A few weeks ago I wrote a piece outlining why I believe that alignment of interests in Common stock and a focus on upside enhancement was a smarter way to invest than today’s typical Preferred Stock (need a quick reminder on what a “preference” is? Click here.)
Since then I’ve had many lively conversations with entrepreneurs and venture capitalists, young and old. As you can imagine everyone has a story they’d like to share –
More than once I heard the story of the entrepreneur who got completely screwed by their VCs because they jammed a lot of money into the company, insisted that management spend it to build a unicorn, quickly decided it wasn’t working, forced the sale of the company and took essentially all of the proceeds when it was sold for less than capital raised.
Or the story of the VC who had a company raise $2M at $6M pre-money and is so glad that they had a preference because it helped save their bacon when it was sold later for $4M and they got their $2M back — resulting in a “fair” outcome. Why should employees walk away with millions of dollars when I lost money?
Every story seems to try to get at the core underlying theme of “fairness”. What exactly is fair in the context of startup investing? If we are re-examining how investments are made in trying to achieve alignment, what structure can we put in place that will most likely result in a fair outcome given the uncertain directions a company may take?
In a sense, what shapes fairness? What shapes our views of right and wrong?
A recent piece in the Atlantic, “How We Learn Fairness” may shed some light on how our ideas of fairness are shaped.
“Our ideas about fairness are relativistic, rather than absolute. In many ways, we approach fairness as a form of social signaling. People tend not to care about equality as an abstract principle; instead, they use fairness to negotiate their place in a social hierarchy.”
Perhaps entrepreneurs give their blood, sweat, and tears for the “standard” investment terms because this social hierarchy has been established over time. In this case, many decades of the status quo.
Interestingly, the Atlantic article also discusses our frequent aversion to inequality even when they have the long end (the good end) of the stick…“we’re especially willing to give up our unfair advantages when there’s the possibility of strengthening a future relationship.”
Ever since I was a padawan entrepreneur, I’ve been hearing that “investors deserve to get their money back first,” referring to the situation where a company didn’t work very well and the exit price is less than the price the investor paid. Therefore the investor would be better off economically by getting their investment (preference) back rather than the percent of the company they purchased — and of course, they deserve to, right? Isn’t this what is fair?
My friend Bob Tinker, the Founder & CEO of MobileIron (NASDAQ:MOBL) and previous VP Business Development of Airespace (acquired by Cisco) shared his insight:
Why should an investor deserve to get all of their money back first? The investor purchased a piece of a pie. They deserve a piece of the pie. If the pie is big, they should be happy. If the pie is small, it didn’t work. Their slice of the pie shouldn’t grow if the size of the pie shrinks.
Yet this is the invisible habit that we’ve been living with for years.
On one hand you have a venture capitalists. They arrive to the board meeting, participate in the dialog and approve important strategic and recruiting decisions. They have a few hours, maybe a day per month invested in the company. They are making a salary that is an integer multiple of the entrepreneur if not an order of magnitude or more. They have spread their risk across a personal portfolio of 6–10 companies and a fund portfolio of 25–75 companies. They are diversified. In the famous chicken and pig analogy, they are the chicken. Interested in helping with breakfast but not committed.
On the other hand is the entrepreneur. Making a modest salary, working 90 hours a week for a period of years. A huge proportion of their net worth, sometimes more than 100% (school loans) tied up in the equity of the company. They are very much the pig, completely committed.
And for whatever reason, the company doesn’t perform well.
Does it feel fair that the investor gets their money back first? Does the entrepreneur get their years back? If we want people to take risk and be willing to fail, why make them pay 100% for failure?
These are all invisible habits.
The rest of Bob’s quote:
Assumptions over time become habits….. and then taken for granted….and then invisible. When those invisible assumptions change, the incumbents throw stones made of tradition….then all hell breaks loose. May you cause hell to break loose. 🙂 Bob Tinker, Founder & CEO MobileIron
Amen. The best entrepreneurs I’ve know questioned everything. I think it’s time we investors did the same.