I’ve been an angel and I am a VC. I’ve been involved in approximately 60 investments since 2003. If there is one issue that always – ALWAYS – comes up and causes friction when a company moves from angel funding to venture backing it is the pre-emptive (or pro rata) right.
For the uninitiated, this means the right to invest in a subsequent financing round to the extent necessary to protect one’s percentage ownership interest in the company. In essence, the ability to immunize the dilutive impact of a new financing round. And if the company is doing well and executing its plan, this is potentially a very valuable right. It is a measure of compensation for early investors who bear extreme risk by committing funds early, and who were instrumental in helping the company get to the point of raising its first institutional round.
Yet somehow it has become de rigueur for VCs to do away with these rights, either explicitly or implicitly, using a variety of arguments such as “We need to get to our target ownership threshold of x%; figure it out” or “There simply isn’t enough capacity in the round.” So management is put in the position of either pissing off the VC and running the risk of losing the deal, or having to go back to their angel investors who helped put the company in business and say “Tough luck. Really sorry but the new VC just won’t make the room.” There are two words that encapsulate this situation: F&*%ING BU&&S*$T.
Over the years, I’ve witnessed a litany of what I’ll refer to as bad VC behaviours around this issue and I’ll tell you something: I’ve had it. Maybe I’m particularly sensitized to the issue given my years as an angel, or maybe I’m just a generally righteous (self-righteous?) dude, but it really gets my hackles up when I see VCs driving a wedge in between management and the original angel investors because of their own selfish motives. It is predatory behaviour, plain and simple, and it has to stop.
I’m not some mamby-pamby kumbaya deal guy; in fact, I think I’m generally thought of as tough (but fair). But this isn’t about being weak: it’s about being ethical. Angels deserve respect. They serve a vital function in the capital formation process, and this needs to be taken seriously. Managements also need to find the guts to tell potential investors to bugger off if they try and pull this crap, and VCs should be increasingly mindful of the rising influence of professional angels and smaller VCs from whom they may very well want deal flow from in the future.
I am right now in the midst of a follow-on round with one of my portfolio companies where the pro rata issue has really been painful and added layers of complexity. The management team desperately wants some of that capacity to give to other investors who are likely to have a greater impact on the company’s development in the next phase of its growth. However, after discussing the implications of such a step with the team, we collectively agreed that denying the original angels pro rata rights (which, by the way, were not contractually given in the seed round) was simply the wrong thing to do. We’ll do the best we can with the capacity that’s available, but the angels are protected. I give huge kudos to the team for doing the right thing; not only will this result in bonus karma points, but I’m sure this will pay concerete dividends down the line.
So, if one of your prospective VCs says, “We just can’t do it unless we get to 20% (25%, name your threshold) ownership,” do one of two things: (1) refashion the deal in order to get them to their target without screwing over the angels; or (2) tell them that if they really want to invest in the company, they can deal with a few points less now with the understanding that you will fight for them to be able to buy up in the next round. Is this optimal for the VC or the company? Of course not. But can the VC and management give a little in order to acknowledge and respect the support given by those who first had belief in the company, the team and the plan, the ones who gave the company life, the angels? Of course they can. And it is the right thing to do.
This post originally appeared at Information Arbitrage.
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