Tuesday October 7, 2014 3 comments
By Peter Adams
Rockies Venture Club
Venture capital investments are extremely risky, and over the years a balance of power in negotiating deals has gradually evolved that leads to fair deals for both investors and entrepreneurs.
In just this past week, I've encountered two examples of entrepreneurs and investors negotiating deals that disrupt this balance of power by swaying the terms of the deal wildly in their favor. The irony is that while individuals may benefit from negotiating a good deal for themselves, when the balance of power tips to one side or the other it's bad for entrepreneurs and the startup community.
The ABC TV show "Shark Tank" sets a bad example for investors when they negotiate deals for 60 percent of the company for five and low-six-figure investments. Granted, many of the deals portrayed on Shark Tank should never be considered for venture capital investments because they're too early, can't scale, don't have an experienced team or a million other reasons, but when investors take so much of a company's equity, they virtually guarantee its ultimate failure.
What many TV viewers don't understand is that most of these early stage angel investment rounds are not the only funding the company will need to achieve success. After angel investors come onto the picture, the companies typically have 12 to 24 months "runway" to get to positive cash flow or their next venture round.
Companies that grow fast and grow big may go through three or more rounds of funding before they get to an exit. While every deal is different, each of these rounds may take between 20-30 percent of the equity available. If the company has already given away 60 percent of their equity in an angel round, they won't have anything left to continue to grow.
Without additional equity investment, the company is stuck and ultimately turns out to be a bad investment for the sharks who took all the equity in the first place. As a general principle, it's better to have a smaller piece of a bigger pie and investors who don't get this can ruin an opportunity for everyone.
This week I saw another case of investors negotiating deals that would put the company at risk. The investors demanded "Full Rachet Anti-dilution" on their deal because that's what they always ask for. What this means is that if there is a "down round" in which the price-per-share of equity in the company is less than what the investors paid for it, the company will make them whole by issuing new shares.
So, if an investor paid two dollars a share initially and the new round is at one dollar a share, then the company will double the amount of shares the investor owns. What this means is that if the company needs to raise even a little bit of additional equity to complete a milestone or bridge to an institutional investment round, they can't since they would have to give up as much as 30 percent of their stock -- even if they only raised $100K.
Most deals use "weighted average antidilution," in which the investor is made whole only to the extent that they are actually diluted, so a $100K bridge might result in the issuance of a relatively small number of new shares to investors.
It's not just investors who ask for ridiculous terms that are ultimately bad for both investor and entrepreneur. Many startup founders seek terms that make no sense for anyone, as well.
Specifically, I'm thinking about many of the "Convertible Debt" deals I'm seeing lately. Y Combinator has one called SAFE, or "simple agreement for future equity." The principles behind these notes is that they don't have a fixed term, the investor has no idea what terms will accompany their equity purchase and ultimately the interests of entrepreneur and investor are not aligned.
Yes, these are "easier" to do than equity investment - but ultimately kicking the can on valuation and terms down the road trades off minor time-savings with huge uncertainty and an imbalance of power in the terms of the deal.
Some of these convertible debt deals don't have a valuation cap, which means that even though the company may go for two years or more before raising their institutional round and they may double in valuation each of those years, investors are stuck with a 20 percent "discount" on their purchase. A 20 percent discount sounds great if you convert to equity in a short period of time like three to six months, but if it goes to two years, that means that the investor makes only 10 percent return on investment in the most risky asset class there is at the riskiest part of that asset's growth.
And it's even worse, since many of these deals will fail before they ever get to another round, resulting in a zero percent return.
Investors who make investments in these deals won't be around long, since they won't be able to build enough upside to pay for the companies that end up not making it. When entrepreneurs push these deals, and inexperienced investors jump in, everyone loses because investors will become disillusioned and will leave angel investing as an asset class.
In Colorado, we have a small portion of our accredited investors who are actively involved in angel investing. Rockies Venture Club is a nonprofit that is working to educate, engage and mobilize our angel community to invest in smart deals with smart terms. This means fair terms for both angels and investors.
We hope to teach angels how to be ethical investors and entrepreneurs how to negotiate deals that are fair and most likely to lead to everyone's success. This balance of power and fairness is just one part of how successful entrepreneurial communities are built.