The risks of being a small investor in a private company

With the passage of the JOBS act, it seems that many more Americans will soon be able to buy equity in private companies. I am no expert on the law, but I have been investing in private companies for about a decade, and during that time I’ve seen many cases where large investors used financial engineering to artificially reduce the value of smaller investors’ equity. Here are a few examples.

1) Issuing of senior securities with multiple liquidation preferences. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred

Series B: Large investor invests $10m, getting 4x senior straight preferred

Company gets sold for $30m. Management gets $3m carveout, Series B investors get $27m, and Series A investors get zero.

2) Issuing of massive option grant to management along with new financing at a below-market valuation. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred for 10% of the company.

Company is doing well and is offered a Series B at a significantly higher valuation. Instead, large investor invests $5m at below-market valuation, getting 40% of the company, and simultaneously issues options worth 50% of the company to management.

Result: Series A investors are diluted from 10% to 1% of the company, even though the company was doing well and in a normal financing would have only been slightly diluted.

3) The company is actually multiple entities, with the smaller investor investing in the less valuable entity. Example:

Company has entity 1 and 2. Small investors invest in entity 1 that licenses IP from entity 2. Value of IP increases and entity 2 is sold and eventually cancels entity 1′s license, making entity 1 worthless.

4) Pay-to-play or artificially low downrounds. Example:

Series A: Small investor invests in $1m round, getting 1x straight preferred

Series B: Large investor invests $10m in pay-to-play round (meaning any investor that doesn’t participate has their preferred shares converted to common). Smaller investor doesn’t have the cash to re-invest in Series B, but deeper pocketed investors do.

Company sells for $10m. Series B investors get $10m. Series A investors get nothing.

There are ways to protect against these shenanigans. Protections can be written into the Series A financings documents (pro-rata rights, ability to block senior financings, etc). There are also some legal protections all minority investors are granted under, say, Delaware or California law. But usually even when these protections exist (and they exist far less frequently these days than in the past), smaller investors usually can’t, say, invoke blocking rights by themselves (indeed, it’s often not economically viable for smaller investors to hire lawyers to review every financing document for every company they invest in). Another way smaller investors can protect themselves is to set aside capital amounting to, e.g. 30% of every investment made, in case they need it later for defensive purposes (I do this). But in my experience this is all very complicated and difficult to execute in practice, even when the small investors are “professional” investors. I worry it will be even harder for “amateur” investors to protect themselves.

Increasing velocity

Two common discussions in the startup world right now are 1) the increasing speed at which new apps/websites can gain mass adoption (Instagram, Pinterest, OMGPOP’s Draw Something, etc), and 2) the rise in seed stage valuations. These two trends are real and related.  An investor with a broad portfolio of companies might rationally invest at an average valuation of, say, 10m (which is historically considered very high for that stage) if they have a chance for one of the investments to become the next Instagram or Pinterest. A billion dollar hit pays for a lot of misses.

The increasing velocity has implications for the valuations of incumbent tech companies. Users have limited time, and while web and app usage are growing, hit startups are growing much faster and therefore gaining adoption, at least in part, at the expense of incumbents. It’s not clear this risk is priced into the valuations of companies like Facebook (P/E expected to be ~100) and Zynga (P/E ~31). In other words, faster velocity should lead to a narrower distribution of valuations from seed to late stages. We’ve seen the seed stage adjust but not the late stage.

The current posture of big VCs seems to be to wait to see what takes off and then chase the winners. Tons of investors tried to invest in Instagram’s A and B rounds, and I’m sure VC interest in Pinterest is intense.

The problem with this model of Series A and B investing is that, in reality, many of the companies with big hits weren’t overnight successes. Pinterest, OMGPOP, Twitter, and Tumblr were around for years before taking off and all benefited greatly from having patient investors. In the current financing environment, a lot of good companies won’t live to get Series As and Bs and big VCs will pay valuations on hits that are priced to perfection.

Increasing velocity is great for users and for the winning companies and investors. But when good companies aren’t getting follow on rounds because they aren’t yet “hockeysticking”, the long term health of the startup ecosystem suffers.

Once you take money, the clock starts ticking

One of the interesting things about having been investing in startups for a number of years is that at any moment you get an inside peek at startups at a variety of different stages. In the course of a few weeks, I might talk to people who are ideating around new business ideas, people raising seed rounds, people raising later (VC) rounds, people whose products are blowing up, people whose product are struggling, people getting acquired, people leaving acquirers to start new companies, etc. Sadly, there are also usually a few companies that are struggling and facing the serious possibility of running out of money and being forced to shut down.

One side-by-side comparison struck me recently.  Company A is just now raising a seed round. The money they raised will last 12 months (personally, I strongly recommend raising 18 months of runway – if you have the option to do so). Company A was also, in my opinion, not ready to raise money (they needed to work on their plan and team more). Company B raised a seed round about 10 months ago and is now struggling to raise more. Company B had the option to raise more money back then but chose to only raise 12 months runway in order to minimize dilution. Company B also made the mistake of having a large VC invest $100K in the round (a meaningless amount to a large VC). The large VC has since said they won’t support the company (despite the fact that the company made pretty good progress on the business) creating a massive signaling problem.

In the current “frothy” environment, where seed investors are aggressively offering money to entrepreneurs, it is easy for an entrepreneur to think “well, if I’m getting offered money this easily at the seed stage, I’ll get offered money easily later.” In fact, once you take professional investor money, the attitude of investors (both insiders and outsiders) changes dramatically: you’ve gone from planning mode to operations mode. When you do planning, research, experimenting etc. without having raised money, investors think you are prudent (I recently interviewed the Warby Parker founders for TechCrunch and they said they spent 1.5 years planning/researching before they raised money). When you do it with other people’s money, and don’t make what they perceive to be enough progress, the investors can quickly lose faith.

The obvious lesson is well known by experienced entrepreneurs. Don’t raise money until you are ready, and when you do, raise enough to have a good shot at reaching “accretive milestones” so you can raise more money, become profitable, or whatever your goals might be.

 

The TripAdvisor IPO

Great startup story. Raised a total of $4.2m in venture capital, sold to IAC/Expedia for $210M, and had some interesting adventures and pivots along the way. They started out by trying to aggregate reviews from other websites and white label their product to Expedia and other large travel websites. TripAdvisor.com was just a showcase that accidentally became a destination site. As of today TripAdvisor is an independent public company, trading at a market cap of $3.5B.

Great for Boston. Fairly or not, Boston is often typecast as an infrastructure, B2B, hardware, and biotech town. Between Tripadvisor and Kayak, Boston now has at least two very important consumer internet companies.

Big win for the “golden age of SEO”.  By which I’m referring to roughly 2001-2008 when “demand” for content (people typing in search queries) far outpaced supply (good content). Companies like Yelp and TripAdvisor (along with Wikipedia, IMDB, etc) grew huge during this period, almost entirely through SEO. They did this by getting highly defensible flywheels spinning where more content meant more SEO which meant more users which meant more content. It is now far more difficult to grow a startup primarily through SEO. Almost all monetizable search categories have vast excesses of SEOd content. Moreover, Google is creating their own content (e.g. Google Places) which, at least at times, they have favored in their search results.

The user experience should improve. MG Siegler and others have criticized TripAdvisor for an excess of ads. I don’t disagree with MG, but I also think this is largely the result of the broken online ad attribution system that punishes intent generators and rewards intent harvestors. Travel reviews are for users at the beginning of the travel research process (which on average takes weeks), but all CPA and CPC ad programs pay only for the last click which usually means when users are purchasing tickets or making reservations. Hence review sites are forced to saturate their website real estate with purchasing widgets and display ads. Hopefully as online ad attribution improves this will no longer be necessary.

It’s weird how little coverage this IPO got and how the financial press missed the interesting stories. TripAdvisor ended the day at ~$3.5B in market cap, making it the second most valuable East Coast consumer internet company (after Priceline). Every story I saw focused on the share price drop over the day. The fact that the price dropped from its opening price simply means the bankers mispriced the stock and therefore insiders didn’t get the sweetheart deal they thought they were getting.

Update: I interviewed the CEO/founder of TripAdvisor on TechCrunch yesterday. Topics include the company’s origins, relationship with Google, SOPA, and advice to fledgling entrepreneurs.

Seth Godin on “organizational momentum” acquisitions

Seth Godin left an insightful comment on my post yesterday (“Three types of acquisitions“) describing a type of technology acquisition you might call an “organization momentum” acquisition:

I think the most common form of tech acquisition is a variant of the [business acquisition], in which the acquirer wants to inject forward motion into the organization. It’s far more difficult for a public company to rally around a launch into what might seem like a small sector… it just doesn’t seem worthy of the biggest brains and bravest folks, so it gets shunted aside.

On the other hand, once a smart tech company acquires a smaller company with momentum, it gives the company permission to drive, perfect, polish and grow that business. I’d argue that this what actually happened with YouTube.

The logic underlying organizational momentum acquisitions can be found in Clay Christensen’s disruptive technology theory. Smart CEOs of large companies realize how hard it is to shift internal momentum away from developing sustaining technologies. As a way to avoid this trap, Christensen recommends that large companies set up internal startups that are as organizationally separate as possible. But, as Seth points out, acquiring startups with momentum is another way to get the same result.