The difficulty of tactical maneuvering consists in turning the devious into
the direct, and misfortune into gain.
– Sun Tzu
A number of you wrote me after my post on "The Power of Dry Powder". Many of you have heard about contentious situations between investors in the same company and were curious about how this comes about. I will lump most of this discussion in the bucket of "class warfare". During periods of "misfortune", many later round investors turn things into gain at the expense of earlier investors.
As a company grows, it takes on multiple rounds of investment. This usually constitutes several "classes" of convertible preferred stock, with each designated alphabetically (Series A, Series B, etc). The founders and angel investors often have common stock which is junior to the various preferred stock series.
Each new round usually has at least one, if not more, new investor(s) to price the round and set the terms independently. The new class of stock is usually senior in liquidation to the series before it. So, if Company A raises $2M of Series A, $5M of Series B and $10M of Series C, investors in Series C get their money first, Series B next and then Series A. If there is enough left over, the common gets the remaining unless it is participating preferred. This means the preferred get their money out and then participate in the remainder with common based on their % ownership in the company.
Different classes with different rights and seniority creates a broad array of misaligned interests:
Acquisitions: If the Company gets an acquisition offer for $11M, the Series C investors might push to sell if they have lost faith in the business. They get their $10M back (and the Series B gets $1M). However, the B and Series A would not want to sell since they get little. If they have blocking rights, they will prevent the sale from occurring. This happens when major decisions (sale, new capital, etc) must be voted on individually by each class versus combined by everyone (pari passu). In the later case, the C would be able to push through a combined vote since its $10M is greater than the $7m from the other two classes combined (assuming simple majority, etc).
New Capital: When new rounds of capital are raised, all kinds of games can begin. If the older investors are tapped out, the recent investors are not overly excited about carrying the company for the free riders. So, they throw in a pay to play. In this situation, old investors have to invest their pro rata (% ownership of the preferred) or their preferred stock gets pushed to common. This means that even if you are a Series B investor, if you don’t invest your full amount, your Series B stock converts to common and falls behind the remaining Series A, B and C stock. This is particularly nasty if there has been a lot of money raised. Let’s say there is $20M in each of the classes and you are a Series C investor. Before the new financing, you needed a $20M exit to get your money back (C comes out first and was $20m in total). If new money comes in (say $10m) and you don’t invest your pro rata, you get pushed to common and now need a $70m (minus your investment) exit just to get your first dollar out (A,B &C are $20m each and the new D is $10m). You then participate with everyone based on your % owned in the company. If you invested $10m and own 20%, then you would get your full money back $50M later. So, before, you needed a $20m exit to get all of your capital out and after the Series D came in, you need a $121M exit ($60m in remaining preference ($70m-your $10m) ahead of you and $50m for ownership).
It is for these reasons, that investors like to have blocking rights on sales and financings. This means that they own enough of a Series (or they and "aligned co-investors") that the Company needs their approval to sell or raise. This prevents a pay-to-play from being crammed down on them.
There are a vast array of other scenarios, but these give you an initial feel for how messed up syndicates can get when a) classes have different rights and b) investors begin to run out of capital. Since angels often don’t have sizable reserves for future rounds (or don’t know to save for them), they often get hammered during these kinds of financings. I have had my share of both sides and can tell you, like at Christmas, it is "much better to give than to receive". In all honesty, though, if a deal starts to take on these characteristics, no one usually wins and most of the manuveurs are like rearranging deck chairs on the Titanic..
Here’s the real irony… the entrepreneur puts nothing up, just sweat equity. He works hard and gets a year+ under his belt and vests his stock (at least 50% of it). Now along come the VC’s. All kinds of whatever… the entrepreneur keeps his head down and works hard… vests more stock AND gets a paycheck.
Company is doing OK… VC’s start adding more money just like above… entrepreneur gets stock options and keeps working hard. Finally everybody cashes out. VC’s just about break even – Entrepreneur makes out like a bandit. Got paid, Got equity, virtually ZERO cost in his equity vs. the VC’s who had to put up or shut up.
Entrepreneur walks away with experience, money in his pocket and ready for the next one…
VC’s – either got screwed by another VC or got a 1x return. Not enough to move the needle and certainly no “Carry”.
You guys are in a tough business. Out of 10 investments, at least 4 will tube, 2 or 3 will break even, 1 or 2 deliver a 3x and 1 makes it past a 10x. You have one chance to get it right, otherwise no carry and no big paycheck (essentially you’re a service business until the Carry brings home the bacon) and are working for a paycheck like the entrepreneur.
Still you have the gold and that makes you attractive 🙂
Cheers,
Peter
Matt: thanks for the succinct overview
Peter: “the entrepreneur puts nothing up, just sweat equity”??? And “zero cost in his equity”???
Are you kidding?
As a serial entrepreneur I can tell you there’s an awful lot more to this than a bit of sweat and the equity is certainly NOT zero cost by ANY measure.
As CEO of a startup, I’d like to enlighten you:
1) There always an opportunity cost. Any of us could be making a good salary in a regular job.
2) There’s the risk. You just assume that because a VC puts money on the table that the entrepreneur will be fine. This is categorically not the case. The majority of startups fail. While VCs lose their money when a business fails, it’s the entrepreneur that has to burn all the bridges with suppliers he/she can’t pay, deal with employees that have to be laid off etc. Have you ever had to lay off a guy with two kids and a pregnant wife because your company can’t make payroll? It doesn’t brighten your day, that’s for sure.
Not to mention that most entrepreneurs invest some of their own money. While it isn’t always a significant number of dollars, as a percentage of their net worth versus the percentage of the VC fund’s value, I’d bet it is a greater investment.
3) Vesting. 2-3 years is typical for a restricted stock agreement or vesting schedule, not 1 year. What’s more the clock on that often gets reset when investors add money.
4) Most entrepreneurs don’t take a paycheck for a LONG time. When they do, it is almost ALWAYS well below market rate.
5) As Matt’s post points out, there are common circumstances where the VC’s have priority in the “cash out” process. It’s pretty rare for an entrepreneur to EVER cash out ahead of an investor.
6) “Entrepreneur walks away with experience, money in his pocket and ready for the next one…”
Yes to experience. But money only happens when the VCs make money too. As for “ready for the next one”, you forget that track record is everything. As an entrepreneur, you gamble your reputation every time you start something.
7) “…are working for a paycheck like the entrepreneur.” No entrepreneur I know works for a paycheck. Many don’t even take a paycheck. The whole point of being an entrepreneur is to BUILD something. That’s why we do it. Like VC’s, if we just wanted a paycheck there are MUCH easier ways to do it.
There’s another thing you seem to utterly ignore here is: YOU NEED AN IDEA and that idea has to become something REAL. Money is certainly important, but without an idea AND the ability to execute that idea, you have nothing.
As most VC’s will tell you, what they do is one skill set. Building a company is another. They’re not the same but they both have considerable value.
I love being an entrepreneur. I appreciate the dynamic nature of the role and environment we work in. I enjoy problem solving and building things that have value. And I for one wouldn’t want to be doing anything else.
But there’s a lot of risk, a lot of heartburn and a lot of sleepless nights… And that’s when things are going well!
VC’s provide an important piece of the puzzle, but your utter disregard for what the entrepreneur contributes is simply wrong.
Guess I struck a nerve… so let me add some context around me.
I’ve been an entrepreneur for 17 years. I’m on my 4th startup. I’m the co-inventor of mod_gzip which is the defacto standard for accelerating content from an Apache web server (they run 65% of the web). My last startup built the worlds first secure operating system kernel for Itanium (Secure64). We showcased a 4 privilege level operating system immune to hacking and offering incredible transaction scalability (Factor 25x). My new startup is adding Location Based Services to Apache (http://www.5o9inc.com). I’ve been in the trenches for 17 years, I’m still learning and I’m still sweating. I’ve vested, I’ve had the vesting removed, I’ve had a paycheck and I’ve lost a paycheck, I’ve delivered technology globally to some large companies so I know how to execute. As for the idea, give me a call, we got lots and we can show them working live right now.
I think Oscar Wilde said it best, “We’re all ignorant, just about different things”. The key to success is a team in alignment that executes on a common plan under one leader. VC’s offer different things and help fill out the team. The trick is to get everyone in alignment… that was a very hard lesson to learn.
Cheers,
Peter
Great dialog. First, I’ll comment that I am amazed by the commitment and risktaking that entrepreneurs take. As you all discuss, they have everything on the line, take low salaries (relative to working in an established larger company) and if things go poorly, their families are impacted.
Second, I will also say that the venture business has become exponentially more difficult in the past 10 years. Exits have become more infrequent, players are getting bigger and money continues to flow into the business. There are too many companies with trashed cap tables & lots of preference. When you exit these, management usually gets a carve out so they may get a six or seven figure payout and the VC’s, because too much capital flowed in (shame on them), get 50% of capital back. That said, it is the fair thing to do for a team that has sweat blood and tears for years (unless they are inept and then the carve out is usually small). However, when things work out (the 1 in 10), it is a great experience and makes up for the other issues above.