The dark world of investing in startups is exposed in this piece that details what legal ways some investors use to crush founders and leave them broke. This piece dives deep into how it works, who’s a target, and how to avoid being left broke and screwed by investors.
A few weeks ago Rus Yusupov, founder of Vine, found out that after a $30 million dollar sale in 2012, Twitter is shutting down Vine. The Tweet that followed sums up many startup founders egregious feelings towards investors.
When you hear a founder saying something like this after a company sale, it’s a big red flag that something bad happened with the founder’s shares. There are numerous other examples of founders getting screwed out of their business by investors.
Lane Beck, founder of the $50 Million dollar backed startup Get Satisfaction, notably got nothing after his startup was sold to social media management company Sprinklr in a “fire sale”. This, and others like it, are evidence of something that’s happening regularly with startups and isn’t getting much media coverage.
Here’s how it works
In general, if an VC investor has 10 startups, 9 of them will lose money. The investor has to cover the loss of the 9 by making as much profit as she can from the 1 successful startup. Since there’s no way to know which one will succeed, keeping profit options as high as possible must be built into each relationship from the start.
Here’s How Investors Squeeze As Much As They Can
Replacing management is a popular method for screwing the original founders of a startup. In the TV show Silicon Valley this happens to Pied Piper’s CEO Richard Hendricks, and he gets replaced by the board of directors. Like in TV show, new management may be older, more experienced and is probably a loyal soldier for investors.
In addition to losing position and influence in the company, ex CEO may also lose vesting rights for the remaining shares, resulting in significantly lower stake at exit.
The next one used to trick startup founders is liquidation preference. They are supposed to protect investors in downside scenario, but in reality they are heavily misused.
Let’s say your startup is worth $10 million, including $1 million of investment you ask for 10% stake. A slick VC may say “let me give you $10 million instead.”
The startup says “I don’t need $10 million because it will dilute my shares close to 50%.”
“Let’s value your startup at $100m” – investor says, and you take the bait.
Then the investor says that there are a few small details we need to include, and downplay the liquidation preferences added by his lawyers. Some investors even put a 3x non-participation liquidation preference in a contract. This means the investor will get 3x his money before anyone else can get any profit.
It’s like a loan with 300% interest.
The next investor wants to play the same trick. They put $100m more, with a 2x liquidation preference in it. By the time the business is sold (which is very unlikely) for $1 billion, the first investor is getting 2x of $10m and the second is getting $200m. This is still a good deal for the founder at this point.
But here’s the trick: the investors don’t intend to sell this business for $1 billion.
They want to sell (or know they can only sell) it for just above their liquidation preference rate amount. Sometimes investors will say “let’s sell it at $20m above our liquidation preference, so there will be $20m for the founders and anyone with a lower class share of stock.” Other times, founders get nothing.
Investor On Investor Scamming
In this scenario, the most recent investor with higher liquidation preferences get paid out first, while early stakeholders get nothing or unproportionally low.
Imagine how this works for investor pyramids like Uber or AirBnb that have rounds and rounds of investment. The more the new investors put to the top of the investment pyramid the less likely the early stage or angel investors are going to get anything. Companies have to enforce special limitations on transfer of shares to avoid panic secondary sales.
Investors can also force a startup’s sale. They do this by having a drag along clause in the contract. This type of clause may say, “the owner of at least 10% of X shares has the right to execute the drag along right (sale)”, forcing all other shareholders to sell even if they have no intent to do so.
Vested Share Strategy
The next way founders sometimes get tricked by investors is by vesting the shares. Let’s say I own 10% of the company where you own 90%, and as part of the investment agreement I request that you vest your shares. This means you pledge to get them back over a period of time (let’s say 5 years). Let’s also say I have the right to fire you after 1 year, but your shares don’t vest until 3 years, you’ve just lost ⅔ of your shares.
Then if they hire someone else, and put their non-vested shares in a new employee, you don’t get any shares, and don’t even work at the company any more.
The ‘Spending Money Like It’s Nothing’ Strategy
During a board meeting the investors says to you, “Hey, why do you have so much cash? We didn’t give you money to let it rot in the bank account. The market is not going to wait for you. Go and spend it to grow the business – and when you need more, we will give you more. We love you.”
“Grow fast or die fast” they say.
Then, once you are out of money and there is no other investor on the horizon, they will offer an unfavorable next round of funding, called a “down round”. The company is valued at a lower price because it is out of money. Then the startup founder has an option of losing everything or taking money and giving more stake to the investor.
The ‘Time Bomb’ Strategy
This one is directed at early stage startups, and some of the most well known VC firms are using it. The very popular VC wants to invest and offers a convertible note with a very favorable valuation cap, let’s say at $7m.
Anything above $7m converts into equity at $7m. That is completely legitimate. But this VC puts in the fine print something that says “If you fail to raise the next round, we have the right to demand our money back, or convert it into equity at $1m cap.” This amount of equity equals the entire value of the company, and just like that, the startup founder is screwed, if they fail to raise next round on time.
How Investors Use Founder’s Ego To Crush Them
Most first time founder aren’t paying attention to small details, they only care about optics. What’s the valuation? Do the investors respect me? And so on.
A good investor shields the founder from his ego. The VC says “I don’t think your company is really worth that much. You should reconsider and make it more realistic, so you don’t put yourself in jeopardy in the next round.”
A bad investor plays on this ego issue and says “I’m ready to give you the biggest evaluation on the market. You don’t need to deal with those losers who don’t think you’re worth that much. I just have a few small details we need to change in the contracts.”
The founder’s ego may feel good, but if he’s not careful, he can give away the company.
Look Out For This Minor Thing That Can Become Major
Investors are very strict on what kind of expenses they will pay for from the management fees. Normal funds typically charge 2% of management fees from their investors per year. But at the same time, they may try to spread the cost around with their business partners (startup founders), and sometimes investors put more of their expenses on the startup.
The investor may say, “I put $1m into you, but you have to cover my costs of closing this transaction with you” These costs incurs to $100k, and you end up returning 10% of what you got as investment.
If founders are not careful with these details, they could be losing a significant part of the investment.
Years ago I was part of a startup and we received $1m investment, but the investor surprisingly charged me $50k in transaction costs. When I asked him about it, he said “Do you remember all of the expenses we incurred, the travel, the restaurants and everything else?”
When I told him I didn’t think we spent $50k, he said “Well, we had to do the same for all of these other founders that we never invested in.”
Swimming With [Sharks] And Protecting Your Startup
Get good advice, get a good lawyer. Stick to whatever is the common practice. Avoid any non-standard clauses in the agreement. Founders must force their ego to stay out of the equation. Nothing will go well with this one.
In many cases founders want celebrity investors, who have the name and reputation to execute all these tricks. Desperate founders agree to any terms, which screw their co-founders, angels and other investors.
Having at least one trusted early stage investor or advisor as well as professional lawyer can keep startups from stepping on these landmines.