How to Avoid Bad Deal Terms
Entrepreneurs lose everything when their capital structure becomes their biggest enemy. What does this mean?
The way private capital works today is quite good for investors, but it’s not necessarily so great for entrepreneurs and company founders. On one hand, it is capital that enables the entrepreneur to build and grow their business. Capital is good. On the other, the terms for that capital can be disadvantageous to entrepreneurs.
Terms that Harm Entrepreneurs
In order to protect themselves from losing their money, professional investors, which include venture capitalists, private equity funds, and angel investors, demand specific terms for their investment. This often includes having a liquidity preference over the shares of the founders (which are common shares), board seats on the company, the ability to block subsequent raises or the sale of the company. These are examples of the tight control exhibited by professional investors in the companies they choose to invest in.
Entrepreneurs love receiving money (who doesn’t?), but sometimes that money becomes their own undoing because of the control they give up in exchange. When a company gets into trouble and things go wrong, who is to blame? Of course, it has to be the entrepreneur who must take responsibility, but the sentences imposed by professional investors can be too harsh. The entrepreneur can get fired from their own company or crammed down, which means the shares they own become worthless.
In the past, an entrepreneur’s dream was to take the company public through an IPO (Initial Public Offering) and thus flatten the different layers of shares of the company into one common share class with no investor rights. An IPO was the get-out-of-jail-free card for founders because it meant they would no longer be tucked under the heavy capital structure of a multiple of preferred share classes and terms that control the company’s destiny.
How Founders Lose Their Equity
Yet the path to an IPO is fraught with dangerous scenarios for entrepreneurs that can strip the founders from their returns. What generally happens can be described in three typical scenarios:
- The company is doing poorly. As a result, the board fires the CEO and recapitalizes the company, rendering the common shares owned by the founders worthless. The board can also vote to sell the company and all the proceeds, if any, go to the investors.
- The company is growing very fast. As a result, the board still fires the CEO because they believe someone else will be better at managing this unicorn and navigating its explosive growth. In reality, they just want the company to be sold, so they can get their carry of the gains (usually 20%). Though sometimes, the investors are patient and wait for the IPO.
- The company is growing, but not fast enough. So it runs into a cash crunch as their revenue can’t outpace spend. As a result, the business needs another round of funding, but the company hasn’t grown fast enough to entice investors into an upround. Instead, new investors agree to a down round, killing the founder’s equity. The CEO may keep their job, but their shares are now worthless.
These types of outcomes have made some founders, such as Mark Zuckerberg and Evan Spiegel, give themselves 10x voting rights through a dual voting-class structure. In this structure, the business can issue new shares that only have 1 vote (or none) compared to the 10 votes per share of the founder’s (and perhaps early investors’) holdings. This means that while their shares can be diluted, founders retain voting control of the business. For example, Zuckerberg and a small group of investors own nearly 18% of Facebook’s shares but control almost 70% of voting shares.
Say goodbye to investor control. However, this practice of dual voting-classes is the antithesis to real governance as it significantly overpowers the voting power of the CEO. Governance is important to keep the CEO in check with shareholders. Those checks and balances shouldn’t be thrown out the window just because the founders don’t want to face the music.
Finding An Alternative
Equity crowdfunding provides a solution to that. It is a great way for entrepreneurs to raise capital at terms that do not put a noose around their neck. In equity crowdfunding, companies typically sell common shares to the general public. This is the first time since the Securities Act of 1933 that the public has had access to investment opportunities in early-stage companies and startups well before a company is fully valued at the time of its IPO.
Imagine being part of the early investors in Uber. They got 2,000 or more times their money back. This is certainly a rare occurrence, but it sparked the interest of the general public: there can be value in participating early.
Always Be Raising
There is another intriguing part to equity crowdfunding. Entrepreneurs have been trained to raise capital only when they need it and only when their metrics have delivered on their financial projections. This is great for the businesses who are always making their numbers, which is rare, but it’s not so great for promising businesses who will end up being successful but are experiencing bumps along the way, which as you can imagine is much more common.
Picture a scenario in which you take double the amount of time to build your unicorn company only to find out that your hard work has made you nothing. In the course of your growth, and the rounds of capital you have raised, you have sacrificed any sense of meaningful equity in your company. This is a reality for many businesses, and it is erased by equity crowdfunding and the concept of perpetual raising, which is a new kind of behavior for entrepreneurs.
What is this concept all about? The idea is simple: toss out the concept of raising money only when it is almost too late and your runway is already drying up. Eradicate the idea that if you do not make your metrics you lose, and say goodbye to the minority investors who can push you out.
With equity crowdfunding, a company can first raise $1M with a Regulation Crowdfunding campaign, then invest $100K of that money into legal and audit fees and then go on to raise $5M with a Regulation A+ campaign.
Both of these raises can be the sale of common shares that don’t have killer terms for the company. Better yet, the fundraising never pauses and goes on as the company grows and continues to develop the business.
What about dilution? After all, many founders spend more time worried about dilution instead of those terms that can come back to bite them. However, with equity crowdfunding, the company sets the valuation. Pick a reasonable basis for your share price and go raise.
A company could raise $1M at a $10M valuation and then go on to raise $5M at a $25M valuation without any magical performance or gravity defying metrics that only 1 out of 100,000 companies can deliver.
This concept of perpetually raising capital is a new tool for the entrepreneur to get the capital they need to grow and achieve their dreams. It’s no longer a far fetched concept or a crazy idea. It’s now a reality with hundreds of companies raising capital day in and day out.
To sweeten the deal, equity crowdfunding creates an army of shareholders that become brand ambassadors and the most loyal customers you have ever met. Not bad.