Tuesday, October 18, 2011

Lesson #102: Protect Your Equity and Control Post-Financings

Posted By: George Deeb - 10/18/2011


& Comment

The other day, I was speaking with the founder of a recently-funded startup business.  Her founding stake had been diluted down below 20%, based on a financing of under $1MM.  This 20% stake was now subject to a four-year vesting period by the new investors (with a one-year cliff vesting period before she earned anything), instead of being free and clear.  She was replaced as CEO by a friend of the investor, who she didn't think was doing a great job or listening to her to input.  She had no voice on the board of directors, with all seats held by the new investors and new CEO.  And, now, she had to make the god-awful decision of staying with the business she founded (in a disgruntled kind of way), or walking away with no equity in the business she founded, and the disappointment she lost control of her business post a very small financing and not being able to participate in raising her "baby".

What a horrible situation to be in.  My immediate reaction was: (i) you should have gotten solid legal advice prior to executing any arrangement where you would lose control of the business--and that means from your personal lawyer, not the company's lawyer, whose job is to protect the company's shareholders (not you); and (ii) it is not worth crying over "spilt milk" at this point--what is done is done.  Your #1 goal is to make sure your equity value has the best chance of becoming valuable some day, most-likely by recruiting the best CEO leadership you can find to replace the current CEO not doing his job very well (with no ego that you need the CEO reins back--as there is a reason the current investors thought they needed to replace you).  But, if the current investors/board do not agree with you that the current CEO needs to be replaced, I would cut your losses and move on to your next gig (with valuable real-world lessons for next time), regardless of how painful and emotional that may be as the founder of the company (as you can't work in a relationship where there is no mutual respect).

I share this story with you, so you don't repeat the same mistakes made by this young, first-time CEO who didn't know any better about how best to structure deals like this.  In any scenario where you are taking in new money, do your best to: (i) get good legal advice for yourself (not the company); (ii) keep a board seat; (iii) where you can, make sure your shares are not subject to a vesting period (it is your company for crying out loud); and (iv) never give up more than 49% in your first round of professional financing.  And, as for (iii) above, there are ways to give investors the protections they want, without four year vesting periods that have you losing 100% of your equity if you quit at anytime in the first year (e.g., multiple classes of stock, founder floor stake).

What this feels like to me is the investors basically saw a good business idea, but didn't think the skills of the founder were valuable to the team.  And, they basically communicated that to the new CEO, who made life miserable on the founder to the point of her wanting to quit, and the investors basically "stole" the company.  Although, the investors may tell a different story (whom I haven't spoken with), so take everything with a grain of salt.  Always remember, professional investors may have long term objectives that are different than your own, and you need to protect yourself in all scenarios (good times and bad times).   Never look at the world through rose-colored glasses, when structuring complex deals where the odds of downside, far exceed the odds of upside.

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