Later-stage rounds and “setting the bar too high”(cdixon.org)
cdixon.org
Later-stage rounds and “setting the bar too high”
http://cdixon.org/2011/12/13/later-stage-rounds-and-setting-the-bar-too-high/
4 comments
Sure, the VCs know how to take care of themselves, but what about the risk of putting your employees underwater?
That's every financed startup, regardless of whether the company gets a spectacular valuation or not.
This point feels pedantic (sorry), but it's worth pointing out that underwater employee options aren't some weird corner case. It's the common case.
This point feels pedantic (sorry), but it's worth pointing out that underwater employee options aren't some weird corner case. It's the common case.
Startups are risky to begin with, but raising a big round shifts the risk from founders to employees.
Based on the emails I get from recruiters bragging about how much money their companies have raised, it's clear that most engineers don't understand this, even if it's obvious to founders.
Based on the emails I get from recruiters bragging about how much money their companies have raised, it's clear that most engineers don't understand this, even if it's obvious to founders.
I'm not even disagreeing with you, so much as I'm saying "it is probably a common misunderstanding that less capitalized startups have lower 'employee risk'†".
No; the reality is that the "employee risk" is complex and has as much to do with revenue growth and market conditions as with capitalization. Some firms capitalize on spectacular growth, and some huge capitalizations also create strategic leverage for the whole company that improves outcomes for employees.
But in every case, equity in a financed startup is freighted with enormous risk. The fundamental issue is simple: corporations are managed by boards of directors chartered with looking after the good of the shareholders, but, in virtually every financed startup in the world, the actual board puts employee outcomes low on the list, invariably below investor outcomes.
This is actually as it should be. You could no more demand a more "protective" board for employees as you could a 50% increase in valuations; market conditions and pricing are what controls board makeup.
One of the few gratifying memes emerging on HN over the last two years (just after "use bcrypt") is the notion that startup employee options are very risky. I'm writing noisily to combat any implication on this thread that you can mitigate that risk by picking undercapitalized startups to work for. If you want to avoid the conflicting interest risk with startup boards, avoid financed startups.
Or, don't; financed startups are also the ones that (rarely, very rarely, but still) return huge rewards.
† Imprecise, but let's have it stand for "risk that employee stock options are worth zero".
No; the reality is that the "employee risk" is complex and has as much to do with revenue growth and market conditions as with capitalization. Some firms capitalize on spectacular growth, and some huge capitalizations also create strategic leverage for the whole company that improves outcomes for employees.
But in every case, equity in a financed startup is freighted with enormous risk. The fundamental issue is simple: corporations are managed by boards of directors chartered with looking after the good of the shareholders, but, in virtually every financed startup in the world, the actual board puts employee outcomes low on the list, invariably below investor outcomes.
This is actually as it should be. You could no more demand a more "protective" board for employees as you could a 50% increase in valuations; market conditions and pricing are what controls board makeup.
One of the few gratifying memes emerging on HN over the last two years (just after "use bcrypt") is the notion that startup employee options are very risky. I'm writing noisily to combat any implication on this thread that you can mitigate that risk by picking undercapitalized startups to work for. If you want to avoid the conflicting interest risk with startup boards, avoid financed startups.
Or, don't; financed startups are also the ones that (rarely, very rarely, but still) return huge rewards.
† Imprecise, but let's have it stand for "risk that employee stock options are worth zero".
The most likely exit for today's startups is a talent acquisition. In that event, would you rather be at an "undercapitalized" startup or an "overcapitalized" startup?
What's the difference? The "valuation" of a talent acquisition is about retaining talent. No matter what your shares are worth on paper, your outcome is going to be the same; if the paper itself doesn't say so, the retention grant will.
Why would a company do a "talent acquisition" at all if the best team members were immediately going to leave for a better upside elsewhere?
Similarly, if the outcome for the company is "talent acquisition", the outcome for an employee who leaves before that exit is probably zero.
Why would a company do a "talent acquisition" at all if the best team members were immediately going to leave for a better upside elsewhere?
Similarly, if the outcome for the company is "talent acquisition", the outcome for an employee who leaves before that exit is probably zero.
That DropBox example is not typical though. What about the case when investors want to invest a couple of million, and make the valuation 10-20 million. Wouldn't that rule out a potential acquirer who wants to acquire it for $5 million after a couple of years? Because the investors want a bigger return? Investors are looking for home-run. You, as a normal Joe are happy with a base-hit and some fu money.
Uh, yes?
As a rule of thumb: you can't take a VC round expecting to exit for $5MM. If you're looking to exit at $5MM (which is totally reasonable, in fact more reasonable than shooting the moon), you're looking to bootstrap.
As a rule of thumb: you can't take a VC round expecting to exit for $5MM. If you're looking to exit at $5MM (which is totally reasonable, in fact more reasonable than shooting the moon), you're looking to bootstrap.
Why do founders and VCs get different stocks? I just do not get this logic. I am fine with you getting your money out first, however if that is the case, you shouldn't have any sort of vote on the outcome of the company. You should just be a silent partner.
Why is one startup worth $10MM and the other $20MM?
Because prices, like terms, are set by the market.
Is there any fundamental reason a VC gets participating preferred stock? No! By all means, when you fund your next company, refuse that term.
Obviously, every VC you talk to may then walk away. But maybe not.
The question of "why do VCs demand this term" is closely related to your question (and maybe what you intended). The answer appears to be "to protect from the risk of putting $5MM into a company and having an outcome that is lucrative for the founders but loses money for the VCs". The idea is to align the interests of the company operators and the investors, by taking the money the VCs themselves put into the company out of the equation for the outcome.
Because prices, like terms, are set by the market.
Is there any fundamental reason a VC gets participating preferred stock? No! By all means, when you fund your next company, refuse that term.
Obviously, every VC you talk to may then walk away. But maybe not.
The question of "why do VCs demand this term" is closely related to your question (and maybe what you intended). The answer appears to be "to protect from the risk of putting $5MM into a company and having an outcome that is lucrative for the founders but loses money for the VCs". The idea is to align the interests of the company operators and the investors, by taking the money the VCs themselves put into the company out of the equation for the outcome.
An important point to keep in mind is that, in order to maintain flexibility, entrepreneurs shouldn’t give new investors the ability to block an exit or new financings. Investors can get this block in one of two ways – explicit blocking rights (under the “control provisions” section of a VC term sheet) or by controlling the board of directors. These are negotiable terms and startups with momentum should be very careful about giving them away.
There's the rub.
Founder control of the board is hard but possible.
I really can't imagine a VC fund being happy about an exit below the valuation at their round, especially when they have deployed a big chunk of their fund via a big round.
Any experienced VCs/founders want to comment on how common it is for startups to be able to negotiate a term sheet where VCs have no explicit blocking rights?
For reference, YC's AA round template documents for angel investments, widely considered to be very founder friendly, include the following:
So long as any of the Preferred is outstanding, consent of the holders of at least 50% of the Preferred will be required for any action that: (i) alters any provision of the certificate of incorporation if it would adversely alter the rights, preferences, privileges or powers of the Preferred; (ii) changes the authorized number of shares of Preferred; or (iii) approves any merger, sale of assets or other corporate reorganization or acquisition.