Continuing my love-in with founders this week, I wanted to share some thoughts around founders and exits.
When VCs invest, they do so through preferred shares. These vary in shape and size from straight “plain vanilla” prefs to very complex founder-unfriendly prefs. The main goal of holding prefs vs. common shares (the ones founders have) is to enable VCs to exercise their “liquidation preference”. This allows them on exit to choose between converting to common and taking their share of the sale price, or taking their cost base off the top (this is the liquidation preference) leaving common shareholders with whatever is left.
It goes without saying that if a VC is exercising its liquidation preference, then the sale price is a modest one. Otherwise, they’d convert to common. What I find all too often, from both investors and entrepreneurs, is that there is so much thinking and effort put into these deal terms, when all we should be thinking about is how to create big enough win that we all end up holding the same shares and splitting the spoils of victory between us.
Everyone’s goal should be to create enough shareholder value that the common shareholders win big. This thinking has long-term benefits for the ecosystem by:
- Bringing more angels in to the mix (because they will have less fear about being crushed by VCs)
- Enabling more repeat entrepreneurs
- Creating more angels (because we have more entrepreneurs that win big when their companies exit)
This last point is a key characteristic of the US early stage funding landscape that is missing in Canada. In the US, it is “relatively” easy to find angels who come from the domain. They may have made their money in selling software or web 1.0, but its not a huge leap for them to get today’s new crop of startups. Here in Canada though, this is less common. I often find myself explaining startups to people who made their money in completely unrelated industries. It is frustrating for everyone.
One of the more exciting developments in the funding landscape these days is the emergence of seed or micro VC funds and super angel funds. Some people think there is a bubble in this part of the funding chain. I think that the reason we are seeing more seed funds is simply natural market forces adapting to today’s reality. Entrepreneurs do not necessarily want to go down the big VC path. At the very least they want the choice of only going big later.
For example: in this interview with Paul Graham of YCombinator, he says that 70% of his graduating cohort go on to either raise series A or not need to. i.e. they become cashflow positive after getting $ 25K from them.
Chris Dixon has some great thoughts on why seed investors are great for entrepreneurs here.
If you raise from seed funds and angels, there is complete alignment between company and investors. We’re all in it together. Neither has big capital bases. We often hold common shares together. Even if we don’t we’re all fine with an early exit. If we choose together at some point to double down, raise VC and go for it, it’s fine. But at least we have preserved the choice to go out early. And by taking this dual track, capital efficient approach, we have maximized the chances for founder success at every step.
Coming back to my original point. Its not a “real” exit unless the founders and common shareholders win. This is what we should all be shooting for as entrepreneurs and investors. This is the key metric (% of deals where the founders are in the money) if we want to build a long-term viable startup ecosystem of successful, repeat entrepreneurs, value-add angels, and funds (be they seed or VC) that deliver returns to their investors.