Note: This article is the third in an ongoing series on Exits. To learn more about how to plan for exits and maximize returns, download our free eBook today Angel Exits: Perspectives and Techniques for Maximizing Investment Returns or purchase our books at Amazon.com.
With our discussion on key deal terms, we introduced some of the many issues investors and management teams face when it comes to the topic of alignment. In the case of a startup company, alignment means that investors and management agree on key corporate development issues such as strategy, team, financing and exit planning.
You shouldn’t expect smooth sailing all the time with a startup company, but alignment issues can be especially stormy, which is very dangerous. Building a successful company is hard enough without having investors and management pulling in opposite directions on fundamental topics. Since investors typically hold board seats in startup companies, you better have core alignment if you want the company to move forward and succeed.
Since this article is part of our exit series, we will focus on two key company issues: financing and exit planning. We will leave alignment discussions on strategy and team for another article.
Q: Ham, what are some of the typical areas where investor alignment issues pop up?
I think we all can agree that management and investors are both looking to build a company that delivers significant shareholder value. Unfortunately, how the CEO defines (or comes to define) success can be quite different from how the average investor defines success. I can provide you with dozens of scenarios where misalignment occurs. For the sake of brevity, I will provide you with a few examples:
A first-time management team raises $5M from a big name VC and gives up 50% of the company to the VC. Less than 12 months later, an unsolicited offer comes in to buy the company for $25M. Since the management team owns about 50% of the company, they are looking at a $12M exit. Not bad for a few years of work for a couple of 20 something year old guys. However, the VC isn’t interested in turning $5M into $12M in a year’s time. That kind of exit doesn’t allow them to achieve the returns they need for their fund. So, the VC blocks the deal and the management team has to keep working.
A startup CEO raises $1M from a small group of angel investors. As part of taking the money, the CEO promises that she will try to limit any future equity financings. This will allow the company to be well positioned for a smaller earlier exit in the $20M - $40M range. Both the angels and the founders will have a nice return and the risks associated with inexperienced founders growing a large company are capped. Fast forward 18 months and the CEO receives a term sheet from a VC for $15M on a $30M valuation. Everyone should be happy, right? Well, not necessarily! In this example, the new VC investor isn’t interested in buying out the early angel investors. And, the VC puts a provision in the deal terms that allows them to block any exit that’s less than $100M. The angels are trapped in this investment for at least another 5-7 years, because it will probably take that long before the company exceeds a $100M valuation. And, there is risk it will never happen.
After raising $1M from angel investors, the company raises an additional $25M from VCs. Even after the VC investment, the angels own 10% of the business. But, the VCs preferred shares come with a 1X liquidation preference and an 8% dividend. After 5 years, the value of the liquidation preference and the dividend has grown to approach $45M. When the company exits for $75M, the VCs take $45M off the top leaving $30M to be split between all shareholders, including the VCs. That 10% equity stake owned by the angel investors is worth $3M. So the angels get a 3X return... It’s better than a sharp stick in the eye, but, wow, can future round deal terms result in a suboptimal IRR!
Variations on these three examples happen quite frequently with early stage investments. They incorporate the three most common areas where management and investor misalignment occur:
Acceptable size for an exit
Acceptable timing and plan in place for an exit
Size and deal terms around future rounds of financing
Q: Are there things you can do to limit the likelihood of misalignment happening?
As very early investors in a startup company’s history, angel investors will participate in one way or another in most of a company’s equity financing rounds. Whether you are a board member or key investor, it’s important that you discuss with management the implications of taking investment from new investors. Most first time entrepreneurs, and even some experienced CEOs don’t fully understand the financial implications of raising additional rounds of financing.
One of the most important discussions at board meetings relates to the company finances. But don’t limit the conversation to simply discussing whether there’s enough money in the bank to make payroll this month. You want to make sure management and the rest of the board are in sync with a long term financial plan. And, make sure you revisit the plan on at least an annual basis.
For example, is the board’s objective to build a substantial company and take it public? If the answer is yes, you will need a financing plan that will allow the company to achieve over $100M in annual revenue and maintain a 40%+ annual growth rate. In most cases, such a company will raise $20M+ in multiple rounds of financing. But let’s say the board’s objective is to get a product to market, attract a small set of early adopter customers, and then sell the company for $30M. If that’s the case, then you probably can’t raise much more than $2M to achieve a 10x return for the investors.
Another way to avoid future misalignment on financial and exit issues is to discuss the financial plan with new investors before they invest. You must understand how they see the company’s path to success, and evaluate whether their plan is achievable and lines up with your expectations.
Angels should be proactive and have the discussions with management early on when their relative influence is greatest (i.e.during the period when angels are still the dominant investors). That is the period for angels to add value, build trust and form lasting relationships. Worst case, even if major new investors come in, those relationships will allow you to maintain at least some moral influence down the road.
Q: When it feels like things are drifting out of alignment, what can an investor do to help get things back on track?
Lack of regular communication is the main culprit for the creeping advancement of misalignment. In the answer to a previous question, I recommend that the board have at least an annual discussion on the company’s long term financial plan. This plan needs to address key issues such as the financing and exit strategy. In companies where there are a number of angel and VC investors, things can move quickly and a lot of different threads can develop in parallel, so you may need to discuss these plans more frequently than once a year.
Another major culprit creating misalignment is different deal structures between the rounds of financing. Examples of these deal terms include liquidation preferences and dividends. Later stage investors can still achieve a good IRR even if earlier investors don’t. So make sure you carefully review the deal terms that most closely impact your returns with each new round of financing. And, if possible, work with the board to negotiate out the most egregious deal terms so you can avoid future misalignment issues.
Want to learn more about how to plan for exits and maximize returns? Download our free eBook today Angel Exits: Perspectives and Techniques for Maximizing Investment Returns or purchase our books at Amazon.com.