Fundraising and how to avoid the (VC) preference shares trap...

I know what you are thinking, why is someone talking about venture capital being a trap in fundraising... After all, VCs are there to give you capital to grow your business... They are there to set your business free, so you can achieve great things, and become Elon Musk and relax on Mars in a heat proof suit, right? Well, maybe that will happen but chances are that ain't going to happen. If you are successful in getting some VC capital, in the process you are also going to sign away some powers, and will be the proud recipient of some spicey preference shares in your cap table. Oh, and you might get temporarily overexcited about having too much capital.

What is the VC model?

To lay the foundations of preference shares, it is worth a quick refresher as to the VC model. The VC goal is very simple really. They take other people's money and invest that money for a return. Their fees as a business, usually come in the form of 2 and 20. 2% capital management fee, and 20% performance fee. The 2% usually doesn't do jack for them though, as it is only applicable to the undeployed capital, which naturally declines as they make investments. So that means the 20% is what they are interested in, as that is open ended and in success scenarios that share in the mutual upside. However, to ensure that they, and their investors, get some cash out of their endeavours even in the downside outcomes, they add protection to increase their chances of success.

Why do they need protection?

Well, VC investing is risky as start-ups themselves are risky. If you run on the following basis that 9/10 start ups fail, and you only start getting a return as a VC investor when you pass the 20% threshold, the job of a VC to make a return is not that easy. You need your 1 golden start-up to deliver 12 times return to start getting your 20% return as a VC to pay out, if the majority of the investments are toast. In reality, it is never as simple as 1 in 10 succeeding and making 12 times though. VC portfolios are usually a mixed bag of some bubbling along, some doing round after round, and maybe some minicorns in the making. So to protect themselves, VCs use preference shares to get their returns, and this is where the venture capital preferences shares trap can come in.

What are preference shares?

Preference shares are a way for investors to protect their capital that they invest, so that they increase their chances of a return. It is a key part of the VC returns strategy. It is probably the main reason you see all these over-inflated headline valuations of VC backed start-ups, because the headline valuation itself does not mean as much in reality. Because you can claw back your returns at any valuation through preference shares. Some common forms that preference share come in are as follows:

• Anti-dilution preference: this means that the amount a VC invests must be returned in any liquidation scenario. They are designed to protect investors from the inevitable dilution that happens in the future funding rounds, particularly if these rounds happen at a lower valuation by adjusting the price at which the preference shares convert into common shares.
• Participatory Preference: participatory preference shareholders not only get their their invested amount back but also participate in additional distributions alongside common shareholders. We called these double-dip shares. Investors get their money back (or possibly multiples of it...), and get the percentage of the spoils after that. So they are protected in downside scenarios, and get paid twice, hence the double-dip. So if your valuation goes down, and you raise again things get tricky.
• Liquidation preference: in this scenario, the investor will receive their invested capital first in a "exit" event, usually above all other common shares first. This can be at a multiple of their original investment, so you need to be really careful here, as if you make a sale and you have not done that well, you are going to get far less back on your exit.

3 Tips on how to avoid the preference shares spiral

When preference shares kick, they kick very hard when things go wrong. To avoid the downward spiral of your returns, by seeing the returns go to select preference shareholders, you need to take some pretty serious precautions to protect yourself, and all the non-preference shareholders who have supported you along the way. Here are 3 tips.

1. Don't get greedy and take the highest valuation

Be very level headed when you are taking in capital, and look at what preferences the investors are asking for. Odds are, the higher the valuation, the greater the preferential returns for the investor so the greater the risk of getting caught by pref shares in downward scenarios. If it means taking a lower valuation with less onerous preference rights, I highly recommend it, as you never know what is around the corner, and you can get more options at a later date.

2. Don't get drunk on "spare" capital

Often VCs will give you a lot of capital, as they need to deploy their capital, and that can unlock many possibilities for you. Indeed, your investors will be driving you to hit certain returns, as will their investors, This means you can end up deploying excess capital in many areas in the hope of getting these returns. This may not materialise though, and whilst it is tempting to take the extra cash, don't take this extra capital if you do not need it. Plan very carefully about how much you actually need, and don't get drawn in by the offers of bigger tickets just because they are on the table.

3. Really, really focus on capital effectiveness

Of course, you should always focus on the effectiveness of your capital being deployed, but when their are pref shares around really need to make sure you do not lose focus about what your return on capital will be. You really must minimise the need to raise capital at all times, and maximise returns, because if you do not and you misspend, preference shares kick in and start to ruin the returns of not only your founder shares, but equally of all the other non-preference shareholders who gave you their risk capital. This can of course also impact your employees who are often not protected by the same preferences.

Don't hate the players, hate the game.

I have had the pleasure of meeting some very well meaning, experienced and helpful people in the VC world, and they have very much helped us get on to new levels. But this is not about whether the people are nice, or not, or experienced, this is about returns for investors and returns for you as a founder. The VC game is a financial game. The VC market will dangle golden carrots in front of ambitious founders with high valuations, and can make them temporarily lose their senses by thinking only of upsides. So when you are out looking for capital, you must remind yourself of the job of a VC and how it is that they make their money. When push comes to shove, venture capital is most certainly not about you, and frankly it is not really about your team's wellbeing either. For VCs, it is about protecting their fund, their reputation, their investors and making a return of course.

So, before you get into your heat proof suit and plan for Mars, follow these 3 simple tips when you are raising capital to avoid getting caught in downward preferences shares trap. Good luck.