Tiered equity structure and investor conflict

About this time last year, I’d written this article for Mint about optionality in startup valuations. The basic idea there was that any venture capital investment into startups usually comes with “dirty terms” that seek to protect the investor’s capital.

So you have liquidity preferences that demand that the external investors get paid out first (according to a pre-decided formula) in case of a “liquidity event” (such as an IPO or an acquisition). You also have “ratchets”, which seek to protect an investor’s share in the company in case the company raises a subsequent round at a lower valuation.

These “dirty terms” are nothing but put options written by existing investors in a firm in favour of the new investors. And these options telescope. So the Series A round has options written by founders, employees and seed investors, in favour of Series A investors. At the time of Series B, Series A investors move to the short (writing) side of the options, which are written in favour of Series B investors. And so forth.

There are many reasons such clauses exist. One venture capitalist told me that his investors have similar optionality on their investments in his funds, and it is only fair he passes them on. Another told me that “good entrepreneurs” believe in their idea so much that they don’t want to even consider the thought that their company may not do well – which is when these options pay out, and so they are happy to write these options. And then you know that an embedded option can increase the optics of the “headline valuation” of a company, which is something some founders want.

In any case, in my piece for Mint I’d written about such optionality leading to potential conflicts among investors in different classes of stock, which might sometimes be a hindrance to further capital raises. Quoting from there,

The latest round of investors usually don’t mind a “down round” (an investment round that values the company lower than the preceding round) since their ratchets protect them, but earlier investors are short such ratchets, and don’t want to see their stakes diluted. Thus, when a company is unable to find investors who are willing to meet its current round of valuation, it can lead to conflict between different sets of investors in the company itself.

And now Mint reports that such conflicts are a main reason for Indian e-commerce biggie Snapdeal’s recent struggles, which has led to massive layoffs and a delay in funding. The story has played out exactly as I’d written in the paper last year.

Softbank, which invested last in Snapdeal and is long put options on the company’s value, is pushing the company to raise more funds at a lower valuation. However, Nexus and Kalaari, who had invested earlier and stand to lose significantly thanks to these options, are resisting such moves. And the company continues to stall.

I hope this story provides entrepreneurs and venture capitalists sufficient evidence that dirty terms can affect everyone up and down the chain, and can actually harm the business’s day-to-day operations. The cleaner a company keeps the liabilities side of the balance sheet (in having a small number of classes of equity), the better it is in the long run.

But then with Snap having IPOd by offering only non-voting shares to the public, I’m not too hopeful of equity truly being equitable any more!

The problem with venture capital investments 

Recently I read this book called Chaos Monkeys which is about a former Goldman Sachs guy who first worked for a startup, then started up himself, sold his startup and worked for Facebook for a number of years. 

It’s a fast racy read (I finished the 500 page book in a week) full of gossip, though now I remember little of the gossip. The book is also peppered with facts and wisdom about the venture capital and startup industries and that’s what this blogpost is about. 

One of the interesting points mentioned in the book is that venture capitalists do not churn their money. So for example if they’ve raised a round of money, some of which they’ve invested, liquidating some of the investment doesn’t mean that they’ll redeploy these funds.

While the reason for this lack of churn is not known, one of the consequences is that the internal rate of return (IRR) of the investment doesn’t matter as much as the absolute returns they make on the investment during the course of the round. So they’d rather let an investment return them 50x in 8 years (IRR of 63%) rather than cash it one year in for a 10x return (IRR of 900%). 

Some of this non churn is driven by lack of opportunities for further investment (it’s an illiquid market) and also because of venture capitalists’ views on the optimal period of investment (roughly matching the tenure of the rounds). 

This got me thinking about why venture capitalists raise money in rounds, rather than allowing investors continuous entry and exit like hedge funds do. And the answer again is quite simple – it is rather straightforward for a hedge fund to mark their investments to market on a regular basis. Most hedge fund investment happens in instruments where price discovery happens at least once in a few days, which allows this mark to market. 

Venture capital investments however are in instruments that trade much more rarely – like once every few months if the investor is lucky. Also, there are different “series” of preferred stock, which makes the market further less liquid. And this makes it impossible for them to mark to market even once a month, or once a quarter. Hence continuous investment and redemption is not an option! Hence they raise and deploy their capital in rounds. 

So, coming back, venture capitalists like to invest for a duration similar to that of the fund they’ve raised, and they don’t churn their money, and so their preferences in terms of investment should be looked at from this angle. 

They want to invest in companies that have a great chance of producing a spectacular return in the time period that runs parallel to their round. This means long term growth wise steady businesses are out of the picture. As are small opportunities which may return great returns over a short period of time.

And with most venture capitalists raising money for similar tenures (it not, that market fragments and becomes illiquid), and with tenure of round dictating investment philosophy, is there any surprise that all venture capitalists think alike? 

Venture capitalists, diversification and innuendo

Sometime back I was talking to a friend who is a venture capitalist, and pointed out about how one of the companies he has invested in has a great opportunity for diversifying their opportunities (I had a vested interest, for I wanted to get involved in the said diversification). This guy (the VC) wasn’t too pleased, and he said that while an opportunity existed, he wasn’t in favour of the company pursuing this opportunity.

Talking to other friends who are in the VC industry since then, I understand that in general, venture capitalists are loathe to let their portfolio companies diversify. I had never really understood why, until I discovered it for myself when I was writing this post on whether you should go to market with a focussed offering or offer a bouquet of related products. In this post on LinkedIn, I write:

..if you have venture funding, your investors will not want you to expand scope. Venture capitalists are extremely loathsome about their portfolio companies diversifying – for it makes it harder for the VCs to flip the company at a later date (the VCs themselves achieve their diversification through their portfolio, so they don’t need a particular company in the portfolio to diversify).

Bingo! There’s no surprise that VCs hate their portfolios to diversify!

Anyway, while I was editing the above post, I realised that there are some instances where I’ve written stuff that can potentially have double meaning. Since I had written those lines when I was in the flow of writing the post and I wrote them with the best intentions and no puns intended, I let them remain. Here is possibly the best (worst?) of them:

Secondly, expanding after you’ve penetrated is hard on several counts

Read the whole post!