“Hey,” comes the investor’s voice on the phone, “I’ve got good news for you. We are going to make you an offer. What is more, it is at the £10 million post-money entry valuation we were talking about in our last meeting. We will invest £2 million for 20%.”
You wander around for the rest of the day feeling like a Manchester City fan might feel after Rooney has been signed. Then the term sheet arrives and your euphoria ebbs away; of course, it was unrealistic to hope that Rooney’s form would improve overnight.
And then, the next day, you are feeling positively angry about £35 million of your club’s money going on the poorly performing star striker. With those Preferred Participating Shares you have not got a £10 million valuation at all. If you sell your company for £10 million, your new investors get their £2 million preference, and then their 20% participation worth another £1.6 million - (£10 million - £2 million) x 20%. Far from getting 20% of the proceeds for their 20% equity stake, at the same exit valuation as their headline entry valuation they get 36% of the proceeds. To my old-fashioned eyes that is an entry capitalisation of £5.56 million (£2 million/36%), not the £10 million valuation so recently mentioned on the phone.
In fact, in this structure, at an exit valuation of £10 million, the investor makes 1.8 times his money. How can he make 1.8 times by selling at the very same valuation at which he came in? Even the best venture capitalists are not alchemists who can turn base metal into gold. But they are quite good at smoke and mirrors.
And they might say that this example shows that downside protection does make you money. But they are overlooking one important aspect of human nature. The PPS structure actually makes this outcome less likely. And if there has been another round of funding which has triggered the anti-dilution warrants, then this outcome becomes less likely still.
Investors rely on the entrepreneur’s energy and skills to make money. Rooney, motivated in the right way, is a great footballer. Pissed off, he’s useless. Investors make money when their interests are aligned as closely as possible to the interests of the entrepreneurs they back. Introduce a divergence of interest, create irritation or resentment, and the prospect of success recedes. So maths may say that the Participating Preference Share structure is a good idea; psychology does not necessarily lead to the same conclusion. And in my experience it is the human element that is most vital in building a business to success.
So what is the answer? How about a straightforward old-fashioned deal where the investor and the entrepreneur are both ordinary shareholders, side by side, with their interests aligned? Sure, the entrepreneur might have to accept a lower headline valuation to make the deal possible for the venture capitalist. Sure, the venture capitalist will need to sacrifice some protection at the bottom end. But if it makes achieving the upside more likely… well, surely it is as much of a no-brainer as Rooney scoring goals again.
About Simon Acland -
He worked as a venture capitalist for over 20 years. He was managing director of Quester, one of the UK's most active technology investors with more than £250 million under management. He was non-executive director of 23 companies in Quester’s portfolio. 7 of these were floated, 2 reaching the FTSE 250, and 8 were successfully sold.
His book ‘Angels, Dragons and Vultures – How to tame your investors…and not lose your company’ is published on 21st October and is available from Amazon
http://www.amazon.co.uk/Angels-Dragons-Vultures-Investors-Entrepreneurs/dp/1857885511/ref=sr_1_1?s=books&ie=UTF8&qid=1285684139&sr=1-1
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