DECONSTRUCTING THE MYTH ABOUT VENTURE RISK: A WAY OUT OF DILUTION
VCs are just great. They are there waiting at the finish-line to see startups through the race. Angels are so graceful. They are the proverbial friend who saw the pulloff from the beginning, and even went down with the buddy to jail saying that was darn good! Whatever’s wrong with the gap between money and ideas, it never should play us all dead about the natural forces of the market and what exactly we stand for in the marketplace.
Since Joe left his fine job to join Dick, fresh out of college and so stubborn for not taking that big offer from General Everything, to turn a question into a startup; someone reading their story later in time, like their families and friends now, should see that they were making or breaking it. Stupid or brilliant, only time can heal what reason can’t.
They met an angel through another friend. He falls in love and tears his check leaves. The prototype goes live and the market is made. That wonderful thingumajig is sold for $3 apiece. Where no taxes apply because of tax holiday for startups in the state they live in, all the revenues amount to $450, 000. Figuring out the total cost of production of $65, 000, they are left with $385, 000 in profit.
If only they had paid back in 1 ½ years after company launch the $80,000 lent by the angel, they would not have had to convert the loan to 20% shareholding. According to their agreement, a share unit is worth two dollars at pre-money valuation of $800, 000. In fact, the work-out posits that the effort of each of Joe and Dick is worth twice the amount invested by the angel. Therefore, each of them has invested $160, 000 without handing in any money save for all-important brains and brawns.
$160, 000 of Joe + $160, 000 of Dick + $80, 000 of the angel = $400, 000 total investment in the startup. In the same proportion, the goodwill accruing to each of them amounts to an equal $400, 000. Because there’s no established custom or popularity, the goodwill should not count now, but they figure that VCs might come calling once the promising product is launched.
Besides, they feel that they should be really compensated for risking spending and exerting so much means and pain on proof of concept delivered to two such clients without any remuneration and contractual obligation to buy. One of them was provided by the angel.
Transport, everyday office rituals, sleepless nights, involuntary fasting, costly PR and shoestring marketing went with the whole gamut. They played deep for a great amount of work effort and thus, the longer time before they could avoid the 1 ½ year loan clause. Just why goodwill came a fair deal.
Press rave is here about the product. Pop culture and the TV people are dying for attention from Joe and Dick. They are reminded by the angel that they could let out some steam motion, yet they should not abandon substance for vanity. They are always back at work. Giving attention to events and the people that matter at every point in time.
Looking at the future before them, sound reasoning points in the direction of more important product features, valuable employees, necessary Intellectual Property tying-here-and-there, more solid collaboration, research and development, due diligence, etc.
It all goes from making the market to meeting the demands of the exploding market. The VCs are getting in touch with one another about this new high-tech star. The shepherd and the sheep are running to graze the bounty grass. By now, everyone in town knows how much more Joe and Dick figure the growing company needs in the way of money.
Before sales, if the share price was $2, the share price after sales takes after this picture:
$385, 000 (profit after tax: recall no taxes apply in this instance)/ $800, 000 worth of existing shares in the company = $0.48125, what is called the market quotient.
Add the pre-sales share price of $2 to the market quotient of $0.48125. And you get $2.48125 for the new share price. As simple as that. This is the market price, and it represents the least rational price any new investor should be paying to own a piece of the company.
In that wise, because the quotient could have been negative as a result of loss instead of profit, such a market price should serve as the lowest extreme of the share price band. If it was so a loss, the same formula applies and the market price should possibly be the highest extreme. And in both scenarios, whatever might count for premium and added value between buyers and sellers of the company’s shares should be taken into consideration in each unique trading case.
Already, some readers would say that the allegory is demonstrating the reality on stock market floors (IPO or trading publicly quoted stocks), or common everyday buying and selling of anything founded on value. In every form of enterprise, startup investing, shipbuilding, fashion house, electric car manufacturing or trivia gamemaking, it indispensably counts to let reward and risk take their natural place in the scheme of things.
We never should attempt to trick the market, if we don’t want to see another market crash or an unfortunate founder suicide. The market should decide how much reward goes to any risk-taker. From above, if any VC would invest in the hypothetical startup, he should be paying at least $2.48125 and nothing less. Doing otherwise is tricking the market, which is the prevalent culture of Series A funding in Silicon Valley.
His later involvement with the company should reward the angel and the founders for all the risks they’ve taken before now: the VC should stop tearing apart previously existing term sheets and creating new ones for the sake of importunely favoring himself and the fund management people he works for. His attitude is mostly driven by irrational fear.
There is no power in arbitrariness. Even if it exists anywhere, such power function never lasts. That’s easily evident in Third World dictatorships and command line communist states. Being in need of more money to run a startup shouldn’t make VCs twist and wriggle angels and founders because he wants to protect investments from risk.
The only optimal and efficient way of protecting investments from risk is identifying its intrinsic value before time, and taking the well-angled dive into the startup just early enough. That’s what separates the best from the worst in managing funds for startup investing.
That viewpoint already puts the angels at vantage position. It explains why nowadays the species of superangels are evolving in the ecosystem of startup investing. Some VCs are realizing that “early enough means most profitably enough”. Jump on it before time asks for a greater price.
Such VCs know that the absolute power the VC community wield now would not last long. Not in the face of a whole lot of market-determined eventualities: far cheaper servers, ubiquitous open-source tools and libertarian programming languages, to mention just a sliver. Dead seriously, running a startup to profit is increasingly a function of how far along determination gets and an efficient combination of these consequences.
Merely observing the market rules and staying fair to the pricing process, is way enough to autocorrect the market in a way that the levers of demand and supply are made to naturally belong to the right sides of the marketplace. The good ones would remain, and the bad ones would be gone.
Matter-of-factly, to have more of the company, using the vast warchest in his possession, the VC should just buy more units of the shareholding at the market price. It’s the price he pays for coming late to the jamboree, and might as well be his deep goblet when General Everything starts an acquisition party or the stock market invites the startup to the IPO frenzy.
If startup founders would only concentrate on creating a product the market is dying to have, the cost of funding would increasingly lower out; since such an important market factor would signal the early value investors to invest when it’s so cheap to do so.
As a result, should the law of large numbers prevail; as bringing about a fairly good count of value-product startups backed by a broad population of early value investors; stock dilution caused by irrational fear would be eliminated.
That’s because more would-be investors would see that it’s just the way to go. Of course, it would establish the pre-eminence of deciding the value of any startup (any kind of company for that matter) on the benchmark of market price.
It should even give convenient rise to founders building from day one a company meant to make them a lifetime living. It would not matter then if things turn out to be acquisition or IPO for an exit strategy on the part of market forces.
Lean startup, blind resolve to intuition, cost-bursting technology, ready candor to mend mistakes and restiveness for innovating right are raw qualities that count for guiding lights to the typical founder that will build the value-product company of the future. Together they should materialize into traction space and undiminishing liquidity. All for one reason: any semblance of that $2.48125.