This week on the startup to scaleup journey:
How experienced founders build investor alignment
The relationship between startups and their investors is never an easy ride. This is hardly surprising. Rarely does the original mission prove to be the final destination. Early startup life is characterised by new discoveries, changes in direction, and readjusted expectations.
The vision alignment that existed pre-investment only lasts for so long. As the plan evolves, a key part of the founder's role is to ensure continuous realignment. As the major investors will likely have board seats, this is done through the board.
Provided the potential for financial return is maintained, the investor directors will usually be supportive. All parties realign. But when the return is under threat, trust is eroded. Relationships can start to break down.
The founder's focus then becomes inward rather than outward. This is often why second-time founders delay creating a formal board with investor directors until it becomes absolutely necessary. In the very early stages when so much is changing, collective decision-making can hamper progress.
But for any startup looking to scale, this moment inevitably arrives. To ensure the board operates as a force for good, experienced founders work proactively to ensure investor alignment. Funding rounds provide a unique opportunity to recalibrate the vision and secure alignment with all parties.
There are 3 areas where investor alignment is crucial.
Understanding the main sources of misalignment and how investors rank their importance can help founders target the right investors, negotiate fair investment terms, and manage the board.
1. Outcome alignment
Experienced founders work hard to ensure that every major investor they bring onto the cap table is fully aligned on the ultimate outcome. Having an investor or a group of investors whose interests are at odds can create havoc.
The scale of the potential outcome (the cash-on-cash return) is something that all institutional investors will model prior to offering a Term Sheet. Understanding the VC mindset on this topic is crucial for any founder seeking to avoid outcome misalignment.
The timing of a potential exit can also be a key factor. If one investor is looking to invest more (e.g. a new fund eager to deploy and keen to help the company grow) whilst another is looking to sell within a few years (e.g. a fund coming to the end of its life and pushing the company for an M&A event), then big problems can ensue.
This could also arise if a financial investor (e.g. a VC) is looking for an exit but a strategic investor (e.g. a corporate) is looking to sit tight and just leverage the relationship with the company. This doesn't assume that such investor types are always misaligned. Often, they can work very well together.
The seeds of the most emotionally charged misalignments can be sown by accepting punitive terms from new investors. The 2 big ones are 1. Anything above a 1x liquidation preference, and 2. Participating Preferred stock. These should be avoided at all costs as they can dramatically degrade returns for non-participating shareholders. This will almost certainly include the founders and early Seed investors.
In times of liquidity crisis, such punitive terms may be unavoidable to save the business. But they are almost always just a way of storing up massive investor misalignment for later on. For more on these terms and how they operate, see our earlier piece: Punitive deal terms returning.
Experienced founders only invite investors onto their cap tables who they know well and trust. Quick deals with unknown investors have a habit of coming back and biting founders hard. Proceed with great care here and do your own due diligence. This is going to be a 10-year relationship. Unlike employees, you can't fire investors.
Serial entrepreneur Dan Siroker, co-founder and CEO of Limitless, puts it perfectly: "It's like getting married without the possibility of divorce."
2. Strategic alignment
Developing the strategy - and the business plan - that will deliver 'the return' to investors is a core role of the founder and the executive team. Formal strategy alignment with current investors is then achieved via the board. At each funding round, new investors (literally) buy into this strategy.
Board effectiveness is often a source of great angst amongst founders. Out of the 60+ startups we have worked with over the past 10 years, all but a very small number have expressed deep frustration over this topic at one point or another.
In our prior piece, How effective is your Board?, we looked at the role of the board and its composition at different funding stages. In early-stage businesses, founders are responsible for assembling the board and ensuring its effectiveness. An effective board composed of the right individuals is crucial in enabling any founder to cement strategic alignment with the key investors.
Managing the board is thus paramount as we described in our earlier piece: Your Board is probably going to fire you. This is based on an excellent analysis by founder and investor Jerry Neumann. He offers 5 pieces of advice to ensure founder/CEOs carry the board and lock in their support.
The top 2 pieces of advice are: 'control the board composition' and 'be the hub of the board'. As time progresses the common shares will no longer control a majority of the seats. The founder's 'hard' power must then shift to 'soft' power. Selecting the right investors is always critical. After that, it's down to the founder's leadership skills.
3. Operational alignment
Institutional investors generally have little or no interest in intervening in routine operational matters, unless something is going seriously wrong. They want to stay removed from the day to day running of the business, except where specifically invited. For example, founders may ask certain investors to help recruit key employees.
Founders shouldn't assume, however, that investors want to be totally hands off when it comes to the big operational calls. Embedded in any investment agreement will be a long list of 'consents' where the permission of shareholders or the investor directors is required. The shareholder consents typically relate to corporate matters (for example the issuing of new shares) and are there to ensure good governance.
But the Investor Director consents, often found in an appendix to the Term Sheet, can get right into the weeds of operational activities. Many of these may at first seem innocuous, for example exceeding certain levels of indebtedness, acquiring property, or disposing of assets. But others can provide catch-all control mechanisms, such as committing to expenditures above a certain level, entering into certain types of contracts, or hiring senior executives (or changing their employment terms).
These sorts of terms may seem unimportant when negotiating the final stages of a time-critical investment. If the pressure is on to close the deal, perhaps due to an evaporating runway, it can be tempting to just wave them through. But experienced founders know they can become a big operational impediment later on. They will quickly take a red pen to anything that appears unreasonable.
In summary
A key part of any founder's role is to ensure continuous vision alignment amongst all stakeholders. Funding rounds provide a unique opportunity to recalibrate the vision and secure alignment with all parties.
Understanding the main sources of misalignment and how investors rank their importance can help founders target the right investors, negotiate fair investment terms, and manage the board.
By separating the big picture view into outcome alignment, strategic alignment and operational alignment, founders can focus on tangible actions to keep all stakeholders moving in the same direction.
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