Thursday, November 08, 2018

Founders: Please don’t allow anyone to screw your early backers

Understanding the mechanics of founder re-ups in financing rounds

This post will likely not make me more popular and might offend some people. But if your core beliefs on how business should be done are at stake, you can’t try to win the popularity contest.

If you know me a little you’ll probably agree that like everyone at Point Nine, I’m a pretty nice guy. We’re trying hard to make venture capital a little more human, and we really mean it when we say that we aspire to be good VCs. I’m pretty sure that almost all if not all of the more than 200 founders we’ve worked with over the last ten years would confirm this. 

I’m not saying this to brag or to say that we’re perfect (which we are not, of course). What I’m hoping is that the reputation of being a nice, founder-friendly VC, which I believe we’ve earned in the last ten years, as well as the fact that I’ve co-founded two VC-backed startups myself and therefore know both the founder perspective and the VC perspective, gives me the right and credibility to write this post. Calling out others for questionable behavior always comes with the risk of hypocrisy, but I’m happy to subject our business practices to public scrutiny. If you think I (or anyone from my team) ever did not meet our standards, please reach out.

In the last year, we have seen, on more than one occasion, a behavior among later-stage VCs that we’ve rarely observed in the years before. This might be due to the fact that our portfolio has become mature, which explains why there are now more portfolio companies that are at the stage at which the issue (which I will detail in a second) tends to occur. It’s also possible that the increasingly intense and sometimes downright crazy competition for the hottest deals among later-stage VCs has made this behavior more prevalent.

Here’s what I’m talking about. In the last 12 months or so it happened several times that later-stage VCs, as part of financing rounds, offered a “re-up” (i.e. new shares or options) to founders of portfolio companies. By doing this, they try to partially or completely offset the dilution (i.e. reduction of ownership percentage) experienced by the founders in the financing round. If you think “Great, if founders get more shares and are diluted less, that’s awesome!”, think about the effect which this maneuver has on the existing investors of the company (as well as on employees holding options or shares).

If founders get a re-up, every single share, option, or ownership percentage that they receive (obviously) needs to come from someone. And that someone are the existing shareholders of the company. Oftentimes, the re-up shares are proposed to come out of the pre-financing cap table, in which case it’s obvious who bears the dilution. Sometimes it is proposed that the re-up shares are created post-financing. The latter might make the maneuver seem fairer on the surface, as it appears as if the new investors joined the existing investors in paying the price for the additional founder shares. But if you do the math, you'll see that it doesn’t solve the crux of the issue. More on that in the example below.

An investor who suggests a founder re-up does that, of course, to make his/her offer more attractive to the founders in order to increase the chance of winning the deal. If a founder considers two offers, one with a founder re-up of a few percentage points and one without, the offer with the re-up will be significantly less dilutive to him/her even if the offer without the re-up comes with a significantly higher valuation. Consider this simple example:

(click for a larger version)

This (simplified) cap table model shows the effect of a $40M investment on the founders’ shares in two scenarios: The first one assumes a $140M pre-money valuation and no founder re-up; the second one assumes a $120M pre-money and a founder re-up of 10% pre-financing (which equals a transfer of 3% of the post-financing equity from the existing investors to the founders). As you can see, the founders are better off in the second scenario, in spite of a ca. 15% lower valuation.

Let’s take a closer look at the mechanics that are at play here:

(click for a larger version)

(Here is the Google Sheet if you'd like to see the calculations)

For all scenarios, I assumed that before the financing round, the founders and the existing investors own 60% and 40%, respectively, of the company. I further assumed that the company wants to raise $40M and that the existing investors will participate with an investment of $10M, so $30M come from the new investor.

Let’s say a VC (who I’ll call “VC 1”) offers the company a pre-money valuation of $120M (Scenario 1A). In this scenario, the founders and existing investors would hold 45% and 36.25%, respectively, after the round. Now let’s say another VC (“VC 2”) offers the company a higher valuation, $140M (Scenario 2). In this scenario, the founders would hold 46.67% after the financing, while the existing investors would be at 36.67%. Scenario 2 is significantly better than Scenario 1A, for the founders as well as the existing investors, so (assuming both VCs are of equal quality) the company should go for VC 2.

But VC 1 doesn’t want to lose the deal, of course. He/she could increase the valuation to make his/her offer more attractive, but hey, that would reduce his/her stake. So instead of offering a valuation that is equal to or higher than what VC 2 has offered, VC 1 now proposes a founder re-up of 10% of the pre-financing equity. As you can see in Scenario 1B, this would result in a 48% stake for the founders, which is significantly higher than the 46.67% they would hold if they went with VC 2. Meanwhile, nothing changed for VC 1, as he/she would own 18.75% in Scenario 1A as well as 1B, so everyone should be happy, right? Not quite: The existing investors’ stake in Scenario 1B is reduced from 36.25% to 33.25%, precisely by the three percentage points by which the founders’ stake is increased as a result of the re-up. This is the 3% transfer from the existing investors to the founders that I’ve mentioned a few paragraphs ago.

If VC 1 wanted to get the founders to 48% without meddling around with the cap table, he/she would have to increase the pre-money to $160M. You can see this in Scenario 1D. By offering a re-up instead, VC 1 managed to make his/her offer the top offer for the founders while offloading 100% of the costs of the re-up to the existing investors. Scenario 1C shows what happens if the investor is willing to do the re-up after the financing. In that scenario, he/she does end up with a lower stake compared to Scenario 1B (17.73% vs. 18.75%), but if you compare it with Scenario 1D (AKA the “don’t mess around with the cap table” offer), he/she is still much better off in 1C, at the expense of the existing investors.

I want to believe that the later-stage investors we’ve worked with so far all had good intentions, and maybe I should understand that if you’re trying to win a competitive deal and want to set up a company for success, concerns of other investors aren’t your number one priority. That said, there is an act which, according to Wikipedia, is defined as “giving something of value [in this case shares] in exchange for some kind of influence or action in return [in this case the deal] that the recipient would otherwise not alter.” ;-) The fact that here that “something of value” doesn’t even come from the later-stage investor, doesn’t make it any better.

Obviously, investors engaging in this tactic aren’t stupid, so the official version is usually not “rather than offering a higher valuation [which would benefit all shareholders equally], we’ll give you a lower valuation but will offset some of the dilution by giving you [the decision makers] some extra shares”. The official justification is almost always incentivization of the founders, i.e. some variation of “the founders only own x% of the company, we need to make sure they have enough shares to be fully motivated”. Well, if that was your concern, Mr. Late-Stage Investor, offer a higher valuation to make the round less dilutive. Oh, I forgot, that’s not possible because you have to own 20% of the company to make the investment worth your while. Sorry for getting cynical, but as you can see, this issue has caused me a great deal of annoyance.

The prospect of keeping a larger stake can understandably be tempting for founders, and once the pandora box has been opened by a new investor, it can be hard to shut it. What makes the situation particularly uncomfortable is that if as a seed investor you object the founder re-up, you suddenly look like the bad guy who doesn’t want to grant the founders some additional shares for all their hard work and who risks the entire deal by bringing up your concerns, while the later-stage investor looks like the good guy who wants to reward the founders. As we’ve seen in the example above, this interpretation is absurd because the later-stage investor proposes a reward that benefits him/her and is borne by someone else, but in the hectic and pressure of term sheet negotiations, this can be forgotten. Therefore it’s all the more important that founders fully understand the implications of a re-up and that they don’t let anyone divide their interests from the interests of other existing shareholders.

So is it always bad if an investor proposes changes to the cap table? No. There can be situations in which cap table restructurings may be necessary. If, for example, we wanted to invest in a seed-stage startup and found out that the company is majority-owned by an angel investor or incubator, we would most likely conclude that for the company to be VC-backable, and for the founders to be motivated and incentivized for the next ten years, something needs to change. But these are rare cases, and the fact that they exist doesn’t justify using founder re-ups as a tactic to win deals.

If any later-stage investors are reading this, please reconsider your tactics. Just treat upstream investors how you want to be treated by your downstream investors. Easy.

And to all founders out there: Please don’t let anyone screw your early backers.

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