Your “screwed-up” startup capital structure may doom your business

Over the past several months, I have seen a number of companies with seemingly good businesses and innovations struggle to get early stage funding.

Why is that? Because they already have problems in their capital structure that make it difficult to obtain funding from anyone other than their existing shareholder group.

Specifically, the problem arises when the founders are left with too small an interest in the company at too early a stage in the company’s fundraising. In that context, sophisticated investors will worry whether the founders have sufficient “skin in the game” to stay the course with the company. While share options to founders can ameliorate this issue at the margins, option grants are unlikely to be large enough to fix the problem.

What can cause this to happen?

Departing Founders

As I’ve written previously, founders should enter into founder agreements when they form a startup that, in particular, provide for “reverse vesting” (i.e., forfeiture of some or all of their shares) if a founder leaves in the first four years. http://bit.ly/WhenFoundersFallOut There can be valid reasons that a founder may need to leave the business. However, if she leaves she will need to be replaced, and her successor will need an equity grant. Particularly at early stage, investors will not accept that a substantial interest in the business is owned by a former founder who no longer contributes to its development.

Unfortunately, first time entrepreneurs frequently fail to enter into founder agreements, and consequently have to address this issue “after the fact.” That requires a difficult discussion with the former founder, who needs to understand that, e.g., 5% of something is worth more than 20% of nothing, and the company is likely to fail through lack of funding if this issue cannot be resolved.

Badly structured institutional spin-outs

Significant intellectual property is developed by researchers employed by universities and other institutions, and the exploitation of that technology usually requires that it be licensed to startups, either for a license fee or for equity.

The problem occurs where, if the consideration for the intellectual property is equity in the new company, the institution insists on taking too large a share of the initial equity in exchange for the license. This intellectual property is usually only the starting point of a long development process, which will include substantial efforts by founders, the development of significant additional intellectual property (to transform the intellectual property, and/or significantly augment it, to develop a product/business that is commercially viable), and material investment.

In this context, it is self-defeating for the institution to insist on a 30% –40%, or even greater, share in the new company. Unfortunately, this is not uncommon, particularly in Europe. 

In my experience, something like a 5% or, at most, 10% interest typically would make more sense, and I think that institutions would find that they earn a greater total return on their intellectual property portfolio if they were to incentivize the successful development of a greater share of it. Alternative approaches might include (instead or in addition) a reasonable (i.e., low) license fee based on revenues from eventual sales of products incorporating the intellectual property.

Excessive demands of early investors

Ideally, founders will bootstrap a business until they get to a point whether they can secure external investment on a basis that is not unreasonably dilutive. Depending on business vertical and geography, grant funding may also be available to help in this effort.

However, founders have to eat and put a roof over their heads, and this frequently may require them to seek external investment at a pre-revenue stage. 

As I’ve noted previously, traditional methods of valuation would suggest that these businesses are worth very little. http://bit.ly/ValuingStartupScaleup However, investors who look at the businesses on this basis should not be doing venture deals. At this stage, the investor is primarily investing in a partnership with the founding team, focusing on the investor’s view as to that team’s ability to execute, as well as in the underlying business proposition. Investors who take too large a share, for too little investment, are handicapping the ability of their investee companies to secure the additional investment required for the businesses to succeed. This is particularly a problem in those countries, and in respect of those business verticals, where there is a limited supply of venture investment. I have seen cases where very early stage investors have taken a majority of a startup business, and for as little as $50,000.

Sophisticated early stage investors recognize this problem, but I continue to be surprised by the number of times that I see companies that have become uninvestable at early stage because founders retain too small an interest. The point is the same as with the universities – investors who take too aggressive a position will find that this disadvantages their portfolio as a whole.

So what should founders do?

The key point is that founders should beware. They are committing significant time and energy to the development of their startups and scale-ups, and over an extended period. This typically involves financial sacrifice – most founders I meet could earn more by working in established businesses.

As an initial matter, founders should put in place founder agreements among themselves. Four year vesting, with a one year cliff (i.e., no vesting until the end of year one) is typical.

Second, no matter how attractive they find the business opportunity, founders should beware before accepting equity arrangements that are likely to doom their ability to develop their businesses. Walking away from a startup is very painful, but it is even more painful to have a startup fail after several years of effort for reasons that could have been foreseen from the very beginning.

Finally, founders that already suffer from an unworkable capital structure should obtain advice. In most cases, it will be difficult for the founders to persuade their institutional or very early stage investors with excessive holdings to reduce their interests. However, a more neutral party, such as a new investor that indicates it will only invest if such an adjustment is made, may be more persuasive. If the principle is agreed then the adjustment can be accomplished in a variety of mechanical ways, including through cancellation of shares, partial exits of existing shareholders and/or equity grants to founders. 

* * *

This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact [email protected].

You will find a listing of Bob’s startup and scale-up blogs on US and international expansion and other startup and scale-up matters here: http://bit.ly/StartupGuidesIndex