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Unicorpse and The Moral Hazard of Making Unicorns

UnicorpseI’m sure that many more thoughtful than me has written about the moral hazard of venture capital. In economics, moral hazard occurs when one person takes an unreasonable risk because someone else will bear the burden of the negative consequences. In the age of unicorns, the moral hazard in venture capital has never been greater. Moral hazard and exuberance to make unicorns leads to unicorpses. I was reminded of this today during a conversation with an emerging growth business run by capable, but  young entrepreneurs.

The Situation

The 20 something entrepreneurs with whom I was talking have built a solid, already profitable business generating $4.3 million ARR. The company has taken a total of $200k of outside financing. With a modest amount of incremental capital, the business has the potential to be a $30 to $50 million revenue business in 5 years and to be meaningfully profitable. Such a business could easily fetch $100 to $150 million in exit value, producing a significant amount of wealth for the entrepreneurs. In addition to producing personal wealth, after such an exit the entrepreneurs will have built a successful company, made money for their investors, established a reputation for themselves and find themselves with the personal wealth necessary to finance the start of their next business. They would be imminently “back-able” and set up nicely for a long and productive career.

Objectively, a $100 to $150 million exit in three to five years is possible for this company. Objectively, a unicorn type multi-billion exit isn’t possible. But sticking to the straight and narrow of building a solid profitable business is hard. Bad influences abound. Entrepreneurs, like the ones running this company, are flooded with tech-centric news about the birthing of a unicorns and are shielded from the harsh reality of entrepreneurial failure. The infrequent unicorn gets lots of press where the 40% failure rates that plague venture capital fade to black. It is no wonder then that many entrepreneurs (particularly young entrepreneurs) fall victim to the instinct to try to make their company into a unicorn. Lets go raise $[fill in the blank] and pursue [fill in big hair audacious goal] becomes the mantra, whether or not the opportunity has unicorn characteristics or the use of proceeds is well aligned with what the business is. Raising all of that capital leads to spending, and higher burn. After all “we’re not giving you the money to have you save it” and “you can’t save your way to success” are common refrains. In most situations, higher burn rate equals higher risk of failure. High risk, but not necessarily higher reward.

Who mourns the unicorpse?

With high-loss rates and returns concentrated in a small number of investments that go full unicorn, venture capital is more fraught with moral hazard than ever. Venture capitalists have portfolios and their performance is generally evaluated at a portfolio level. This portfolio level evaluation applies whether the evaluation is of a firm or an individual investing partner. Venture capitalist cares less about the success or failure of any single investment than the success of his/her overall portfolio. Knowing that loss-rates are high and returns are concentrated in a few large deals, venture capitalists have an inherent incentive to swing for the fences on every investment, increasing the risk and potential reward of each investment.

Who bears the cost? The entrepreneur.

Pragmatically speaking, an entrepreneur can manage only one entrepreneurial endeavor at a time. In fact, we investors often tacitly, if not explicitly, require this. We want the entrepreneur single-threaded, we need the entrepreneur single-threaded. I’ve got a portfolio, but you put all of your eggs in one basket…

To make ourselves feel better, we have lots of platitudes for entrepreneurs who experience failure.

It is better to have tried and failed that never to have tried at all.

You learn more from failure than you learn from success

There is no shame in failure.

All true; but when push comes to shove, venture capitalists are master pattern matchers and a tried and true heuristic is that past entrepreneurial success is a predictor of future entrepreneurial success.  Many investors would prefer to back an entrepreneur with a successful track record and a mediocre idea over an entrepreneur coming off a failure with with a good idea. A 20/30 something entrepreneur coming off of a failure is going to have a very difficulty time getting his/her next business financed. Conversely, a 20/30 something entrepreneur coming off of a successful exit is with a successful exit under their belt is much more likely to get financed.

No Villains Here

To be clear, I’m not vilifying venture capital or venture capitalists. There is nothing untoward about the economic motivations of investors.

I’m also not suggesting that intentionally increasing the risk of an investment is risk-free for the investor. Higher operating  risk implies a greater chance of capital loss. There isn’t a moral hazard in every venture capital investment situation. For example, some businesses operate in winner takes all markets. In such situations the motivations of the investor and the entrepreneur are nicely aligned because the go big or go home philosophy of company building is the right approach due to market structure.

I am, however, suggesting that the entrepreneur bares a greater proportion of the risk associated with venture capital investments; or at least that the consequences of failure are greater for the entrepreneur than the investor.

An Alternative Approach

When you swing for the fences, you strike out a lot. No manner of platitudes for the entrepreneur who tried and failed can remove the moral hazard.

Entrepreneurs in growth stage businesses face different calculus. In a situation like the one I described, the entrepreneurs have already created value for themselves. Taking a bigger than necessary financing round and swinging for the fences puts that built in value at risk and buries it under a larger preference stack than is necessary.

Making unicorns is risky business. There is another way.

Consider taking less capital. Consider staying laser focused on your core market and building a defensible position that is resilient to attack. Win narrowly and then exit. This may mean taking a more risk averse path to unlocking the value of the business. Raise less capital. Moderate burn. Get profitable as soon as possible and exit sooner. If that means not raising capital or raising less capital (and taking less dilution) all the better.

Young entrepreneurs operating an already successful business would be wise to remember that some unicorns end up unicorpses. It is better to be modestly valuable and alive than to have had the potential to be wildly valuable and dead.

Call me old fashioned. Call me risk averse. I’m guilty as charged.

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Founder Liquidity and Growth Equity

<img
class=”size-full wp-image-937 alignright” style=”line-height: 1.5em;” alt=”Founder Liquidity” src=”http://derekpilling.com/wp-content/uploads/2014/03/images.jpg” width=”192″ height=”191″ />I’m seeing more and more growth equity financings come to market with an over-sized <span
style=”line-height: 1.5em;”>component of the <span
style=”line-height: 1.5em;”>financing allocated to existing shareholder liquidity. I’ve seen enough of thes<span
style=”line-height: 1.5em;”>e transactions to consider it as a trend and to wonder what is motivating it.

Founder Liquidity in Context

<span
style=”line-height: 1.5em;”>Whereas liquidity isn’t typically a feature of venture financings, it is  often – but not always – a feature of <a
title=”Ready For Growth Equity” href=”http://meritagefunds.com/ready-growth-equity” target=”_blank”>growth equity financings. A modicum of liquidity for key management team members or founders can act as lubricant for a growth equity investment, particularly where the management team founded and has successfully bootstrapped a successful business. The founder liquidity component of a financing can de-risk a management team’s personal balance sheets, enabling the team to rationalize the dilution and loss of control that are inherent in taking growth equity capital. So, how much liquidity is reasonable?

How Much Founder Liquidity Isn’t Too Much?

The answer depends on whether the management team wants to be part of the Company going forward. Presuming that management desires to be involved or is required to be involved, then it is reasonable for the founders to pursue an amount of liquidity that de-risks their personal balance sheets, subject to ownership considerations. I like to look at the specific use of proceeds for the founder liquidity component of a financing. A short list of good and reasonable uses of proceeds follows:

  • Pay off the mortgage, second mortgage;
  • Pay for kids college education; and
  • Pay off credit card debt.

The logic behind this short list is that a management team member that doesn’t have to think about providing shelter or education to his/her family will be happier, more productive at work and able to dedicate the time, attention and effort to the business that is required of growth-stage entrepreneurs. A modicum of founder liquidity in the context of a true growth equity financing can serve the entrepreneur and investors well.

That said, the amount of liquidity that is reasonable must be measured in relation to the seller’s total ownership stake in the business. It is imperative that a management team member who is critical to the business’ ongoing success retain the majority of their ownership in the business. In some cases, this requirement may limit the amount of liquidity that can be made available. In general, I feel it is reasonable for a founding management team member to sell between 5% and 25% of their ownership stake in the context of a growth equity financing. If a founding management team member wants to sell more than 25% of their stake, one has to wonder how much the team believes in the business future.

If the founding team wants to sell more than 25% of their stake and a $ value that exceeds the de-risking level outlined above, the transaction may be best structured as a control transaction, rather than a classic growth equity investment. There is nothing wrong with a founder pursuing a full control sale; it just means that institutional growth equity firms aren’t the right target investors for the opportunity.

What is Driving the Drive Toward Liquidity?

As I said, recently I’ve seen more and more investment opportunities positioned as growth equity financings with unusually high founder liquidity requests. It is my sense that this trend is driven by increasing – and in some cases unrealistic – expectations on the part of founding management teams. More often than not, the unusually high liquidity requests are associated with opportunities represented by investment bankers. Perhaps there is some self-selection bias here – entrepreneurs who desire liquidity see the need to engage a banker. Or, perhaps the bankers – seeing a hot market – view founder liquidity as a way to increase deal-size and their transaction placement fee. I can’t say which – if either – of these dynamics is at work. My best guess is that both dynamics are factors and that they are mutually reinforcing.

For the most part, the market is remaining disciplined, at least in the segment and company size range where my firm, <a
title=”Growth Equity Firm | Meritage Funds” href=”http://meritagefunds.com” target=”_blank”>Meritage Funds, is operating. Regardless, the frequency with which I’m seeing unusually high requests for liquidity can’t be interpreted as anything other than hot market conditions exerting their influence on banker and seller expectations.

First Thing First

The focus of growth equity investments must, first and foremost, be on providing the company with adequate capital to execute an accelerated growth plan. Founder liquidity can be an important, albeit secondary, consideration in such a financing. The company’s capital needs come first.

The post <a
rel=”nofollow” href=”http://derekpilling.com/founder-liquidity/”>Founder Liquidity and Growth Equity appeared first on <a
rel=”nofollow” href=”http://derekpilling.com”>Non-Linear.

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What is an entrepreneur to do when restrictive covenants become restrictive

Restrictive Covenants - HandcuffsRestrictive covenants are standard features of venture capital, growth equity and private equity transactions although each investor type has its own standards. Restrictive covenants are the actions a company cannot take without investor approval. A short list of typical restrictive covenants includes:

  • A sale of a Company or sale of a majority of the Company’s assets;
  • Sales of new securities;
  • Changes to Articles or Incorporation that change the rights and preferences of existing securities;
  • Changes in Board Composition;
  • Payment of dividends or any kind of not previously agreed to distributions;
  • Changes to the size of option and other incentive plans;
  • Incurrence of indebtedness above a certain dollar threshold; and
  • Transactions with affiliates.

These covenants are described as “restrictive” because management and the board are precluded from taking these actions without the express approval of the required shareholder (or group of shareholders voting as a class). The purpose of restrictive covenants is not to “restrict” a Company from being able to operate. Rather, restrictive covenants are intended to protect investors from management/board actions that a) cause value to leak out to junior shareholders or managers without value accruing to the senior shareholders; b) change the terms of a previously agreed to investment documents, or c) cause dilution to the value of an equity holders position.

Where management and investors are aligned, these restrictive covenants are rarely (if ever) an issue. Only where a management team and investors are mis-aligned do these terms come into play. In my experience, this happens most often when an investor doesn’t want to participate in a financing and is facing a highly-dilutive financing as a result. The investor may seek to block such a financing even though they do not intend to provide the company with additional capital. A management team is totally handcuffed in cases like this and the business may be at risk of running out of money and hitting a wall. What is a management team to do if an investor is leveraging restrictive covenants as hold-up value?

  1. Get Re-Aligned: The best starting place is to work with your investor to re-align expectations. If your investor is of an institutional variety, chances are they will work to understand your issues and accommodate what you are working to accomplish. After all, the death knell for an investor is for word to get out that they are holding up one of their portfolio companies.  Likewise, it is critical that you take the time to understand your investor’s point of view. It is possible that they are protecting you from yourself. If you have already tried getting re-aligned and failed, try again!
  2. Give the Investor a Hard-Choice: For example, if an investor won’t approve a financing despite the fact that they won’t/can’t participate, the best thing to do is to put a term sheet in front of the investor and ask for their approval. Take the term sheet to the board first, have it approved and then seek shareholder approval. Most times, an investor faced with the decision to either bless a financing already approved by a Board or blow it up will make the right call.
  3. Offer to Buy-Out the Investor: In the worst of scenarios, it may make sense to buy the investor out of their position. This is a version of a hard-choice. You may not have the cash to pay a very high price, but that is exactly the point. The fact that you can’t pay much creates huge negotiating leverage for you.
  4. Leave: Working for an investor backed-company isn’t indentured servitude. If an investor is holding you up via restrictive covenant, you can leave. This is the hardest of all decisions because you probably have a lot of blood sweat and tears invested in the business. Don’t do this if your business is already successful and one of your investors is just being belligerent. In that case, try options 1, 2 and 3 again and again until you crack the code. This is also not permission to leave if there is a clear fiduciary responsibility that you should carry out before departing, like winding the business down if the business is insolvent.

I’d call out that nowhere on list is “lawyer-up and figure out a loophole” in the restrictive covenants. There is probably not a loophole to jump through in the first place. Even if there were, using a loophole usually makes matters much worse and gives leverage to the uncooperative investor.

I’m not advocating for bad behavior on the part of a management team and I don’t feel any of the actions recommended above can be characterized that way. An investor that is intentionally holding up a management team without a very, very, very good reason is exhibiting the worst kind of behavior. Sometimes the only way to get to a resolution is to escalate first. Having never gotten into a tussle with a management team over restrictive covenants makes it easier to make the recommendations suggested here.

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Growth Equity Investors are Hedgehogs; VCs are Foxes

Growth equity is increasingly being recognized as an investing discipline that is separate and distinct from venture capital. That being the case, how does one distinguish between a venture capitalist and a growth equity investor. In my mind, growth equity investors are hedgehogs; venture capitalists are foxes. Allow me to explain.

Ever since I read Jim Collins’ book Good to Great, I’ve been fond of Isaiah Berlin’s parable of the Hedgehog and the Fox. The story of the Hedgehog and the Fox revolves around a quote fragment attributed to the Greek poet Archilochus:

The fox knows many things, but the hedgehog knows one big thing.

Long-story short… the fox is cunning, sly, creative, etc. and out to get the hedgehog. By contrast, the hedgehog is – on the surface – mundane, plodding, un-inspiring and looks like easy prey. However, every time the fox tries to attack the hedgehog, the hedgehog responds consistently and effectively by turning into an impenetrable ball of quills, rebuffing the fox time and time again. No matter what tactic the fox tries, the hedgehog “wins”. Hedgehogs don’t do a lot of things; they don’t have the broad repertoire of skills that foxes have. However, they do turn into an impenetrable ball of quills really, really well.

Collins applies the parable to a business context, arguing that companies that are Great (as opposed to good) have hedgehogs as their leaders. Those hedgehogs are able to make a complex world simple, by creating a unifying view of the world and driving single-minded execution in their organizations. Long-term success in these hedgehog businesses comes from relentless and effective pursuit of that execution focus.

Venture capitalists are foxes

Venture stage businesses experience significant uncertainty. That uncertainty necessitates frequent strategy shifts and changes in execution focus. Rare is the case where an early stage business gets the formula right the first time. The skill-set and mindset of venture investors must accommodate this reality. I’d make the case that successful in venture investing requires a skill-set and mindset that is more akin to the fox than the hedgehog. It’s all about broad experimentation, trial-and-error, pattern recognition and connecting dots. It is a gut instinct driven process. Act, evaluate, re-calibrate, repeat…

Growth Equity Investors are Hedgehogs

By contrast, growth stage investing is about backing companies that are developing a successful, growth-generating formula and consistently and maniacally pursuing execution of that formula. Growth stage businesses need to do a few things and do them at a world class level. For the sake of capital efficiently, it is equally important for growth stage businesses to know what they are not going to do in order to maintain a narrow focus on the few things that will move the needle. Execute, execute, execute is the mantra. As a result, growth equity investors have to be hedgehogs. Growth equity investing is all about data driven decision-making and focusing management teams on a narrow set of objectives that generate profitable growth. This isn’t to say that growth stage businesses don’t experiment, they do. Their experimentation is just more data driven and graft onto a growth formula that is already working. The experimentation can’t distract from the core execution focus.

Are you a Hedgehog or a Fox?

I’m not suggesting VC and growth equity investors are in an epic battle as in Berlin’s parable. I’m also not suggesting that one is superior to the other. Hedgehogs are not better or worse than foxes, just like growth equity investors are no better or worse than venture capitalists. But, hedgehogs and foxes are different as are growth equity investors and VCs. As with most things in life, it’s all about fit between skills and scenario. Growth stage businesses benefit from hedgehog leaders and hedgehog investors. They are focused, data driven, execution minded and consistent in their pursuit of a growth formula. Venture stage businesses benefit from having fox leaders and fox investors. They are instinctive, opportunistic, and willing to change tactics quickly, frequently and sometimes with little to no data.

None of us are 100% hedgehog or fox; we all have attributes of both. I tend to lean toward the hedgehog mentality in a business context. In part, and over time, this has led me to prefer growth stage investments. Growth stage investing is a better fit with how I frame the world.

Unfortunately, none of this helps answer the timeless and timely question: What does the fox say?

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