Understanding the mechanics of founder re-ups in financing rounds
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For all scenarios, I assumed that before the financing round, the founders and the existing investors own 60% and 40%, respectively, of the company. I further assumed that the company wants to raise $40M and that the existing investors will participate with an investment of $10M, so $30M come from the new investor.
Let’s say a VC (who I’ll call “VC 1”) offers the company a pre-money valuation of $120M (Scenario 1A). In this scenario, the founders and existing investors would hold 45% and 36.25%, respectively, after the round. Now let’s say another VC (“VC 2”) offers the company a higher valuation, $140M (Scenario 2). In this scenario, the founders would hold 46.67% after the financing, while the existing investors would be at 36.67%. Scenario 2 is significantly better than Scenario 1A, for the founders as well as the existing investors, so (assuming both VCs are of equal quality) the company should go for VC 2.
But VC 1 doesn’t want to lose the deal, of course. He/she could increase the valuation to make his/her offer more attractive, but hey, that would reduce his/her stake. So instead of offering a valuation that is equal to or higher than what VC 2 has offered, VC 1 now proposes a founder re-up of 10% of the pre-financing equity. As you can see in Scenario 1B, this would result in a 48% stake for the founders, which is significantly higher than the 46.67% they would hold if they went with VC 2. Meanwhile, nothing changed for VC 1, as he/she would own 18.75% in Scenario 1A as well as 1B, so everyone should be happy, right? Not quite: The existing investors’ stake in Scenario 1B is reduced from 36.25% to 33.25%, precisely by the three percentage points by which the founders’ stake is increased as a result of the re-up. This is the 3% transfer from the existing investors to the founders that I’ve mentioned a few paragraphs ago.
If VC 1 wanted to get the founders to 48% without meddling around with the cap table, he/she would have to increase the pre-money to $160M. You can see this in Scenario 1D. By offering a re-up instead, VC 1 managed to make his/her offer the top offer for the founders while offloading 100% of the costs of the re-up to the existing investors. Scenario 1C shows what happens if the investor is willing to do the re-up after the financing. In that scenario, he/she does end up with a lower stake compared to Scenario 1B (17.73% vs. 18.75%), but if you compare it with Scenario 1D (AKA the “don’t mess around with the cap table” offer), he/she is still much better off in 1C, at the expense of the existing investors.
I want to believe that the later-stage investors we’ve worked with so far all had good intentions, and maybe I should understand that if you’re trying to win a competitive deal and want to set up a company for success, concerns of other investors aren’t your number one priority. That said, there is an act which, according to Wikipedia, is defined as “giving something of value [in this case shares] in exchange for some kind of influence or action in return [in this case the deal] that the recipient would otherwise not alter.” 😉 The fact that here that “something of value” doesn’t even come from the later-stage investor, doesn’t make it any better.
Obviously, investors engaging in this tactic aren’t stupid, so the official version is usually not “rather than offering a higher valuation [which would benefit all shareholders equally], we’ll give you a lower valuation but will offset some of the dilution by giving you [the decision makers] some extra shares”. The official justification is almost always incentivization of the founders, i.e. some variation of “the founders only own x% of the company, we need to make sure they have enough shares to be fully motivated”. Well, if that was your concern, Mr. Late-Stage Investor, offer a higher valuation to make the round less dilutive. Oh, I forgot, that’s not possible because you have to own 20% of the company to make the investment worth your while. Sorry for getting cynical, but as you can see, this issue has caused me a great deal of annoyance.
The prospect of keeping a larger stake can understandably be tempting for founders, and once the pandora box has been opened by a new investor, it can be hard to shut it. What makes the situation particularly uncomfortable is that if as a seed investor you object the founder re-up, you suddenly look like the bad guy who doesn’t want to grant the founders some additional shares for all their hard work and who risks the entire deal by bringing up your concerns, while the later-stage investor looks like the good guy who wants to reward the founders. As we’ve seen in the example above, this interpretation is absurd because the later-stage investor proposes a reward that benefits him/her and is borne by someone else, but in the hectic and pressure of term sheet negotiations, this can be forgotten. Therefore it’s all the more important that founders fully understand the implications of a re-up and that they don’t let anyone divide their interests from the interests of other existing shareholders.
So is it always bad if an investor proposes changes to the cap table? No. There can be situations in which cap table restructurings may be necessary. If, for example, we wanted to invest in a seed-stage startup and found out that the company is majority-owned by an angel investor or incubator, we would most likely conclude that for the company to be VC-backable, and for the founders to be motivated and incentivized for the next ten years, something needs to change. But these are rare cases, and the fact that they exist doesn’t justify using founder re-ups as a tactic to win deals.
If any later-stage investors are reading this, please reconsider your tactics. Just treat upstream investors how you want to be treated by your downstream investors. Easy.
And to all founders out there: Please don’t let anyone screw your early backers.