Founder-friendly is good business...

Recently, one of Fairbridge’s portfolio companies received a term sheet from an investor, laden with conditions and performance hurdles. The investor sought to establish better alignment and accountability. Fairbridge declined to participate in the round.

Today I’ll share thoughts on the potential dangers——particularly at the early stages——to value creation and relationships stemming from onerous transaction documents. 

Philosophy

Risk: New ventures face a myriad of risks simultaneously–—product, customers, technology etc., rendering them highly unpredictable. Much of this risk is beyond the control of management teams. Moreover, many important drivers of value creation are not easily quantifiable. This creates fertile ground for truly shared risk. Amidst this chaos, price emerges as the cleanest, catchall measure for risk. Additionally, venture documents typically include robust standard provisions to manage the rules of engagement between investors and operators.

Relationships: The relationship between investors and founders is asymmetric, particularly concerning information flow. When unreasonable barriers exist, founders may engage in selective information sharing, often without malice, but with the optimism and hope to share everything once an issue is fixed.

Adverse Selection/LIFO: A company without alternatives will accept onerous terms… but this doesn’t make it a bad company. A savvy contrarian investor who sees value in such a company, risks sabotaging herself by presenting onerous terms to lock in an “attractive” deal. Future investors without time to learn the business will interpret the terms as adverse selection.

Here are areas that I encourage founders to be cautious of:

Price & Return

Valuation: Lowball valuations create challenges with founder motivation, low anchoring for downstream markups, and navigation of founder equity in future financings. Warrants may also present challenges downstream especially where meaningful value is created after issue. The goal is for the sticker price to fully, and transparently represent true exchange of value at the time of the trade.

Liquidation preference: Liquidation preference is designed to protect investors’ principal from suboptimal outcomes and not to engineer a return. A liquidation preference greater than 1 (or maybe with some reasonable adjustment for opportunity cost) doesn’t seem to make sense.

Antidilution: Full ratchet anti-dilution puts the burden of down rounds entirely on operators. It can result in endless amount of dilution -- the death spiral -- which effectively kills motivation and the relationship.

Interim cashouts: Certain redemption terms and payout structures based on interim performance (% of revenue or profit), create immense pressure on management teams who need every dollar and time to reinvest in growth. Ideally, return should come from an event that benefits all investors e.g., M&A, IPO. Secondaries where a new investor wants a target ownership are also reasonable.

Maintenance Rights

Information: The quality of information exchange between investors and founders is pivotal to success. Founders who perceive a true sense of partnership with their investors tend to be more transparent. And, investors who trust their founders become fierce accomplices.

Participation: Early-stage investors seeking to bolster cash returns value participation rights. In cases where downstream investors oppose such rights, founders have often fiercely advocated for their early backers.

Blocking: While standard protective and veto rights are reasonable, founders should be wary of restrictions to selling the company. A provision guaranteeing a minimum return to clear investors hurdle rates is reasonable.

Alignment Is Founder-friendly

In early-stage investing, it’s imperative for transactions to be founder/company friendly. In today’s tough funding environment, investors often forget that venture is a LIFO business. Today’s onerous terms set a dangerous precedent, justifying escalation from future investors. At Fairbridge, we believe that founders and their teams should reap most of the benefits of their ventures. We achieve this by avoiding situations of adverse selection and investing only in high quality companies at fair valuations and aligned, simple terms. When I see investors overly engineering a transaction, I encourage them to instead look elsewhere. After all, there are plenty of fish in the sea…

In an upcoming post I’ll share in depth thoughts on the topic of valuation.