The Price of Money Part 4: Say No, No, No, No Till Your Tongue Bleeds

31 OCT 2009

I have been writing a series of articles recently entitled “The Price of Money” that grew out of my unease that people neither understood how great the cost of capital is nor the enormous difficulty involved in pricing capital. I was further dis-enchanted by the rhetoric amongst government ministers reciting mantras of entrepreneurship and access to capital as though their wholesale theft of the language of the Schumpterian community absolved them from actually doing anything effective in support of small business growth.

What tipped me into action was Jason Calacanis’ outrage recently that some Angel Investor networks were charging unwary entrepreneurs to pitch; the “pay-to-pitch” scandal. I was caught off guard by his naïveté. As I said in my first essays (The Price of Money: Sex, Lies & The Bottom Feeders of the Angel Community,  The Price of Money Part 2: At Least You Can Eat Catfish, & The Price of Money Part 3: Angel Investing & One Night Stands), no one should be charging entrepreneurs merely for the right to pitch to them and then disguising the fee by claiming that they provide investment readiness support, or they  help them write their business plan. That is a just a form of “tying”: forcing you to buy one product to get access to another and shifting the cost of one onto the price of the other.

And Jason is naive. At least he appears so. Because the chain of iniquities may start with the egregious behavior of the bottom feeders who swarm around the business support industry like so many curb-side window cleaners in Manhattan, or tourist guides outside the Taj Mahal; but it continues right up into the lofty thin air summits of the most successful venture firms whose behavior is primarily characterized by doing only those things they can get away with, and doing everything they can get away with.

This is not a rant about VCs though. It is a measured reflection on power and the inevitability of a bad deal when there is a tremendous difference in negotiating power. Money, after all, is in short supply. Or to be more accurate, it appears in short supply because the venture industry has grown up without any need for disclosure and thus has been able to limit the access of the people with the money (the limited partners) with the people who want the money (the entrepreneurs). And that will be the subject of another post.

But for today, accepting the reality that there are a relatively small number of VCs and a nearly unlimited number of entrepreneurial opportunities; then it is inevitable that the VC will have the upper hand in negotiation. And that some VCs will not feel constrained by any impulse when it comes to negotiation.

The heart of the matter is that you cannot know how expensive capital is if you don’t know the value of the business of which that capital is purchasing a part.

Furthermore, the only way to know the value of an investment is to get two investors bidding over it. Why is this so? Well, I presume everyone understands that valuing things gets different when the number of transactions one can benchmark against goes down. Take homes for example, the reality is, is that a home is only worth what the other guy will pay for it. And the only way to get a decent price on a home is to get two people bidding on it. The highest value will emerge. Moreover, the buyer and the seller are on essentially equal footing. If you can get a couple of interested buyers, they will each be forced to reveal the highest amount they are willing to pay and the competition forces that information out of them.

It is no different with VCs except that it is a requirement. That is, in the absence of a competition, unlike the residential home market where there is broadly even negotiating power, in the venture capital market; there is a huge power difference between the VC and the entrepreneur. Thus in the absence of competition, and in the absence of meaningful benchmarks, or transparency of prior transactions, the price can fluctuate wildly: almost indiscriminately. In fact, I have seen VCs make offers that assumed the company was worth nothing, nada, zippo, not a cold hard dime. And of course, it was perfectly evident that that wasn’t the case.

Whatever else you may take from this essay, take this: if you want a good deal get two VCs to bid. The corollary to that is no matter how annoyed they may get with you, do not tell VCs which other VCs you are in discussions with. Because they will frequently just call each other up and form a syndicate removing the opportunity to get bids. Oh, and they generally don’t like it when you do that. I have seen VCs stand up and walk away, calling me rude and other names when I politely declined to tell them who else might be giving me a term sheet. It is a discussion for another day how to manage such an issue. Today I remain firmly focused on one point. You cannot know the value of your company and thus how much you should sell a portion of it for unless two or more parties are competing for the money. In the absence of that, some VCs will take extraordinary advantage of you.

Which brings me neatly back to why I think Jason is slightly naive. As offensive as it is for skulking figures in the undergrowth to be charging entrepreneurs to pay to pitch; how much more offensive is it when a VC takes a 2 times liquidation preference or insists on reverse vesting of founders shares. In each case there is a genuine economic concern that the investor has a right to have protection against; but in each case the fair approach is rarely employed.

Liquidation Preferences or “I Used Cash You Simply Gave Up Your Life So I Get My Money FIRST!”

A liquidation preference if you are not aware is the means by which the order of payback is determined at the point of a liquidity event (ie when folks might get their money like going public, or selling the business etc). Now naively you might think that if a VC bought 30% of the company then, when the company sells, they should get 30% of the money. Well, maybe. Let’s use an example. If the VC invested 300,000 for 30% then the value of the company just prior to his investment was £700,000 (“the pre-money value”) and it was worth £1,000,000 (“the post-money”) just after the investment. Thus £300,000 neatly equals 30%. But let’s say that for unknown reasons the company is sold for £500,000. Then the VC get 30% of 500,000 or £150,000. The founder who hasn’t put in any money walks away £350,000 richer and the VC walks away £150,000 poorer. Not good.

The general view, and one I agree with, is that the cash investors should be able to get their cash back before the non-cash investors are entitled to receive money. Thus in this scenario, the VC would get his £300,000 out of the £500,000 and there would be £200,000 to distribute. And this is where things get complicated. One view is that the £200,000 should be split 30%/70%: the VC gets an additional £60,000 and the founder gets £140,000 in direct proportion with the share ownership (30:70). Another view is that the founder should get the entire £200,000 and in fact he would get all the money until he got £700,000 so that the VC and the founder’s ratios once again matched.

Not many VCs like that idea. In fact, they do much the opposite. They will assert that there is a dividend on the preference shares (say 10% per annum). They won’t take the cash but they will expect it to accrue. And they will in addition ask for more than a 1X liquidation preference. Let’s say 2X for giggles sake.

In that scenario, assuming the investment had been made one year earlier. Then the VC would get its £300,000 back; it would then get £30,000 for its accrued interest, and then it would get the remaining £170,000 because it would be entitled to 2 times its capital before the founder gets anything. So even if the company were sold for £1,000,000: the amount it had been valued at when the investment was made. One year later the VC would get £630,000 and the founder would get £370,000. Even though the founder owned 70% and the VC owned 30%.

Just shake me when you think this starts getting fair, Jason.

And I haven’t even gotten to reverse vesting. And I don’t think I can right now. I need to lie down. But I will say this. If you are going to get investment, it is your job to know what you are doing. And it would be my pleasure to teach you. For the first time, the School for Startups is going to be holding a boot camp on investment. It is being held on November 18th at the Royal Institution. It’s eight whole hours and costs £95 (or less if you are a student or a social enterprise). C’mon, let me lead you to the water….It’s your call whether you drink. (To sign up: Register Here)

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