My co-founder and I gave up 75% to our Series A investor for just $1 million. Now that the company is taking off and needs new capital desperately, we are finding it impossible to raise additional funds as most VCs won’t touch our deal. Why is this? Is there anything we can do to fix the deal?
I agree this deal structure will make it hard to obtain additional venture financing. First, you as the entrepreneurs will have little incentive to stick around for the long term given that you will have so little upside after additional rounds of dilution from new investors and your option pool. Second, egregious non-standard venture terms are warning signs that the earlier stage investor is not sophisticated and will likely continue to be unreasonable, causing headaches in the future. Third, and I am sorry to say this, such a deal structure indicates that the founders are probably not that sophisticated to have accepted the deal in the first place, or will at least raise a suspicion that some deep damage lies within the company to have justified such onerous terms.
That all said, heavily dilutive terms are extremely common outside of Silicon Valley-style investors, as most investors in the world demand strong majority stakes for even small investments. Although minority stakes are a hallmark of venture investing, most of the financial world believes VCs do not know what we are doing by not taking control positions. (They are wrong, of course.)
The first way to resolve your situation is to have a new investor demand that the company’s capital structure change as part of a new financing, which your earlier investor will accept or not. This outcome is common when an investor finds a good, but broken deal. Most investors, however, will not even pursue discussions and diligence to get to a point of serious interest when a deal is damaged. There are just too many good deals out there without problems.
The second way is you can seek to buy out the earlier investor. Real venture investors hate seeing money invested to buy out earlier investors rather than expanding operations, meaning you will be looking at other sources of capital. Most investors who would support you financially to buy out non-productive early investors will likely demand worse terms than you already have.
The third way is to renegotiate the deal with your earlier investor. This option sounds great in theory. However, most investors enlightened enough to see upside would not have structured such a bad deal in the first place. Here are a few options I have tried in the past:
- You can negotiate to “reset” your valuation and ownership split based upon achievement of milestones that create more value for the investor with the new structure.
- You can split the business by new product line, new business model, or new geography: contain the legacy business with the contaminated capital structure, but spin out additional growth into a new company where the upside is fairer.
- You can negotiate buyouts from a portion of earnings, like redemption. This solution, however, takes cash from expansion, prevents you from growing as aggressively as you could, and sets a bad precedent for future investors.
- Create management “carve outs” or phantom interests. If you negotiate payouts upon an exit to the management team in priority to equity based upon achievement of milestones, you have effectively changed the economic effect of your capital structure, even if it remains the same on paper.
- There are a dozen different permutations, but all rely upon the principle of “good dilution.” The investor must understand that it will make more money from giving incentives to the management team. Unfortunately, most investors who drive bad terms end up entrenching their positions, feeling the entrepreneurs are trying to “pull a fast one,” and end up losing substantial value when the entrepreneurs leave to start a new venture. If the investor is “strategic,” it may even have an affirmative reason to tank you in order to drive a cheap acquisition.
One important caveat is not to confuse a fair deal in accordance with market terms that now looks suboptimal since you have achieved greatness, versus one which was objectively bad and outside the boundaries of market norms at the time. Many successful companies connive with later stage investors to erode ownership of early stage investors, which hurts the startup economy by depriving angels and first round seed investors of needed returns. Those investors often fight back by forcing founders to share any ill-gotten gains in those circumstances.
I suggest you discuss with your investor the trajectory of the company with significant new capital and with the full passion of the management and founding team, both of which require a recapitalization. In my experience, though, your pleas will fall on deaf ears. As I have said many times, one of the greatest enemies of innovative entrepreneurship is bad early investors.