Dirty Capital
No, today I don’t want to discuss about the anti-money laundering legislation that all financial entities, including venture capital funds, have to comply with. What I intend to chat with you about is the great importance of the corporate structure for a startup.
Clean Your Cap Table
Investors look for very specific patterns in the ownership of the company, also called capital composition or “cap table”. It’s something that is not always given due attention and it’s a pity that, having a good project at hand, the operation would fail for reasons unrelated to the merit of the product … but not unrelated to the long-term success of the company, because that’s where the main problem lies.
A cap table contains a list of all the shareholders of the company through its different rounds, either because they have worked (founders and first employees), put money (investors), or provided some other relevant service, each entry annotated with its date, amount and percentage of ownership, which varies as the valuation of the company evolves and more money is raised to finance its viability.
To the trained eyes of a geologist, contemplating a hillside cross-section is like opening a history book: the texture of each successive layer of sediments encapsulates in its interior the narrative of a natural period. They speak about times of progressive expansion, accelerating change, crisis and mass extinctions. In a similar way, a cap table reveals a company’s past and in its composition we can trace the convulsions that occurred during its gestation, its boom phases and, if it’s the case, also its most problematic moments.
Investors look for certain cap table structures… simply because they work. They have been tested continuously, in many different scenarios, and have led to the construction of large companies with international outreach.
With this please don’t think that I am a traditionalist, closed to financial innovation. I precisely hold the view that one of the most interesting things happening in the industry right now is that the Cambrian explosion of fintech companies has led to a tremendous variety in new, disruptive forms of financing; of which of course only a few will prove long-term viability. For instance, although we do not usually favor convertible notes¹, we have used them in Kushki’s last round because it was the proper instrument in the right context, and we regularly work with ratchets, options and other tools in order to align incentives.
In the end this is a cap table’s main purpose: alignment of incentives. That everyone rows in the same direction, only a few experienced hands set the course, and there are no stowaways on board enjoying a free cruise. This is usually better understood on the negative flipside: if there are consultants in your capital who are no longer in the company, or a founder (usually the technical) holds too much equity over the others, or your share percentage as entrepreneurs is already too low (be it due to progressive dilution or because some venture builder considers that the idea is worth 95 cents and the implementation just 5 of each dollar)… prospective investors may most likely be scared away.
Similarly, if you have a very fragmented capital in which there are a lot of small and non-professional investors, venture funds will perceive it as a governance risk because in times of stress it is difficult to bring a large number of participants to agreement, especially if they are not accustomed to these situations and let themselves be carried away by their emotional side. This turns out to be a big problem for crowdfunding due to the impossibility in South Europe to use intermediate vehicles and, believe me, I say this with sadness because I love working with both business angels and online platforms. In these contexts, new investors usually impose a capital cleanup as a non-negotiable condition to their entry, a cleanup that can become traumatic and painful. In general you will stay on the safe side if, at the time you structure the current round, you are also carefully considering how your decisions will affect your ability to raise the next two rounds.
Stay Clear of Exotic Structures
On other occasions, the founders set up corporate structures of a complexity that seem more like a premeditated effort to shoot themselves in the foot … or to play a crooked riverboat poker game with the potential investors.
For example: at Conexo we recently received a fintech investment opportunity, the new project of a well-known Spanish entrepreneur². As this person had structure it, company A (whose capital we would acquire) was actually a matrix organization comprising two startups (B and C), each with its own product, strategy and team (including CEO). To complicate matters even further, company B was the main customer of C. When I expressed my surprise I was told that “obviously it was the best way to leverage the synergies between them”.
That triggered my alarm bells as manager of a portfolio of companies. To understand my concerns it is important to have a more advanced conception of risk than “things do not go well” or a volatility around a statistical mean. I’d refer you to my article “The Bushido of Risk” dedicated to this issue, which will allow you to understand the fundamentals of the financial portfolio creation process.
First approach: we rarely invest in two companies that are dedicated to the same or an excessively close subject. We do not want these two to enter into a collision path and consume precious resources by tearing each other apart for market share. That violence in any case should be reserved for the threat of external competition.
Okay, you will argue, but should collaboration opportunities arise, we have to take advantage of them and it would be great if companies can support each other to go further together. Right? Well, here we get into dark waters and it is not as clear as it may seem at first sight.
Second derivative: the main reason why we do not invest in two companies that do the same is because in essence it would not be two investments but only one. We would be placing the same bet twice. When we have to deal with risks as high as in early stage tech investments the categorical imperative is mitigating them by diversifying our portfolio; that is, placing a series of bets that are mathematically orthogonal to each other, so that the success of one is completely independent of the success or failure of the rest.
You see where I’m going. Of course we like that companies treat each other well and provide mutual assistance. But when that collaboration becomes a relationship of dependence, the game becomes a single bet masked in the appearance of a portfolio, a house of cards that can collapse completely by applying pressure to any point.
As much as we want to diversify at all levels, because the experience in your sector is very valuable, the opportunities are finite and the hours of the day even more so, there is always some unavoidable degree of specialization, be it industrial, geographic or technological. Therefore the last thing we wish for is this concentration to increase due to strong interdependencies hidden in the entanglement of activities between our companies.
Moreover, within a holding structure such as the proposed there is not only the possibility but the clear expectation of such interdependences³. It is expected that B will buy exclusively from C, and that C will never reject the business of B. But what happens if a better alternative, cheaper, more efficient than the one that C offers comes onto the market? Or what happens if a competitor of B wants to offer a higher price for the fantastic services of C? Well, something’s gotta give, with or without intervention from the matrix.
That is what I tried to explain during the meeting, though the expressions on their faces showed it was not very well received. After an awkward silence the entrepreneur said: “Well… look at it this way, Isaac: be independent, or not, or whatever, I’m offering you two startups for the price of one.”
What a steal! Isn’t it? Not really, because the valuation that had been put on the table for these two projects under development, without MVP ready and pre-revenue, was 4 million euro while the current market price in Spain (more or less, you know this isn’s an exact science) for a technology company at that maturity stage rests around 1 to 2 million euro pre-money.
So, far from offering a sweet bargain, they really were forcing me to finance two projects to have the privilege of working with them. Needless to say we kindly passed on the opportunity… although I stood uneasy when they mentioned they already had raised more than half a million through several investors! Are there those who do not take these considerations into account? Just in case I decided to write these lines.
Entrepreneurs, please clean your capital. A pristine cap table is a neat conscience. We will all sleep better this way.
[1] Mainly because a convertible note delays the valuation of the equity until the next round, which is counterproductive for a fund of extreme added value as Conexo, where the least important is the money that we provide and what we are most sought for is the hyper growth that we contribute to generate.
[2] We will keep the identities private so that I don’t get even more enemies :)
[3] Empirical studies show that industrial conglomerates tend to flourish when there are market inefficiencies: problems of legal protection, accounting transparency, corporate governance, etc that generate a lack of confidence. By favoring transactions between subsidiaries this problem is avoided and a degree of diversification is provided to the owners. But in an efficient market the interests of the investors are much better served by being able to go to the capital markets and selecting the most suitable company for each sector.
