<Taking the long view (when building the business)Monday, March 11th, 2013
by Roger Ehrenberg

In the wake of my SXSW chat with Lauren Lyster of Yahoo! Finance, I once again began to think about the relationship between equity valuation and business decisions. In my perfect world, a business is financed in a manner that optimizes financial outcomes by creating a set of decision points along its growth trajectory.

This “optionality” is created by raising capital at times, in amounts and from investors that fund and support the business to the next series of key operating milestones, at which point an assessment can be made: is this working how we’d like? Are we doing a good job tackling our execution challenges? Has the competitive landscape changed? Is our company of particular interest to one or more buyers who are willing to pay for the next several years of growth? This necessarily implies that different kinds of investors can help at different phases of a company’s growth, and that long-term founder goals are essential inputs to the decision-making process.

This also encompasses the concept of founder liquidity, which at appropriate times can be used to re-align motives between founders and investors. As a business becomes increasingly successful, is scaling rapidly and third-party acquisition offers are an ever-present option, it is important to re-visit the goals of both founders and investors. When a business is first seeded, founder/investor alignment is generally tight because both parties want to prove out the business, achieve product/market fit and secure happy customers. But once this happens and the company moves from “proving” mode to “scaling” mode, this alignment can often diverge, especially with first-time founders who haven’t made much money and have gone all-in on their start-up. It may be that both founders and investors believe the business can grow into a multi-hundreds of millions or even billion-dollar exit, but that an M&A offer for $80 million that puts $20-$30 million into the founders’ pockets is just too compelling to pass up. This is the time when a new growth financing coupled with a secondary purchase of founder stock could reduce the founders’ risk profiles, still preserve that vast majority of their ownership and give them the peace-of-mind to redouble their efforts to build a huge company. This closes the yawning mis-alignment bred by success but can only emerge from an environment of partnership, trust and long-term vision.

This is a completely different mind-set than founders saying: “I want to maximize valuation, minimize dilution and treat investors as fungible sources of capital.” In my opinion, this is a dangerous game for founders to play as it sharply reduces the margin for error in executing the plan. In my experience the business-building process is anything but linear and the unexpected and unplanned is the norm. Achieving product/market fit at scale is, as you well know, insanely difficult, and no seed stage company, by definition, has achieved this or they wouldn’t be a seed stage company: they would either shun investor money altogether or jump from a bootstrapped rocket ship to raise a later stage growth round. So just to be clear this isn’t what I’m talking about; I’m referring to the 99.9% of start-ups that have an early product, have engaged with some early customers and are looking for money to continue to prove out the market and achieve a measure of product/market fit. These companies in the best of cases are fraught with risk and will not be fundamentally de-risked for quite some time. This is when having strong investors who are aligned with you is particularly valuable, as they can help provide interested and knowledgeable third-party perspective, serve as a healthy counterweight to the unbridled optimism of early-stage teams and work with management to devise a set of KPIs and metrics for the business. Should additional financial runway be needed because of a delayed product launch, difficult in recruiting the go-to-market team, etc., the strong and committed investor can help provide the resources necessary to achieve the critical operational milestones essential for raising the next round. Either a group of angels without a distinct lead or a firm that is pissed off because they overpaid for a seed stage deal will not be awesome to work with during this challenging time.

Angels are terrific, and we work with them in almost all of our companies. Really good ones have great domain knowledge, expertise and contacts and are super helpful. They are, however, not a substitute for a strong deal lead with reserves held against the investment position who can help drive a round extension or a bridge to the next financing. And inexperienced angels can freak out at times of trouble and be a significant drain on management bandwidth. Also, venture investors who were induced to pay a high price to get a deal may use a hiccup in execution to extract a pound of flesh from the founders in exchange for bridge capital, as they feel a measure of “buyer’s remorse” and are likely unhappy by perceiving they were oversold at the outset. One might say “caveat emptor,” but let’s remember who holds the cards at times of stress: those with the money. The honeymoon is over. The slick fund-raising presentation is long since forgotten. All that’s being looked at is the business and the price paid for the business – and the investor isn’t happy. This is a lousy situation for founders to find themselves in, but is exactly what they’re singing up for by treating the investor selection process as a game of “Who’s the highest bidder?” instead of “Who’s my best long-term partner?”

I know some might say, “You’re talking your book” or “That’s not the way YC does it” and my response to those naysayers is as follows: you’re wrong. Building a company is far more art than science, especially in the earliest days, and having the right support systems around the table – both knowledge and financial resources – is essential for managing the risks and opportunities of a nascent business. If you have complete conviction that you can and will achieve product/market fit and scale to the moon without hitting bumps in the road, then by all means raise a bunch of uncapped or high-cap convertible notes from a dispersed group of investors, none of whom has enough skin in the game or commitment to impact the outcome of the business. Just know that you are betting the entire company on Day 1 by pursuing this strategy. Eyes wide open and acknowledgement of the risks is all I ask. Alternatively, if: (a) you feel you’ve got something hugely exciting where you’ve proven some stuff but have a long way to go before feeling confident that you’ve achieved product/market fit, and; (b) you believe that you’d benefit from the mentoring, experience, commitment and financial resources of a top-quality institutional investor, then perhaps you could re-think the wisdom of the prior approach. Put a more stable capital plan in place through partnership with the right investor for your business with whom you cement aligned motives. This may mean not taking the highest-priced offer on the table, but I believe it will provide the greatest opportunity for maximizing equity value over time. If you are playing a long game, as I am, you need to adopt a long-term mind-set. It’s not about winning the tactical battle of getting the highest price for your seed round: it’s about winning the war. Don’t let ego and crappy advice get in the way.

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