Pro Rats
“I’m one hundred percent certain that I’m right, and there’s a zero percent chance that I’m wrong.”
Perhaps this wasn’t the most eloquent claim, and maybe a little redundant too, but I couldn’t help but admire such a bold display of unfettered confidence. This was a prospective investor’s assertion regarding his ability to, in his words, “add more value than the entire team combined.”
That too was rather hyperbolic, and condescending given the circumstances, but at least consistent with his air of total and utter conviction regarding his self-worth and what it ought to mean for his investments.
In the interest of upholding NDAs and protecting the innocent (which is a generous label here), I’ll call this guy Edward and his company BigCo. Edward’s anecdotal evidence of his ability to add such tremendous value was that a few years back, he had purchased 85% of BigCo when it was just a startup for only a million bucks from a solo founder entrepreneur, and BigCo was now a public company valued in the billions. This was the model he was now apparently aiming to replicate, and he had finished that backstory with a self-satisfied pause and half smile that seemed to demand a slow-clap; I considered starting one but thought better of it.
I’m pretty sure the moral of the story he intended was something to the effect of, “You too can be billionaires if you work with me!” but what we got from it was more like, “We too can get massively ripped off if we take money from you!” This was our first interaction with venture capital, and our first impression of Edward.
Well, technically the second. The first was a phone call I got out of the blue the prior Thursday morning, in which he announced himself with, “Hi, I’m Edward. I build companies.” He unceremoniously invited us to fly out to his offices to talk with him at our earliest convenience, and while it was not remotely convenient, we were star-struck from the very start, so we did as we were told.
Monday
So there we sat in our first VC board room Monday, wondering how we’d gotten there, and trying to absorb and internalize some of the confidence that seemed to radiate from this guy. A few minutes later, he offered us $800,000. Eight hundred, thousand dollars!!! When combined with the expected follow-on participation from our existing angel investors of another $200,000, we would hit our target of a million.
Twenty minutes into our very first VC pitch, it looked like we were already within striking distance of being done with fundraising. He had written “$800K” on the whiteboard in green marker, un-coincidentally I think, and circled it. It was right up there in plain sight, accessible, almost like a briefcase full of cash sitting on the conference table. Then he wrote “$8M” and, immediately following, “10%.” Those looked like good numbers too.
It appeared that he was offering us $800K for 10% of our company, that is, valuing the whole thing at $8M. We hadn’t done much research yet to know what kind of terms were fair or typical for a deal at this stage and this size, but intuitively this felt not more than fair, if not a little too good to be true. By this point the feeble mental negotiation preparations we’d made for this meeting were failing us; the poker faces were dissolving and the four of us were smiling, if not outright grinning stupidly. It’s hard to focus on math when there’s celebration music blaring in your head.
“But it’s not really about the money,” he continued. This was news to us. It sure felt like it was about the money. We’d up and flown out to meet this guy because we were chasing the investment money. Our fledgling startup would soon run out of seed capital if we didn’t raise the money. If the focus of this meeting wasn’t about the money, what was it about?
“As I said earlier, we have a unique investment model because we get a lot more actively involved than other investors. We have plenty of money to invest, but the real value is in the time and guidance that we put into each and every one of our portfolio companies. For that reason we only take on a handful of investments at a time to ensure that we can be really deeply involved and add that value.”
This all sounded great. We were tired of needing to figure out absolutely everything by ourselves. He was right; it wasn’t just about the money — we also wanted help and guidance from experienced professionals. This is precisely why we were interested in talking to VCs. Maybe I was wrong about this guy, and maybe our trip was going to pay off after all!
“We believe that our time investment is worth twice what our money is worth, so when we buy 10% of the company for cash, we also take an additional 20% for our time.”
In video games there are audio/visual effects for moments like this. It’s generally something high pitched and abrupt along with bright visual cues like lightning bolts, used to enhance moments of surprise. When your character is sneaking around to a side entrance of a compound and then the bad guys detect your presence and start sprinting towards you with guns blazing, the echoey piercing violin sound bite adds viscerally to a sense of “Oh, SHIT! What am I going to do now?!” It also brings any ambient sound — such as in-head party music — to a screeching halt.
Given the intentional narrative and build-up, he must have known this would kick off a fight-or-flight response. He must have seen it before, as this was not just an off-the-cuff scenario he was laying out, but actually part of his investment model as he very carefully explained. What did his other portfolio companies do at this point? Was it actually an intended part of the negotiation, a test of some sort to see how we’d handle adversity, or was he actually trying to pull a fast one? Or did he genuinely believe what he was saying and expect us to buy it too? It had apparently worked out well for him once before, but was one a large enough sample?
All of these questions and more flooded into my head in about five seconds as he added “20%” onto the board in a separate circle of its own. Its position there seemed a perfect visual manifestation of its verbal introduction. It sat there floating ambiguously, almost as an afterthought, without any supporting math or apparent connection to the other numbers.
Step one was to make sure that the “Are you fucking crazy?!” remained exclusively in my head, and that my facial expression, while definitely altered from its prior state, revealed only surprise and not indignation. We politely asked clarifying questions for a few minutes until he abruptly ran out of time and said we’d need to continue later in the week. He knew that we had only planned to be there for one day, so I suspect this was part of his strategy, one more mechanism to establish dominance and control. We called his bluff and told him we’d gladly extend our stay, and scheduled time for Wednesday morning.
Tuesday
Tuesday was a fun day. After we’d left the meeting Monday afternoon and gone through the obligatory scramble of flight changes, hotel extensions and pet care-taking phone calls, reality settled in: we had about thirty-six hours to figure out what the hell we were doing.
There were four of us, so we divided and conquered as best we could. We needed a financial model to put real numbers against what had been said in the meeting. We needed to talk to some of our existing angel investors and bring them up to speed, and to a few employees too, to discuss what this could mean for the future. We needed to gather some comparable information from other outside investors and entrepreneurs to get a sense of the market and begin to understand the norms.
Jorge, our CTO, had completed an MBA prior to our startup, so he was eager to take a stab at the financial model. He used the Discounted Cash Flow (DCF) method for valuing a company, which he’d learned in school. Conceptually the idea is that the fair market value of a company should be a sum of the present value of all future cash flows, that is, the total value it will create over time. We had no cash flows yet, so Jorge plugged in what seemed like some modest assumptions. It told us that our startup was currently worth eighty million dollars.
Jorge admitted this wasn’t a usable number, but he didn’t have an alternative methodology for finding something more believable. None of us did. And the numbers people like Edward were throwing around seemed completely arbitrary. A lot of the value we got from Tuesday came from simply hearing and saying numbers of this size and scale with sufficient frequency to start growing accustomed to them. It was becoming apparent that we were entering the next level here, whatever that meant quantitatively, so we had to start talking and acting like it, even if it felt exaggerated or unwarranted.
Wednesday
The preparation paid off: Wednesday panned out pretty much exactly as we’d imagined, and it was a fitting final chapter to the Hollywood-style experience we’d had with Edward thus far. What began just a few days prior with the surprise travel-inducing phone call, and then continued with a used-car-salesman style negotiation now ended with a bang: the term sheet discussion.
The four of us sat on one side of the table with laptops open, just as we’d pictured. He started out as we expected, recreating his simultaneous dual-valuation structure. But this time we’d built our model to accommodate that, so now each time he threw out these two numbers, we’d all immediately huddle, plug in the numbers, and reply fifteen seconds later with a rational, unified valuation.
“I suppose so, if you want to look at it that way,” he’d retort. “But really you should understand…” and then he’d reiterate his shaky logic and ethically dubious rationale. He was demanding two concurrent equity purchases with different terms in order to inflate the apparent valuation number and obscure the true portion of the company that he would wind up owning. We went back and forth like this maybe three or four times.
“Look, we get it,” I said eventually, mustering something, though I’m not sure if I quite knew how this was going to come out.
“You think you’re awesome… and we think we’re awesome… so… we just need to find ONE number that quantifies and fairly values… all that… awesomeness.”
I can’t think of another time in my life where I’ve said anything so pompous, but this seemed to be exactly what was needed. He grinned back at me with a distinct look of, “Attaboy, now you’re getting the hang of this!”
I had temporarily managed to inflate us to a size where we now registered some gravitational pull on him; we were a newly discovered moon orbiting his Jupiter-sized ego. He finally shifted to just using one number himself, which was our first win of sorts: now we were effectively speaking the same language and playing, more or less, by the same set of rules. And on that basis we went back and forth a couple more times, with some minor posturing on both sides, until settling on what appeared to be common financial ground.
We wrapped up the meeting with the volume of our in-brain party music gradually starting to rise again, but managed to all contain our excitement until we were out of sight and earshot. We had an uncharacteristically boozy lunch to celebrate, and I laughingly proposed a well-received toast to the other co-founders: “Here’s to being awesome together!”
Term Sheet
Later that day, the term sheet arrived in email as promised. It seemed consistent with what we’d already discussed and agreed upon earlier, but it was still an important box to check. Now we had something in writing on real letterhead from a real investor. Even if it did have disclaimers about not being a binding agreement, and even if we’d seen tons of red flags over those last few days, a term sheet in hand was still a significant milestone.
As we began our diligence though, those red flags immediately became larger and more numerous. There was a strange EIR (“Entrepreneur In Residence”) provision, whereby BigCo was effectively attempting to pawn off the cost of one of their own analysts onto us. And the financing piece — though the numbers themselves appeared to net out to what we’d discussed in person — was still split into two different buckets, coming from two different legal entities and entailing simultaneous equity purchases at two vastly different prices. Why was this exotic structure so important? Who was meant to benefit from what seemed like a lot of unnecessary complexity?
Most memorable and somehow most perturbing, though inconsequential to the actual potential deal, there was a typo. One of the terms guaranteed BigCo the right to participate pro rata in future financings, meaning that they’d have the option to avoid dilution via additional investment. As we’d soon learn, this piece actually was one of the more sensible and standard elements of early-stage financing.
Only here, it didn’t actually say “pro rata.” It said “pro rats.”
Yeah, yeah, the “a” and “s” are right next to each other on the keyboard and “rats” is a real word so it got by spellcheck. Fine. But still, there was $800K on the table here, and even if that was peanuts for BigCo, it ought to merit some attention to detail, no? And they’d supposedly done this before, too, with this clause being one of their standard terms, which meant presumably this same typo was on other deals and had gone undiscovered.
We couldn’t help feeling given the circumstances like this particular typo just screamed Freudian slip. We’d already gotten a sketchy vibe from these guys from the start, and now here they were on paper, unconsciously admitting to us in their offer that they were, indeed, pro rats.
Calling All Angels
One of the seeds we had planted in that flurry of outreach on Tuesday happened to be with AngelList. At the time AngelList was only a fledgling platform and marketplace for potential angel investors and startups to find one another — it has since grown tremendously — and we were fortunate to have an opportunity for the founders of AngelList to feature us in a weekly email to their investor community.
Within about two days of the email blast, we had somewhere in the neighborhood of forty meetings lined up. And in addition to giving us credibility and a foot in the door with so many additional investors, going out on AngelList also had another unintended effect: Edward saw it and withdrew the offer. This was, perhaps, the strongest signal of all regarding potential foul play. As we soon learned, most investors had the exact opposite perspective: they’d show some interest, but were hesitant to make firm commitments without knowing that other investors were on board. So dropping out at the notion of others joining the crowd of supporters was definitely not a good sign.
AngelList was ultimately how we raised our million. It was not a flashy, three-day Hollywood-style adventure, but rather a grueling several-month-long process entailing nearly a hundred meetings all-told. But through this exhausting process we ultimately found a group of well-meaning investors — angels and VCs alike — who were all genuinely in our corner rooting for us to succeed, and none of whom were attempting to swindle us.
We still reminisce fondly about this week, as it somehow felt like our first foray into the big leagues. It was our first time contemplating numbers of this size, and our first time really imagining a future that went beyond building a product. It catapulted us into a fundraising process for which we were ill-prepared, but which we then managed to survive a la trial by fire, true to startup form. And it was our first encounter, which we narrowly escaped, with pro rats.
