Entrepreneur: Terms, Preferences & Control Feed A Unicorn With Caution

Bill Mitchell / June 2015 Unicorns, companies with billion dollar valuations while still rare are being created at a faster pace. Startup founders who own stock worth over a billion dollars is rarer. The reason may be a function of how unicorn companies are funded. Unicorns are hatched when a team with an idea (product, service or app), that hundreds of millions or billions of people might potentially use, participates in a seed incubator. The incubator places a non-negotiable investment (amount, valuation, terms, preferences) in the new company. At this point the company usually has no or minimal revenue. The company gains traction; strong user growth and stickiness validate the product/ market fit. Within 3 years the founders have convinced multiple investors to place hundreds of millions of dollars, spread over multiple funding rounds, into the company. The stock price, which was originally pennies per share usually rises 2X or more with each new round of funding. Private investor money is not free, down the road, they expect an exit event (IPO, Merger) that will pay them many multiples of their original investment. Venture capital investors place valuations on startups that are well above those of more established companies (sometimes even in the same space) and typically years before the startup develops a reliable revenue stream or GAAP positive earnings. There are expectations, by all, that the company will grow into and surpass these aggressive valuations. One would think given the multi-billion dollar startup valuations newly minted billionaire founders would be created at an increasing frequency. That is not as easy to accomplish as it might seem. The primary reason is dilution, each funding round decreases the founders ownership of the company. The other reason which doesn't get as much attention are the debt and equity investments terms and preferences. Depending on how well the company performs, these can have a substantial impact on the founders net worth. In most unicorn situations investors own a majority of the company. Beginning with their initial investment, they look for ways to reduce their downside exposure: loans, convertible notes, preferred stock all serve to put the investor(s) in position to be paid ahead of founders / common stock holders if the company doesn't grow as planned. Venture capitalist invest money raised from limited partners. They are placing large amounts of money into the hands of companies with little revenue and no profits.

10X return with no risk Most founding teams are not expert term sheet negotiators while most investors are expert term sheet negotiators this is their core job. Founders tend to be optimistic and only see upside potential. That's partially why they start companies. They may not fully comprehend the impact of the funding documents they sign especially in a less than optimum exit or down round situation. Investors in early stage ventures tend to be risk adverse even though by definition investing in a startup is risky. Starting with the term sheet, investment documents set the boundaries for how much money each party will receive in various exit scenarios. While initial funding may have come from an Angel or VC investor as the capital needs become larger, hedge funds, mutual funds and other sophisticated investors will likely participate. We tend to think of investors acting as a tight knit group but their interests may be divergent. It depends when and under what terms they invested. For example, a cap table (Accounting Ownership) may show the founders own 30% of the company stock, however, if they have raised several rounds of funding with convertible notes, common stock, preferred stock, and debt, the founders payout (Economic Ownership) may be significantly less, even $0, it depends on the sales price and terms negotiated in each funding round. Before signing a term sheet create a cap table waterfall. It should show all prior funding (debt and equity) and the current contemplated funding. Pick a range of Low, Medium and High exit values. The Low scenario should be low enough no one is happy; the Medium scenario should show some happiness; the High scenario should show everyone thrilled. Calculate the payout EACH preferred stockholder, each debt holder and each common stockholder would receive in each of the 3 scenarios. Remember preferred stockholders and debt holders are paid before common stock holders. Don't be surprised if your economic ownership is smaller than the accounting ownership indicates. It's critical that the CEO/Founders ensure the core and extended team have enough Economic Ownership to be sufficiently motivated.