The Unfairness of Inadequate Initial
Premeditated and Predatory
Venture Investing ©
It would be mean and unfair, even if not illegal, for professional investors to intentionally invest an inadequate amount in an early stage company. The deal would be less than honorable, even if it was the amount sought by the business founders, if the investor’s intent was to be able eventually to force grasping terms in the necessary subsequent refinancing of the company.
Entrepreneurs naturally seek as little equity dilution as investors will accept for the initial funding of a company. They are therefore tempted to base the amount of money needed on the assumption that things will go as they believe and hope that they will. The wish becomes “the parent of the thought”, a frequently fatal error.
The negotiating position of the business founder when running out of money and not yet having achieved planned objectives is almost nil. The natural initial underfunding works for the benefit of venture investors if they believe in the potential success of the enterprise, as they can set their own terms for additional and vitally needed capital investment. Proud and hopeful founders can easily become, “we and they” attitude mindset, embittered employees. The reality is that successful business founders are seldomly pleased with the early equity-based deals they made.
Predatory venture investors also frequently require that their investment be in the form of a senior convertible preferred stock, containing both a multiple of cost liquidating preference and an ability to vote their convertible preferred shares as if they had been converted. Also, venture investors are able to play the game repeatedly, when additional equity-based funding is required, until they control the company.
Once in control, these same Venture Vultures (VV’s), claiming publicly to be the “providers of necessary and constructive advice, supervision of the entrepreneurial founders, and the funders of society benefiting enterprise development”, are able to provide self-benefiting additional financial support on terms they choose.
The VV’s are also, once in control, if not having been previously, then in a position to determine board composition, executive compensation and founder roles and rewards. I know of only a few successful VV-backed companies in which the founders were able to retain their control.
The reason why royalties are the better way of financing companies is that the royalty investor is only focused on prospective revenue, not on the company valuation or gaining control of the company. Also, fairly structured royalties provide the royalty issuing companies with rights of redemption. The rights of redemption are based on multiples of the investor’s cost, less the royalty payments, if any, received by the investor. Fairly negotiating the terms of the issuer’s rights of royalty redemption is the aspect of royalty financing requiring the most experience,
The use of royalties in the financing of early stage companies allows the business founders to use equity in the gaining of additional capital as needed at a point in time when the company becomes more valuable due to the use of the royalty-based funding. Of course, the subsequent investors may require that a part of their funds be used to redeem the existing royalty.
It is frequently easier to raise more money on better terms initially, than at a later stage when the company has gone through the first round of equity-based funding without reaching originally projected objectives.
Royalties are the better way of both investing in and financing of privately-owned companies, especially early-stage companies.
Arthur Lipper, Chairman © Copyright 2019 British Far East Holdings Ltd.
British Far East Holdings Ltd. All rights reserved. March 25, 2019