Double-Dipping in Startups: Drop That Chip!
Avoid the dreaded social faux pas and look out for those trying to take unfair advantage of your startup.
The dreaded double dip occurs when someone puts a food item (typically a chip) into a dip, takes a bite and then re-dips the same chip into the dip again.
Watch this video of Seinfeld to understand.
Did you just double-dip that chip?
“Excuse me?” “You double-dipped the chip.” “Double-dipped? What are you talking about?” “You dipped the chip, you took a bite, and you dipped again.” “So?” ”That’s like putting your whole mouth right in the dip. Look, from now on when you take a chip, just take one dip and end it.”
Depending on which side you are on, double-dipping is either a nasty habit that spreads oral bacteria or a great way to enjoy the savoury dip sauce twice. What the heck is your immune system for, anyway?
Double-dipping in the startup world happens when someone tries to (often unfairly) take advantage of the startup. Here are our top four double dips to look out for:
1. The Double-Dipping Mentor
Mentors can provide value to a startup and serve as important role models. Some mentors demand equity in lieu of cash for their services. This is generally good for the startup as the startup gets the mentorship it needs without burning through cash.
However, be vary of mentors that want fair compensation plus equity or who charge cash for their services on top of their equity grants. Also be vary of advisors that want additional equity or cash compensation for making investor and/or business introductions — these guys often put off new investors as they want to dip into the new investors’ bowl as well. Keep compensation in line with services provided and if anyone tries to go in for a double dip, slap them on the wrist.
2. The Investment Bundle
Occasionally you will run into investors or mentors whose business model is to sell services to their portfolio companies. These investors require their portfolio companies to purchase consulting services, back office or other services from the investor. Some investors even require startups to rent office space from them.
Be careful with investors that are trying to bundle services and investments together.
3. Double-Dipping on the Liquidation Preference
Ok, you probably know this already: when investors invest in your startup company they usually want preferred shares. You own common shares as a founder. Preferred stock is better than common stock, because it comes with certain preferential rights.
Included in this set of preferential rights is the liquidation preference, which gives the owners of preferred stock a guaranteed return — typically an amount equal to the amount they invested.
Investors that demand a “participating liquidation preference” or who require a multiple preference are double-dipping.
As the name implies, a multiple preference is when an investor demands their money back in two, three or more fold prior to the disbursement of proceeds to other shareholders. An investor who has a participating liquidation preference has the right to get back their investment (or multiple on investment if it is also a multiple preference), and then the same investors take a second time in the remaining proceeds as they are distributed among the company’s shareholders — totally forgetting that the preferred investors already were paid once.
Neither participating liquidation preferences nor multiple preferences are common in Series Seed or Series A financings, though they do come up when a company needs additional venture funding and are struggling to reach milestones. As the venture investing climate changes, be on the lookout for more participating liquidation preferences and multiple preferences. In Q3 2015, 25% of Silicon Valley venture financings (across all rounds) contained a participating liquidation preference and only 6% had a multiple preference (Fenwick & West Q3 2015 VC Survey).
One last thing, be aware of the conversion mechanics of convertible notes. Notes that convert at a discount or valuation cap should convert to a class of shadow preferred stock with an adjusted liquidation preference to ensure that the liquidation preference of the conversion stock tracks to the actual investment amount and is not skewed by the terms of the new money investors. Without correcting for the conversion discount, the convertible note holders will inadvertently receive an unintended multiple preference.
To illustrate, if a new investor gets a 1x liquidation preference in a $10M pre-money valuation round, a convertible note holder with a $5M cap would get a 2x liquidation preference if their note converted into the same class of stock. Instead, the convertible note should convert to a class of a separate class of preferred stock with a liquidation preference based on the $5M cap.
4. Doubling Down on the Investment
Lastly, we have recently seen a few angel investors and early stage venture firms try to double down on their investment. These investors strike a deal for their investment, then demand that they can make a second investment on the same terms at some later point in time (often a few years later when the company’s valuation has significantly increased).
Startups should push back against arrangements like these. Early stage investors get good valuations because the startup and their business is still nascent with significant product, market, and execution risk.
Letting investors double dip into old investment terms can be highly diluting to the startup and, worse yet, may be off-putting to new investors that are not getting the same terms.
Conclusion
A study done by the Department of Food Science and Human Nutrition at Clemson University found that double-dipping could transfer about 10,000 bacteria from the eater’s mouth to the remaining dip. So it is both a nasty habit and a potential health risk.
Double-dipping in the startup world is just as bad.
So, maybe, when you take a chip, just take one dip and end it.
By Antti Innanen and Pietari Gröhn. Dottir Attorneys is a startup-focused law firm, with offices in Helsinki, Berlin and San Francisco.
