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Seed investors leave whilst party in full swing?

Seed investors leave whilst party in full swing?

With the festive season upon us we should remember that sometimes it is best to encourage bleary-eyed, slightly worse-for-wear friends to leave the party when it is in full swing. And in the sober hours of New Year we might remember to apply this to investees in our companies.

Venture Capitalists are notoriously keen to ensure that no-one takes money off the table before they do. Later stage investors thus tie early investors (and founders) in until sometime after the dawn of the IPO or sale. As a result, Boards carry early investor representatives unable to contribute much to strategy and nothing atall to larger, later investment rounds. At best these investors are neutral baggage but at worst they can represent risk-averse meddlers holding back the growth of a progressive enterprise.

There are two real opportunities available to investors prepared to address this issue:
– troublesome minority shareholders can be replaced with capable growth capital investors
– leveraged returns can be achieved by buying out the seed players at a discount
But why would early investors accept a discount? The reason is because they risk receiving nothing. Capital has been tied up for long periods, and an inability to participate in later rounds is likely to end with substantial dilution.

So how has the market responded?

Over the last three years we have seen growth in a secondaries market for privately held stock, even in tech start-ups. A small number of businesses have emerged to tackle the market – such as SecondMarket and SharesPost – typically enabling seed investors, angels and founders to convert equity to cash.

For Founders the benefits of a secondary market can represent an even more important benefit than for seed investors. Founders are likely to have their capital tied up in just the one company. They have all their eggs in one basket. They are thus peculiarly keen to realise some value – to the extent that they are likely to accept a significant discount for the first chunk of change: the difference between getting nothing and £500k is far more important than the difference between getting £500k and £1m.

Preemption rights mean that shareholders must offer their share to existing investors first but few investors would get in the way if the replacement shareholder is able to contribute to later fundraising or commercialisation.

In the longer term, lack of liquidity for seed investors has a stifling impact on the market with minimal capital available for start-ups and innovative spinouts. This is a cycle we have to break.
So later stage investors, alerted to the characteristic stagger of a party goer who has been at the bar too long, should watch out for exhausted seed investors. Put an arm around their shoulder, find their coat, hand them their early-exit going home goody bag, show them the door and hope for an invite to their next wild party.

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Discussion

  1. Roger Frechette  December 17, 2011

    If it helps to redirect investors to early stage start-ups in life sciences, and especially therapeutics, I’m all for it. The Boston area has Access BridgeGap focused on early stage investments – and a few others who say they’re early stage investors. Problem is too many so-called early stage investors want to see clinical data… With so few interested in early stage stuff, we’ll eventually run out of clinical stage programs.
    rf

    (reply)
    • Simon Haworth  December 17, 2011

      What is required to bring folk back to pre-clinical?

      Corporate venture? Any suggestions from others?

      (Didn’t know you were in BOS, Roger. Will look you up next time I am in town – we have an office in Back Bay via our involvement in BSG Team Ventures)
      SNH

      (reply)
  2. Rayhan Rafiq Omar  December 17, 2011

    Good investors are good at allocating the money they control. They have to spot the right opportunity to invest in: usually a certain market/macro trend and an entrepreneur or team to boot. 

    A good entrepreneur gets things done. Part of that is getting product built, pulling together a team, setting the environment/values and finding capital. 

    Together, investors and entrepreneurs, provide a governance structure. Money makes the world go round. As such, more money has more say in how and what happens next. My opinion is that the more an entrepreneur controls the decision making, the more chance the investor has of outsize returns. I will explain my reasoning below. 

    Companies are not just about making money. If their decision making/governance is entirely bent on making money… Well it becomes quite predictable. Ask an investor how they minimise risk and it often follows a pattern toward making things predictable. Which is fine if you are HP or Vodafone. But start-ups need explosive growth through innovation. Any large company will tell you that predictability benefits sales/business development infrastructure, but slows down/stops innovation. 

    It is interesting to read the comments of Mark Pincus about why he retains an outsize set of voting rights (better to guide the company to growth) and those comments of Michael Arrington with regard to corporate structures, decision making and even installing a CEO above him as his boss (he says she was better for the company in that role). Decisions like these are rare. Investors in start-ups ‘should’ know that they are investing in the ability of the company to be explosive. The moment it becomes predictable… well you will know what the potential is. You’ve all seen that culture: employees grumble, very few decisions are actually implemented and a circle of negative sentiment settles in to ‘protect’ the interests of… nobody in particular. It’s corporate culture. It’s preditable. 

    Past consideration, in the financial world, is often discounted as no consideration at all. Liquidity to founders, employees and early investors is complex. Later/growth stage investors have a point in not wanting to give liquidity before there are real results. BUT early stage investors have DONE their job by that stage: the allowed the company to start up and survive. They should be rewarded and moved on, unless they are clearly useful for the future of the company. These decisions are not easy and made even less so by no structures/processes/precedents in place for liquidating early stage investors at an appropriate time. The industry has only recently come together to create a good standard set of seed financing documents. 

    In my opinion, more effort needs to be put in by VCs to create standards. Maybe, as in other ‘big money’ situations, the complexity aids those with experience and money which helps squeeze situations/valuations/control in their favour. Everyone protects their own interests. 

    (reply)
  3. Simon Haworth  December 19, 2011

    Comments on the blog from Christopher Tuan of SecondMarket, 19 Dec 2011

    o Many investors think of SecondMarket as an OTC market, where shareholders of private companies can freely sell their shares and buyers can purchase these shares at will. However, that could not be further from the truth. While SecondMarket is a mechanism by which shareholders can gain liquidity and buyers can get access to exclusive investment opportunities, there exists a major difference. SecondMarket considers the company to be its client, and will only broker deals if the company approves. Thus, if a company decides it does not want any of its shareholders to sell, SecondMarket will not conduct transactions in their shares, regardless if there is sell-side and/or buy-side interest.

    o If the company decides to work with SecondMarket, SecondMarket will develop a customized marketplace for them, where they have complete control of the following items:

    § Deciding which shareholders are eligible to sell and how much they can sell;

    § Approving eligible buyers to enter the market and view their disclosures;

    § How often trading takes place (most companies conduct a semi-annual basis); and

    § The pricing mechanism of the market.

    (reply)

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