Why first-time entrepreneurs should understand the role of VCs

28 August, 2015

Despite the recent market doldrums, I love the fact that the global entrepreneurial zest is in full swing, and billions of dollars are pouring into startups in Asia – India, in particular. The tech entrepreneurial wave is truly global with yours truly recently having had the pleasure of speaking with entrepreneurs from Eastern Europe (Hungary, Poland, Slovakia and Croatia are building their own consortium) and hosting a group of Turkish and African entrepreneurs in Silicon Valley in recent weeks.  The centre of gravity seems to be shifting to the East, both in terms of innovation and capital flow (that’s why when China sneezes, the world seems to be catching a cold). All the euphoria and excitement is well deserved, especially in a country like India. The domestic consumption story is a strong one, especially with a young population and consequent procreation. Add to that intellectual capital, hunger for success, embrace of hard work (mostly), persistence, jugaad, can-do ho-jaega/ho-gaya (it will be done/it is done) attitude, hyper-growth success stories acting as catalysts, and it’s not a surprise that India startup story is in the limelight.

But, some perspective is needed. One still has to realise that in the scheme of things, India is still in its infancy, especially when it comes to the venture capital industry. For all intents and purposes, the venture capital business didn’t really get going in India until about 10 years ago, which is roughly lifecycle of a single fund. Obviously, the ecosystem is developing rapidly, given the confluence of technology trends and in part because both venture capitalists and entrepreneurs to some extent are bringing their know-how from primarily the US to India. Many funds have presence on both geographies and entrepreneurs are recruiting from places like Silicon Valley. But I wanted to write this piece just as a reminder that it’s much easier to high-five each other during the “up and to the right” phase of a company’s evolution when things are going well. It’s much more difficult when investors and entrepreneurs need to have hard conversations as the company goes sideways or gets into a downward spiral.

The issue with a nascent market is that nuances or dynamics between different players(investors, entrepreneurs, employees, etc) are only understood over time, especially in those downside scenarios. First time entrepreneurs are often eager to get that branded VC on their cap table, not only for the needed capital, but as a stamp of validation, and almost as a perceived ticket to guaranteed success. Many tend to celebrate the milestone of raising capital as being synonymous with the company’s success.  I can completely understand that, especially after months of trying to raise money and hearing dozens of Nos.  In reality, that fundraise is only the beginning of a long and often tumultuous journey. The entrepreneur has sold a dream and set high expectations, which the investors have bought into and backed with their capital. The journey is actually turning that dream into reality.

Entrepreneurs better study the above, do their homework and truly understand the “what if” consequences if things don’t go according to plan, and those high expectations are not met. And how entrepreneurs act and react in those situations have repercussions downstream from a reputation standpoint, and future startups that they may be launching or joining.

Let’s get more specific. I have often said that venture capital is not for everyone. It’s the most expensive capital that an entrepreneur can raise, but it can often be crucial for a company’s success (in all honesty, VC’s probably tend to take more credit than they deserve). A partner or a firm’s experience and connections can be incredibly helpful. Having said that, just like anything else, an entrepreneur ought to do his/her diligence before getting into a relationship with a venture capital firm or a specific partner. Remember, you might be able to divorce your spouse, but divorcing your VC investor is incredibly difficult, if not impossible. So choose carefully.

Before taking venture capital, make sure you understand the key aspects of the terms of the investment. And in the excitement of finally getting venture capital, first time entrepreneurs tend not to internalise the consequences of these terms as fully as they should. Let me focus on two key terms that can cause high drama in a boardroom – liquidation preference and anti-dilution. Liquidation preference, as the name implies, is a preferred return that investors get before common/ordinary shareholders get anything in an exit/M&A. Often, the liquidation preference can be participating; so the investors first recover their invested capital, and then get to participate to the extent of their pro-rata in the remaining funds.  The issue arises when a company ends up raising significant capital, but then has a turn of events that lead to an exit that is less in value than the capital the company has raised. For example, if a company has raised $50 million in financing from VCs, but has to sell for $40 million, the investors are entitled to the entire $40 million or 80 cents on their invested dollar, but common shareholders get nothing in that scenario. That is a concept that is well understood in a mature market like the US. But in India, I have seen instances, where the promoters feel that even in a downside scenario like the one above, they should receive their pro rata of the exit, and that liquidation preference should only apply in a true liquidation of the company. That is not the case or the intent of an investment agreement.

Continuing with the above example, let’s assume that the investors own 60 per cent of the company for the $50 million that they have invested over time and promoters own the remaining 40 per cent. According to the promoters in the above scenario, they should get a $20 million windfall (40 per cent x $50 million), while the investors should get $30 million (60% x $50 million), leading to complete misalignment. There is also a situation where the promoters feel that since they are not going to get anything out of the deal, they might as well derail it, or threaten the investors that they will derail the deal if they don’t receive a decent chunk of the sale (technical term is a “gun to the head” scenario). That sort of blackmail is an unwise tactic. The well-understood compromise in these situations is something called a carve-out for management, which is usually in the range of 5-10 per cent of the transaction, depending on the circumstances. The right investors will make sure that the management and employees are somewhat taken care of, but not to the extent of a pro-rata distribution which makes the promoters rich, even though the company fails, and investors lose money. The preference stack becomes a real issue in situation where hundreds of millions of dollars (or even billions of dollars) are raised. In those cases, if the company does not go public (at which point, preferences usually disappear), but is acquired for less than the total invested capital, tensions clearly mount. This is especially painful if the promoter/management have been building the company for years only to see nothing at the end of it. Those are the stories that don’t really get publicised, but Silicon Valley is full of them. Emerging startups, especially in new hotbeds like India should also be very aware of that possibility, as that trend is sure to be replicated.

The second common point of contention is the notion of anti-dilution. The concept simply is that if the company raises capital at a lower valuation in a subsequent round, there is a mechanism for making sure that the investors don’t take the entire dilutive hit. For example, if Series A is done at $1/share and a Series B is done at $.50/share, and both rounds raise $3 million each, rather than take a 50 per cent hit, the investors have an adjustment mechanism whereby their original investment gets re-priced at $.75/share (I am simplifying to make a point, but the re-price is usually a weighted average of the share prices in various rounds and how many shares are issued in each financing). The result of the above is that management takes most of the hit of the second round dilution. This sometimes triggers another “gun to the head” scenario between promoters and investors. The promoters feel that the dilution is unfair, while the investors may feel that it’s because of lack of execution that the company did not make progress, and therefore had to raise capital at a lower valuation.

In reality, there are circumstances that are within the company or promoters’ control, and there are those that are outside of their control. Overall market environment, cataclysmic event (think 9/11) or regulatory disruptions, for example, are likely outside of a company’s control, but how they manage their business, expenses, strategic direction, hiring etc, is within their control. As an investor, in downside scenarios, I often weigh the circumstances to understand how much of the “down round” was cause by the company/promoters lack of execution versus the macro environment. I have often created incentives for management to make up the dilution they may suffer in down-rounds through additional options by delivering on milestones going forward. That way, alignment of interests is maintained, and you don’t end up in a “tu-tumein-mein” (translates to finger-pointing) at tense Board meetings.

Having said all of the above, I think it is imperative for promoters to honour the contracts that they have executed with their investors, rather than use the sideways circumstances to renegotiate terms in a hostile manner. A deal is a deal. At the same time, investors have to be understanding of the context of the situation and make sure that all parties work together to get through the challenging circumstances startups will undoubtedly find themselves in from time to time. Failing to do so, will lead to a sub-optimal outcome for all. The promoters will wonder “why the hell did they decide to take venture capital in the first place” and VCs will question their judgment by saying “why the hell did I invest in these guys”.

Bottom line: The startup game is incredibly difficult. I have the utmost respect for entrepreneurs who risk it all and put all their eggs in their one basket. But do remember that there are far more failures or “ok” outcomes, than resounding successes in the startup world. There is a high likelihood of the above situations playing out, and therefore having a practical understanding of the key terms of venture capital investments is crucial. VCs are not in the philanthropy business, and neither are they in the passive investment business (promoters often would like VCs to give them capital but have the promoters retain complete control). So, terms like liquidation preference, anti dilution, drag, tag etc are in place to have investors protect their and their Limited Partners’ capital. The sooner entrepreneurs, especially first time entrepreneurs, understand that, the more constructive and fruitful the unpredictably exciting startup journey will be. 

(Mohanjit Jolly is a partner at Draper Fisher Jurvetson.)

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Rohit Mehra . 2 years ago

Good article. Clearly explains the way VC funding typically works.

I have (sadly) come across a lot of new/ young entrepreneurs who do not even understand that funding for their company does not mean money in their personal bank accounts!

Abhijit . 2 years ago

Very nicely written

Why first-time entrepreneurs should understand the role of VCs

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