Never having been one to shy away from a complicated deal structure, I am starting to learn why term sheets and VC deal structures are so vanilla--it’s a little frustrating ;-)
If I put my entrepreneur’s hat on, it seems to me that every entrepreneur wants the chance to raise as much money for as little dilution as possible. So why not structure deals that give the entrepreneur the chance to win by doing a lot for a little, but at the same time, give the VC a win if they don’t--i.e., underwrite the entire round, but put half the money in at the VC’s target pre-$ , and have a tranche and a milestone that if triggered pulls in the other half as a convertible into the next round (probably with a discount for risk); but if the milestone is missed the second half goes in at the same pre$. If the entrepreneur does a lot for a little, then more power to them! After floating this concept past several valley VCs, and wiping the vomit off my shoes, I think I am beginning to understand the problem ... so let’s see:
VCs worry a lot about alignment with the team. Often, especially in other places, you see deals where too little money is put in, and the team is basically set up to fail, but they got the deal done and are then at the mercy of the VCs when they run out of money. Clearly there's a fundamental misalignment here, and not a good working relationship.
A good investor will always want to fund the company with whatever it needs to reach the next valuation inflection, plus a buffer in case things go wrong. If the company does everything right but the market shifts, the VCs will still likely put more money in, and convert into the next round--if the company does not, they will likely put money in too, but at the same terms as the previous round--pretty simple, right?
The misalignment in the first structure is that the VCs will be hoping that the company misses the milestone so they can get to the valuation they need to make their fund economics work--when, instead, they should be cheering the company on to do as much as possible with as little as possible, to get the best valuation on the next round. They are also misaligned on the next round, because if they don’t get the percentage they need on the first round, they will want the new lead to set a lower valuation so they can buy up their percentage to reach their original target. The valuation sensitivity of the company and desire for funky structures also tells the VCs that in the next round, the company will be inclined to take the highest valuation regardless of where it comes from--letting finance dictate strategy, rather than making the best strategic decision to build long term value.
If the VCs don’t get their target percentage, then they will be spending a full partner on working with the company, but only getting a fraction of the reward for it--a good firm will simply not do the deal, a lesser firm might, but basically won’t give the company much time, so why do the deal anyway?
The other argument is, yes, but if you can put in less money you have less at risk, and if the company trips, you will still have an opportunity to buy more. The problem with this, is twofold--most early stage firms are in the business of putting 10M to work, putting 1M in a deal wont move the needle on the fund even if it is a 10x; second, if the company trips the VCs have to take a writedown which their limited partnerss hate ...
I would greatly welcome comment and debate around this issue, especially if someone has a great idea for a deal structure that resolves these issues so we could stop arguing about valuation, and get on with building great companies ;-)
If you prefer not to post, please email me at larrymarshall@sxvp.com and put BLOG in the subject.
Larry's VC View is the bi-weekly blog by photonics entrepreneur and budding venture capitalist Dr. Larry Marshall who shares his thoughts and reflections on the VC scene, as he makes the transition from serial entrepreneur and engineer, to Venture Capitalist. He hopes to share his experiences, lessons and mistakes with fellow entrepreneurs seeking venture funding.
5 comments:
Larry - what are your predictions for the next couple of quarters on levels of VC backing for tech startups in the US? And would you expect to see the same or different trends in the US vs. Australia?
Well I can tell you that it slowed considerably in the last Quarter of last year, and has gotten more shaky since then – despite the VC investment cycle being out of phase with the macro cycle, there are a number of funds needing exits now, and getting them will be unlikely – this has made everyone nervous and caused an intentional slow down in the rate at which fresh powder is being deployed. There has been a bit of a bubble in Australia for a while, but macro issues have affected there as well – generally speaking, VCs should be funding early stage companies that are a couple of years from revenue so that they can take advantage of the downturn – instead what is happening is good established companies that are having trouble raising series B are getting down rounds because investors fear how long they will need to carry such companies before the greater market turns around. While many, many, fund managers & brokers in Sydney assured me back in January that Australia has decoupled from the US, I still don’t think it’s true ;-)
Larry - any update on this now that there's been another month from hell go by?
Larry - I sometimes wonder if the standard VC approach to risk - comes predominantly from addressing risk as one dimensional - i.e. put in less money you reduce risk. Is in not true that sometimes putting in less money increases risk? For example - a start-up is looking to solve some problems occurring in a market that is in a cyclical change - if you miss this cycle your business dynamics will change. In such start-up's a very large risk may be missing a window of opportunity or not capturing sufficient market position to be the leader. There are many other examples. Perhaps it is more a risk/return bias shift - will VC's accept less return for lower risk in this type of environment. We also here often of VC's suggesting that returns are not reduced by reducing the capital invested - I expect there are many examples of where this is the case and many where this is not - where capital must be invested to capture an opportunity. There is also an issue of return on investment at various times - when is the time to be greedy? When is the time to be aggressive? Many famous investors would argue that the best time to be aggressive is when you can achieve much more with your invested dollar (valuations, market share obtained etc). This does not appear to be the attitude of many VC's.
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