidation preference is the amount of money that an investor gets paid before the common stock (e.g. management, founders, angel investors) get any money. In straight preferences the investors only get this money in a “downside” scenario as protection that they get their money back if your company isn’t successful. Once you cross the threshold where their percentage ownership would be worth more than the value of their preference they “convert” their preferred stock into common stock and take their proceeds pari passu (along side and on the same terms as you) with the common stock holder. This math is much worse for you (and future investors) when you have “participating preferred.” Participation means that the investor gets their original money back (often plus dividends) AND they get their percentage ownership in your company after they’ve taken their money off of the top.
Having a large amount of liquidation preferences that would be “beneath” the new money you want to raise is destructive. It creates scenarios where the new money feels it will be too difficult for them to get the return they want in medium-sized outcomes (in great outcomes we’re all friends, in crappy outcomes the new investors always get their money first). It also gets the new investor concerned that management (common stock holders) will not be incentivized because they realize that the investors will take most of the money unless there is a big upside scenario. And it sometimes it creates “flat spots” where some investors become indifferent to the ultimate price you sell your company between wide ranges of outcomes. I’ve actually seen situations where some investors prefer a $30 million exit to a $50 million exit because they earn the exact same amount due to the flat spot and they think they have a higher probability of selling the company at $30 million.
They figure, “why risk the deal to sell at a higher price?” Can you imagine in scenario where you’re trying to sell your company for the highest price and one of your investors is privately signaling to the buyer that they’re fine at $30m? Happens.
There are other problems with “legacy” deals. They often have “dead” or “tired” investors who have stranded capital. They don’t have the appetite to invest more money but they want to protect all (or much of) of the investment they’ve made to date. They often aren’t very participatory in the investment any more, so they become more of a liability than an asset.
Or you find out that management has been through a few rounds of dilution such that the management team only has 10-15% of the total equity of the company and as a new investor you know a priori that management is either going to quit soon after your investment or are going to ask you for a big increase in their equity package.
The list goes on. Legacy deals have “hair.”
And herein lies the problem. Most entrepreneurs think, “well, the new guy is going to get all of the value of the $18 million that’s gone into this company. It’s a steal.” The new investor doesn’t see it this way. Here’s why:
1. The time sink – Most potential investors are thinking, “oh boy, this is going to be a headache to sort out. There are four investors that I’ll have to talk with who aren’t going to want to take a hair cut. It’s going to take me hours to negotiate with them all. I might sink in 4 weeks analyzing the company and completing due diligence only to find out at the very end that previous investors are unreasonable. Solution: pass. There’s easier deals to get done at the same price as they’re offering me and those deals have no hair.
2. The brain damage – Most potential investors don’t want to go through the “brain damage” of having to prod a group of previous investors to accept the new realities. I know this sounds lazy, it’s not. It’s rational. Imagine you walk into two similar homes. One is slightly better and priced at $1 million, which you know from Zillow is what they paid for it in 2007. You know they should be reasonable but they’re likely to be a pain in the arse. Another is slightly worse but priced at $700k and was bought in 2007 for $1 million. Most people don’t want to go through the brain damage to convince seller one that the market has changed. So you don’t bother. Pass. Buy the second home.
3. The relationship breakage - In buying a home you presumably don’t do it very often so there’s no harm in at least submitting a $700k offer on the first home and just seeing if they bite. Not so VC. VC’s will think to themselves, “I really don’t want to piss off their existing VCs because I might like to work with them again or “I already sit on the board with their partner on another deal.” So actually much of VC can be quite collegiate amongst investors who care more about the multi-stage game theory than trying to squeeze their way into your deal. Some investors love to get out sharp elbows. Most play the gentlemanly sport.
4. Reputation – Equally, the investor might not be worried about squeezing out your existing VC, per se, but doesn’t want to develop a reputation as a VC with an edge. I once told an entrepreneur in whom I was going to co-invest with a VC that brought me a deal and the CEO was considering changing that firm out, “I came to this dance with one VC and I’m leaving with that VC. I wouldn’t work in this business long if I had a reputation for screwing over other investors to get a deal. If you need to cut me out too, that’s fine. But I’m not prepared to damage my reputation for this deal.”
So what happens? Usually some combination of 1-4 means that you get polite “passes” from most VC’s you see. It’s frustrating because you did $4 million in revenue last year and have a $7 million run rate for this year and you’re struggling to get financed for even $5 million while other startups are out there with no revenue raising $10 million at a $40 million pre money valuation! But pass they will. Time suck. Brain damage. Reputation.
Your existing investors tell you, “Don’t worry. We’ll adjust the liquidation preference when the new investor comes in.” Every investor says this. If you normally pitch 30 investors to get 3-4 interested in good circumstances all you’ve done by putting off your mess is decrease your odds of getting funded. This doesn’t suit anybody.
So on deals where I really like the entrepreneur (but don’t plan to fund) I normally offer the (unsolicited, I know) advice to “clean your shit up first.” Go have the hard conversations. Take liquidation preferences head on. Deal with the small ownership allotted to management. Talk openly about valuation and what they’ll accept so you know what you’re dealing with. Find out whether they plan to pass on the investment internally. At least you’ll know what to tell incoming investors. It’s not easy. Existing investors won’t want to have these conversations. It’s far easier for them to punt and wait to see what new investors say. In some cases this is logical. In cases where a bit reset clearly needs to take place this is hogwash. It would be in their interest to make it easier to fund.
An investor recently called me to look at a deal. I looked up the funding details on Crunchbase and noticed that they closed a big round in March 2008 (e.g. before the world changed). I emailed the investor back and said, “super interesting company but they funded in March ’08. Ugh.” His response, “don’t worry. we did an inside round in ’09 to recap at a lower price and took care of non-participating investors.” End of story. Issue off the table. Ready to talk turkey.
So what option do you have? You have the “keys to the kingdom” option. It has to be played subtly. And you need to be prepared for any possible outcome. You simply say (and hopefully mean), “listen, unless I can address these thorny issues I don’t think I can effectively raise money. If we make this an attractive investment for new investors I’m going to bust my butt to raise capital and build a valuable company where we can all make money. But I’m not prepared to go through the entire effort and fail because of our [liquidation preference overhang, management team under incentivized, large percentage owned by an unsupportive investor, high valuation – fill in the blank]. If you prefer I will gladly help you recruit a new CEO or groom one of my direct reports to take my job. I’ll give you as long as you need to get this done. I don’t want to leave you in the lurch. But I can’t continue indefinitely with these structural issues because all the hard work is ahead of me. So let me know if fixing the structure is manageable or whether you prefer to leave it in place and replace me. I’ll totally understand if that’s what you prefer.”
Frankly, if they’re not willing to budge now, are you sure you really want to stay? Or are you sure that they’re really supportive of you?