Founders beware: valuation is not necessarily a proxy for success.
Raising too much capital is a risky bet; each investment significantly increases the amount that must be obtained in an exit. Instead, focus on the amount necessary to make it to the next round, with the least dilution, most favorable deal terms, and strategic investors.
Turning down a higher valuation in favor of a better investor is the ultimate founder Marshmallow Test.
(Tweet by an investor at Susa Ventures).
When a VC offers a high valuation for a company it feels awesome for the founder(s)—it's validation that something s/he built is highly valuable. It also gives legitimacy to both the startup and its founder, which not only benefits this venture, but anything the founder(s) may undertake afterward. It's no surprise that founders will seek the highest valuations for their company.
In the process, the purpose of investment money is sometimes lost. An investment is an injection of capital intended to help scale a business and create more value for the company. Accepting too much investment can be extremely risky for founders.
Dilution and Valuation
Founders usually begin with 100% ownership in their company. If a point comes when outside funds are required for continued growth, founders can trade a piece of their ownership pie for the capital. The size of the slice depends on the amount of investment and the price paid per share. While a founder may feel good about the ratio between the amount of ownership exchanged for this new money, they sometimes forget that this money comes with special terms. The new investor may own a smaller piece of the pie, but it may be a more valuable slice. It may have a right to ALL the cherries, not just the cherries proportional to its piece of the pie.
The Liquidation Preference
Founders may not realize that with VC investment, a payout will not be proportional to ownership equity in the company. The liquidation preference is the multiple of the investment that preferred holders are entitled to. The liquidation preference overhang is the amount that must be reached in a liquidation event (merger or acquisition) for all liquidation preferences to be paid before the common holders (usually the founders and employees) will receive anything.
For startups with multiple rounds of funding, each series has their own preference multiple. Thus, the amount that must be offered in a liquidation event increases significantly.
The recent acquisition of FanDuel is a good example of what happens when an acquisition doesn't reach the liquidation preference overhang:
FanDuel raised $416M at a $1.3B valuation and was acquired for $465M. After nearly 10 years of work its founders received absolutely nothing.
Founded in 2009, the British based daily fantasy sports startup FanDuel raised a total of $416 million and had a $1.3 billion valuation. Then, in 2018, after almost a decade in business the company was acquired by the gambling company Paddy Power Betfair for only $465 million—just $50 million more than it had accepted in investment money to grow its business.
So, what happened?
Drag-along Rights
FanDuel's later-stage investors, KKR and Shamrock Capital who had participated in its largest investment round, exercised their drag-along rights. Drag-along rights allow a majority of the preferred shares to "drag-along" the rest of the common (or "ordinary") shares in a vote to sell the company. Since founders generally hold common shares, the preferred majority can effectively force the deal regardless of what any one else wants. And, this is exactly what FanDuel's majority preferred did.
The devastating notice given by FanDuel’s investors:
"The aggregate value of the consideration to be paid by the Company in the Offer is approximately $465 million. As this consideration is not sufficient to satisfy the aggregate preference payable on the A Preference Shares, no part of the consideration payable in the Offer will be payable on FanDuel’s ordinary shares or options to purchase FanDuel’s ordinary shares."
At the time of the deal, none of FanDuel's original founders were with the company. Yet, its management, who were also preferred shareholders and protected by a golden parachute provision, made out very well.
Private Equity vs. Venture Capital
It is also worth noting that the institutional investors in FanDuel were private equity firms, not VC firms. One Y Combinator thread discusses the philosophical differences between the two types of investors and suggests that founders should shy away from the former. Specifically, private equity firms seek to gain a controlling stake in a company at a discount and need to make a return on every single deal. Contrast that with the view of VC firms which invest in multiple startups and rely on the successes of just a few for their ROI.
A month after the deal FanDuel acquisition went through the co-founders brought a claim against their former company for $100 million. Apparently, the FanDuel acquisition has other underlying issues, such as no common stock representation on its board which failed to request a revaluation of the deal in light of a groundbreaking U.S. Supreme Court Case. All of which may, or may not, amount to a breach of fiduciary duties on part of their directors.
Regardless, the FanDuel founders’ saga is a great example of an exit that wasn’t high enough to reach the liquidation preference overhang. There isn't a single founder (or sane person) who would voluntarily spend almost a decade building a company, only to receive absolutely nothing in a multimillion dollar acquisition.
Relevant reading:
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