An Open Letter to Fellow VCs
We need to talk. I mean a real, honest, open debate about prefs, ratchets, liquidation prefs and other such ‘standard’ instruments, prolific in the industry.
I know I am a relative newcomer, having been running my VC fund, Voulez Capital, for less than a year. But I have earned my stripes, after almost twenty years in finance and entrepreneurship, focusing always on building businesses.
Let’s face it. We need a fresh approach. One that works better for our founders AND which delivers better results for us.
Two thirds of VC firms barely return initial capital, let alone make a profit. And those that do, often do so as a result of a huge windfall from a tiny portion of their portfolio.
We CAN do better. We MUST.
Liquidation prefs and other such instruments are everywhere in the industry. I recently received a term sheet from a colleague, full of these things. In response, I politely asked if they would consider ‘plain vanilla equity’. I could almost see the ‘does not compute’ message flashing in big bright letters above their heads!
Here are some of the arguments I have been given for using them:
We pay a premium for equity, which the founders do not.
We need to protect against the next round of investors, who will want them.
We need downside protection in case something goes wrong.
The list goes on and on…
Let’s call it what it is - a badly drafted pre-nup ready to explode in our faces.
1. If the valuation is right, you are not paying a premium.
Yes, founders have become obsessed with valuations. But that’s also partly our fault. We give into their valuation demands and then put in mechanisms to claw that value back.
In pursuit of growth, almost at all costs, we have created a dynamic where we throw larger and larger amounts of money at our portfolio companies, inflate valuations to make room for our friends on specific rounds, and, much worse, have moved away from focusing on the value each business is creating and towards this fictional, on paper number — valuation.
Large numbers look great on press releases and LP updates. But do they really tell us what is going on?
Plus, founders have worked their butts off, often for years, at next to no pay, have given up their savings, private lives, social lives, high earning careers and much more to launch their businesses.
Can we honestly look them in the eye and say that we are paying a premium for shares that they did not have to pay?
Anyone who ever launched and ran their own business will not be able to do that.
I certainly cannot.
2. If you build a great company investors will compete on terms
Subsequent rounds of investors might want to have these instruments but you don’t have to give them to them.
There is not a huge number of businesses out there which are gaining fast, credible traction. The further down the food chain, the fewer there are. There is, however, no shortage of investors. By focusing on building value (and not on valuations), by creating amazing companies, capitalising them at the level they actually need (rather than what looks great), we trigger the oldest instrument of all time — supply & demand. A few hundred years of economic activity has proven that it works. And works really well.
And, by the way, if my portfolio companies are generating healthy revenues, we don’t have a proverbial ‘gun to our heads’ problem, with respect to the timing of the next funding round.
Just something to consider, since we are already being controversial…
3. How many times have these instruments actually saved your butt?
I was recently negotiating with two other VCs on a co-investment into a company. They wanted ratchets in the term sheet and I pushed back.
I asked my colleague how many times in the last 20 years of his VC career, did he actually trigger this mechanism.
You see, if we ever get to a point of having to use these mechanisms, chances are it is too late and we are screwed anyway.
4. These instruments distort incentives
I was recently sent a liquidation pref calculation by another investor. It kicked in when the sale price was at or below that of the current round’s post money valuation.
As a typical geek, I ran a very basic spreadsheet of payouts for investors and for founders at different valuations.
Within two minutes two things became clear.
One — as a founder I would have never agreed to it.
Two — if it was ever triggered, we (as in, investors and founders) would find ourselves in a mortal deadlock over the sale price.
The reason for this was very simple.
With the mechanism being proposed, investors had a cash incentive to sell for an even lower (i.e. below the trigger) price, thus pocketing not just their cash but also at least some return on their money.
Founders, however, would then be losing a third of their value, as compared to a sale at the trigger price.
In the words of Amy Gardner in the West Wing — How do you like them apples?
5. They harm the investor-founder relationship
For me, this is perhaps the most important argument. I have built Voulez Capital on the strength of our relationships with our founders. They are a family. A tribe. We led our first investment while Voulez Capital was not even incorporated yet. My founders came to my house to finalise deal documents, while I was recovering from an emergency c-section and desperately trying to figure out breastfeeding.
And this approach works.
When issues arise (and they always do!), our companies don’t hide them or try to brush them aside at the next board meeting. They pick up the phone and we tackle them. Together.
This extra sounding board and strategic help is part of the value we add to our companies and I expect to see it bear more and more fruit over time. Such relationships are part of our Voulez Capital DNA.
Now, how would you possibly build them with a participating liquidation pref in place?
How do you avoid the ‘us and them’ dynamic?
How do you NOT make founders, who have put their blood, sweat and tears into the business, resentful of you, if you benefit far more than they do, in case of success?
If you strip them off their rightful portion of value, how do you expect them to continue to work hard to create it?
Ordinary shares, appropriate investor director rights, and effective checks and balances within the company, create a positive, healthy dynamic, where incentives are aligned and everyone pulls in the same direction. For the benefit of all — founders and investors!
Oh, and, I nearly forgot to mention the obvious. It is fair!
We call this our Fair Venture Principles and we hope other investors will also subscribe to them.
Anya Navidski Founding Partner, Voulez Capital Once an entrepreneur, always an entrepreneur.