Wicked VCs – How To Not Get Screwed

No Comments

Searching for capital? You may want to think twice about it. As I tell every new entrepreneur, do everything you can to avoid getting investors with your new company. If you truly believe in your idea I recommend bootstrapping, a bank loan, or friends and family before getting involved with Venture Capital.

Before I dig in, I want to start by saying, not all VCs are bad. In fact, the right one will help you make connections, find new customers, and help you grow professionally in ways you can’t even imagine. VCs like Sequoia, Benchmark, and Andreessen Horowitz are the firms that entrepreneurs dream to work with. However, these VCs are very hard to get into. You basically need to have deep connections or have fame already. Just like the music business, it’s best to make your own fame by truly hustling, building your awareness, and getting sales on your own. Only then will the famous VCs call you.

Now for the lesson. Here’s how VCs can screw you:

Participating Preferred, Liquidation Preferences

Participating preferred stock is a type of preferred stock that gives the holder the right to receive dividends equal to the normally specified rate that preferred dividends are paid to preferred shareholders, as well as an additional dividend based on some predetermined condition.

Example of Participating Preferred Stock: Suppose Company A issues participating preferred shares with a dividend rate of $1 per share. The preferred shares also carry a clause on extra dividends for participating preferred stock, which is triggered whenever the dividend for common shares exceeds that of the preferred shares. If, during its current quarter, Company A announces that it will release a dividend of $1.05 per share for its common shares, the participating preferred shareholders will receive a total dividend of $1.05 per share ($1.00 + 0.05) as well.

Now consider a liquidation event. Company A has $10 million of preferred participating stock outstanding, representing 20% of the company’s capital structure with the other 80%, or $40 million, made up of common stock. Company A liquidates, and the proceeds are $60 million. The participating preferred shareholders would receive $10 million but also would be entitled to 20% of the remaining proceeds, $10 million in this case (20% x $60 million – $10 million). Nonparticipating preferred shareholders would not receive the additional consideration. (Source: Investopedia).

VCs can also set a multiple on a “Liquidation Preference”. Which mean a VC can specify which investors get paid first and how much they get paid in the event of a liquidation event, such as the sale of the company. I’ve seen some at a 3x multiple, which means that the investors are guaranteed to get 3 times their investment back before you get anything.

Blocking a Sale

This is a biggie and happened to me personally in one of my companies. You need to understand that VCs only care about one little acronym I.R.R. (investor rate of return). They don’t care about you, your family, your employees, your customers, or your company. Their sole measurement is how much their entire fund returns for the limited partners (their investors). VCs seek BIG wins because many of their businesses fail. Typically they like to get at least a 10x return on their investment. So, if you get $1M in funding, they want $10M when you sell. So the bar quickly gets set pretty high for what they are willing to accept as an exit amount.

Manage Your Executive Team

Most investments have provisions of who you can hire and fire on your management team. Many even include limits on how much you can pay for your talent, etc. While these are meant to protect the VC’s investment dollars, they can also be a huge pain in the ass. Imagine you’re interviewing for a new VP of Sales (like I was) and not only does the candidate need to interview with you and your management team, but also your investors who know nothing about your business or industry, yet have very strong opinions on who they like with zero facts to back up their choices. Additionally, imagine that you hired the wrong person on your management team and you desperately want to make a change but the investors won’t let you terminate that person. VCs can take over total control of your hiring process and it can hurt your company.

Letting You Bleed Dry, Then Save You

Getting money from a VC is great for growing your company, but it can also be bad. I was often called a “fiscally conservative CEO” by my investors because I spent our money more cautiously than they wanted me to. When you get funded, the investors want you to grow quickly. Their main goal is to increase revenue (in some companies it’s users) as fast as you can, then get acquired for multiples of your revenue before you run out of cash, period. Most VCs don’t care about being profitable, which didn’t sit well for me as a Midwest CEO.

I have seen many companies spend their money as fast as the VCs have instructed them to do so and then let them run out of money. When the company is down on their knees, the VC will offer a loan, convertible note, or a bridge round to “save the company”. Although they act as if they are doing you a favor, they will often cut your valuation in half and pick up much more of your company at your time of need.

Tranche Funding

In my experience this typically happens with Series A rounds only. In a tranche deal, VCs will agree to give you your investment amount, let’s say of $1.5M, but want to fund you in stages. So you get $500k now, $500k once you hit the milestone, etc. Don’t be so desperate to take this type of deal. If you fail to achieve the agreed upon goals, they could take a larger percentage of your company OR let you bleed dry (see above). I’ve fought and WON this approach a few times with investors in the past just by telling them “no thank you” and that a tranche deal will force us to spend more cautiously. If we fear losing money, we’ll not use the funds aggressively and won’t grow according to our plan. They hate slow growth, so both times, my companies were fully funded and away we went.

Valuation

If you value your company too low, you get diluted quickly. But if you value your company too high, you might never hit the I.R.R. your VC is looking for and will never see an exit for yourself or your shareholders. Make sure you really believe that you can hit your numbers. VCs have several ways of punishing your performance by taking additional equity, reducing your salary, and even firing you, yes you, if things don’t work out. Always under promise and over deliver on your sales/growth plans.

Different Stock Classes

In one of my companies, I had decided to sell my stock to a private equity firm. Now, I was aware of Preferred Stock, Common Stock, Warrants, and Options, but I did not know that VCs could create different classes of stock within those investments. So the VC who bought my stock wanted to create a Preferred A2 class stock which would grant them more rights than Common shareholders (i.e. my dad who helped me get started) but would be less rights than the Preferred A guys (the big VC firm). Be aware of your VC’s ability to create additional classes of stock without your approval. It can ultimately screw over your original investors and that’s just not cool.

Additional Dilution, Debt, Poison Pills

There are tons of ways VCs can write additional ways of controlling your company into your term sheet. VCs can issue additional stock if you fail to hit any of your promises. I remember one of our first funding rounds where we had about $150,000 in outstanding debt. We told the VC that we could “probably pay off that debt within a year”. Well, they held us to it. In fact, we had to get rid of it all within a certain time period or they would receive an additional equity stake in our company. Surprisingly, my co-founder negotiated almost all our debt to zero within the first 14-days of getting funded. I think the VC was shocked we were able to pull that off. We saved ourselves a lot of equity.

There are also “poison pills” that can be written into deals. According to Investopedia, there are two types of poison pills:

1. A “flip-in” permits shareholders, except for the acquirer, to purchase additional shares at a discount. This provides investors with instantaneous profits. Using this type of poison pill also dilutes shares held by the acquiring company, making the takeover attempt more expensive and more difficult.

2. A “flip-over” enables stockholders to purchase the acquirer’s shares after the merger at a discounted rate. For example, a shareholder may gain the right to buy the stock of its acquirer, in subsequent mergers, at a two-for-one rate.

5 Key Takeaways:

1) Not every investor’s money spends the same – Make sure the VCs you want to work with bring more than money to the table. Nothing is more frustrating than having monthly board meetings with a group of people who have no idea what industry you are in.

2) Always take the extra money – If your goal is to raise $1.5M, go for $2M. You’ll never have enough and you do not want to get bled out (see above).

3) Get an employment contract – This is different than an employee agreement that you’re used to seeing when you had a day job. Top executives get employment contracts that guarantee severance pay, stock awards, etc. Get one and know in advance what happens to you if the board wants you out.

4) Choose your board wisely – Don’t let your VCs choose your board. Give them the seat they ask for and select people your trust for the rest. Do not go for famous people, they won’t have time to help you. Trust is key.

5) Be bold, lead your board, shareholders, and employees. You made it this far by taking charge initially. Your board should verify your decisions, not make them for you. Make bold decisions that will have everyone walking off the plank with you. You’re the boss.

The Good VCs

As I mentioned in the beginning, not all VCs are bad. In fact, there are some that truly help in several ways. I’ve worked with some that provide full operation support (accounting, recruiting, marketing) and office space for their portfolio companies in addition to capital.

If you’re considering raising money through a VC firm, be sure to do you due diligence on them too! Talk to other portfolio company CEOs, ask some of their limited partners how they work, speak to analysts who know them before making a deal.

Check VC firms ratings from other entrepreneurs:

I hope this post helps aspiring entrepreneurs who are seeking funding. Please let me know if you have any feedback.

About Me

Jason Weaver is a prominent author, and a thought leader in product innovation, usability and entrepreneurship. He is considered an authority in social media and mobile marketing. He frequently keynotes industry conferences, summits, and corporate events.

Jason founded and successfully exited from two technology companies including Shoutlet, a leading Social Media Management platform. Today, he runs Halo, a strategic consulting firm that uses innovation, partnerships, and people to fuel rapid growth.

His book, “Manager’s Guide to Online Marketing” , from the Briefcase Book Series (McGraw-Hill) is available at Amazon.com and Barnes and Noble worldwide. Jason has also authored articles for world renowned publications, such as Mashable and Forbes.

Previous Post
Startup CEO Survival Guide Podcast
Next Post
7 Must Read Books Before Starting Your Company

Leave a Reply

Your email address will not be published. Required fields are marked *

Fill out this field
Fill out this field
Please enter a valid email address.
You need to agree with the terms to proceed

Menu