Like most startups, particularly in therapeutics, Jack’s Company faced extremely difficult financing circumstances when first trying to get off the ground. Professional investors, including experienced Angels, expect strong IP coverage, a clean license, an experienced team and sometimes even human proof-of-concept, before they consider investing in an opportunity. Many have seen scores of companies with exciting mouse cancer data and are skeptical without human corroboration. Though there was some interest from some of the investors the University introduced Jack to, they wanted 33-50% of the company for the first $1 million of funding. Jack thought this was ridiculous.
Over Christmas, Jack complained about how greedy the professional investors were and how game-changing OncoFix’s therapy would be for cancer. Everyone was excited for him and agreed this could be a billion dollar company. Before long, he had several family members and friends interested in putting $10-20,000 into his endeavor. A friend who lost his mother to cancer introduced him to his father. He was well off and offered to put $250,000 into the effort. Everyone liked the idea of owning stock in a startup with limitless potential. And instead of a $1-2M pre-money valuation the professionals were offering, fifteen friends and family came up with a total of $500,000 and were willing to accept the $20 million pre-money valuation Jack set, buying roughly 5% of OncoFix. “When it gets to $1 billion, that is going to be a $50x return” everyone said.
The trap
A year later, Jack was raising more money. He didn’t raise enough the first time to get to an important milestone such as an IND or first human dosing – he needed at least $1 million (usually a lot more). His friends and family network could not put any more money in right now. A professional investor was willing to put in $500,000 at a $2.5 million post money valuation for 20% of the company. Jack was in a dilemma. If Jack takes the money, then the original investors who put in a total of $500,000 own 4% while the new investor who puts in $500,000 owns 20%. Furthermore, the value of the $500k put in by the original investors is now only $100,000. If Jack does not take the money, he will probably not find another investor who will put in the $500,000 he needs at the $21 million post money valuation his friends and family need to stay even. Jack is in the Friends and Family equity trap.
The most common sources of the early funds are the founders and their family and friends. This is often called “Seed funding” (though that can also come from professional investors), “Friends and family” financing or less charitably, “dumb money” – because they seldom know how to evaluate the prospects, risk and value of an early stage investment. Professional early stage investors and Angels know that most endeavors at this early stage are very high risk and most will fail before the investment is returned. That is why professionals seek a large ownership stake for the small amount of money they are putting in.
I was recently surprised to meet companies raising Seed or Series A financing expecting to be valued at or over one hundred millions of dollars. Some had raised $5-10 million already at these valuations. Their trap made Jack’s OncoFix look like child’s play.
Let’s look at an example of a company in this dilemma. If the original investors in PainAway put $10 million into the company at a $90 million pre-money valuation, they would own 10% of the company. Let’s say a new professional investor was willing to put in $10 million at a $20 million pre-money valuation and the company could not find a better deal. The new investors would own 33% of PainAway post investment and the original investors now own ~6.7%, which is now equal to ~$2 million. This is an 80% down round for the original investors. If in the next couple years, PainAway has a successful exit at $120 million without any additional investment, the new investor gets $40 million for a 4x return while the original investors actually take a 20% loss, getting back only $8 million. Not much reward for being the original investors, is it?
For some companies it is even worse. The early investors got common stock and the later professionals got preferred stock. Preferred stock most often gets priority for getting paid back when the company has a liquidation event. This means not only did the later investors get their stock at a better price, but in many circumstances they get their money back first. In a modest exit, common shareholders might get nothing at all.
Most entrepreneurs think they are rewarding their early investors with equity and want to maintain control as long as possible so they sell as little equity as possible. But usually they are just putting off the inevitable dilution event a follow-on financing will require and instead of taking the hit on their ownership up front, they are bringing all their friends and family along for the hit.
Avoiding the trap
Most startups in similar circumstances have adopted a convertible note as the instrument for the early investment. I have used this several times with startups I have run, both for Seed financing and for Bridge financing. This instrument is a form of short-term debt that converts into equity upon certain circumstances, most notably when the first professional investment round closes. When applied to a Seed financing, this debt automatically converts into shares of preferred stock upon the closing of a Series A round of financing. It is often priced at a discount to the Series A price to lock in some upside to reward those who took the risk of investing early.
Professional investors are very familiar with this instrument and as long as they will still have control of the Preferred series and the dilution from the conversion is not so much that it substantially alters their ownership position, they will usually let it be. However, if you put a lot of money into a convertible note, like $5-10 million, and the Series A is the same magnitude, it may cause some heartburn depending on the discount and relative ownership.
Getting out of the trap
If you are already in this trap, it may not be too late to get out. Making early investors whole can be done by giving them more shares proportional to the ownership a new investor is willing to buy. It often has to be done prior to a new investor putting money in though, because the new investor is not usually willing to take the additional dilution this entails. Let’s take a look at how the PainAway investors above could be made whole.
To make the original investors whole, i.e. no loss of value with execution of the new investment terms, they need to own 33% of the company after the Series A closing. This means they need to own half of the equity in the company prior to the Series A close. Thus they need to receive 40% more of the PainAway stock for their original investment. That is often a show stopper for entrepreneurs because it means a loss of control. But since a loss of control is coming sooner or later, being open to rewarding investors generously is a good way to get loyal investors.
Worry about the right things
New entrepreneurs tend to worry too much about ownership and control and not enough about capitalization and execution. Sure there are horror stories of investors who make things difficult and founders who get thrown out of their own companies. But there are thousands of untold stories of startups that failed because founders focused on the wrong things and stayed in control of an enterprise they were ill equipped to run to a successful outcome. Get the capital, get the team, and enjoy the ride. Otherwise, you may be driving to a crash and taking your friends and family with you.