Caveat (Searcher) Emptor
December 18, 2024
by a searcher from University of Pennsylvania - The Wharton School in Los Angeles, CA, USA
Just read the below post from Walker Deibel, Mr. "Buy Then Build" himself. Even though the case study is about VC funding and a pitch for becoming a Searcher, it's instructive for any Entrepreneur taking investor money for the first time.
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Jessica Alba built The Honest Company worth hundreds of millions. But she could be left with almost nothing due to a toxic investor clause. The brutal truth about how investors use "cheat codes" to steal from founders.
Jessica Alba's Honest Company story reveals a dark side of venture capital most founders never see coming. Although it's valued much higher currently, for this simple example let's assume the company value is $104M.
When the company hit $104M in value, investors can claim $100M through a hidden "2X liquidation preference" clause. Only $4M will remain for founders and employees to split after years of work. This wasn't bad luck - it was by design. Yes this is a simplistic example, and the company is valued higher now, but the fundamental point still remains:
Professional investors load deals with "cheat codes" specifically written to be overlooked by excited founders. Here are the most dangerous clauses they use:
• Minority Control: Investors with tiny ownership can control board decisions and block sales
• Board Flipping Rights: They can remove founders from leadership overnight
• Drag-Along Rights: Forces you to sell when investors want, regardless of timing
• Anti-Dilution Protection: When value drops, investors get more shares while founders get crushed
Each new funding round makes it worse, stacking new investor preferences on old ones. But there are ways to protect yourself: • Read every single term - don't get distracted by valuation numbers • Get a specialized venture lawyer who knows these traps • Fight for 1X liquidation preference instead of 2X/3X • Demand non-participating preferred stock • Keep investor blocking rights limited
Your leverage peaks before signing. Use it wisely. Build strength before seeking funding: • Get to profitability if possible • Create competition between investors • Maintain a healthy runway • Never negotiate from weakness
Consider alternatives to VC funding: • Revenue-based financing gives more control • Strategic partnerships can fuel growth without dilution • Sometimes the best venture deal is no venture deal
The game of money doesn't have to be rigged against you. Smart entrepreneurs are taking a different path: Instead of building from scratch, they're buying existing businesses.
• Control all terms
• Start with immediate cash flow
• Have proven market fit
• Own your destiny
from University of Pennsylvania in Seattle, WA, USA
When you are running a non-cashflowing company, you will be at the whim of market conditions for capital raises (just like the funds raising capital themselves). See the recent publicity around Service Titan's compounding IPO ratchet. Its a huge company that accepted that funding because it was their best option and it ended well for them.
Search and VC backed companies are two totally different approaches IMO and fall on different spectrums of the risk/return profile.
from University of Missouri in Kansas City, MO, USA
If the opportunity and timing dictate a more aggressive approach, be careful to choose the right partner (there are many who do not have a predatory approach to investment) and carefully understand the deal.