It's important to note that these things are common in the private equity world, not the angel investment or venture capital world. The VC world has totally different tricks, like 3x participating preferred, "independent" board members, collusion, and option pools.
Also, if the PE firm is using a 20% discount rate to evaluate the merits of vendor finance, they are likely fooling themselves more than they are fooling the founders.
There are a few ways you can look at this 20% discount rate:
* Cost of capital for the fund
* Cost of capital for investors in the fund
* Cost of capital for the business
If you can't earn 15-20% on a business, you really should invest the capital in a less risky investment. Additionally, most PE funds look to double their investments in 5 years. So using a 20% discount rate is somewhat conservative with this in mind.
However, I tend to agree that you wouldn't want to be throwing a 20% discount rate around against yourself in deal. It's certainly not outrageous though. Think of it as opportunity cost too.
I stand by my claim that in assuming 20% returns for vendor finance, PE funds are tricking themselves by a greater magnitude than they are tricking founders.
PE firms don't invest (generally) in early stage tech startups. By the time you get to dealing with PE (as an alternative to IPO, or as a path to turnaround if you're company is fucked like Yahoo), you can hire your own lawyers and such to buffer from the sleaze.
How do you find the right lawyer to vet your agreements, as a founder, to make sure something like this doesn't happen to you? Is a lawyer even the right person to look for?
If you find a lawyer that sees many deals, then he/she likely knows many VCs and knows who butters his bread.
If you find a lawyer that doesn't know many VCs, then they likely don't know as well the in's and out's of term sheet tricks.
More fundamentally, the problem is that founders are technical (by and large), and they are up against people who do term sheets for a living. It is a very asymmetrical-knowledge situation.
I would expect a banker / financial advisor to pick up on value and risk points. A really good, experienced lawyer should, but it isn't entirely in their expertise.
(BTW, if the lawyer does see a lot of deals, I would wonder how much of their business is representing investors, and how that colors their thinking. Their duty is to their client, but it's just human nature to see things in the same terms as your client base.)
These negotiate for a living, but investors shouldn't be intimidated. Take your time, think the thing through. DO NOT BE AFRAID TO SAY NO. Always have a plan to walk away, and never get committed beyond your comfort with the terms of the deal. Always have some plan to bootstrap, if only to prevent psychological commitment to _this_ funding deal.
I'm sure the fundraising process is a pain, but a lot of the preparation and strategizing is stuff that management should be doing anyway.
We had pretty good lawyers, but we got the best advice from a couple of guys who had founded and sold their own companies years before and who still had the scars. In my experience, I thought the lawyers sometimes played the whole exercise like an intellectual tennis match - whereas the guys who had been the same process with their own skin in the game could give much more directly useful advice.
For example, a couple of days before our first round of investment one of these guys told us "you do know you'll be expected to sign personal warranties to the investors" - something our own lawyers had managed to forget to mention (and strictly speaking they might have been right as they were, of course, the company lawyers). NB Personal warranties seem to be (were) a common thing required in the UK - I believe they aren't used in the US.
[Edit: I suspect we were made to do quite a few things that would look crazy to folks from the US - our first round of investment was in '97, hopefully things have got a lot easier in the UK for startups.]
* Spend an entire night reading the term sheet yourself. Your interests in a good outcome (as founder) may uncover details others have missed.
* Ask other founders (who've previously taken investment) to look at the agreement too. A fresh set of (experienced) eyes can't hurt.
* Make the most of lawyers. They've certainly been around the block too, but the trick is to tap their knowledge and not incite a fee-charging frenzy.
* Lastly, search for terms you don't know and try to understand everything. After all, for most of us, it would be one of the most significant moments of our lives.
This would be one of the situations where a BigLaw lawyer is a benefit and not just a horrible waste of money. (BigLaw = 500+ lawyer law firms, like Skadden, Cravath, Wilson Sonsini, etc). Those lawyers will personally have the experience handling these situations, or at least they'll have access to someone in the firm who has had that sort of experience.
Wilson Sonsini is pretty popular up in the SF Bay Area. Goodwin Proctor for NY-area startups.
This is only marginally relevant for venture funding. All of the discussions in the article are about how to value a company based upon its current earnings and earnings growth -- your average start-up has zero (or, more accurately, negative) earnings, so the value equation is completely different. Start-ups don't have EBIT.
That said, I wouldn't really qualify any of the items mentioned in this post as "tricks" or "sleazy". Any halfway decent CFO or attorney can run the numbers and explain the outcomes. Instead, the bigger point is that any deal has to be viewed through the lens of the needs of both sides. For a businessperson who desperately needs $7 million today to pay for a new factory to fill an order, it may be worth giving up something down the road vs. foregoing the investment and losing out on the opportunity.
I think all of these are easily trumped by the ol' bit of common sense : "a bird in the hand is worth two in the bush". Don't trust someone who is a professional crook to propose you a deal that includes long term promises.
If people want to pay half later, find a way to cut what they want to buy in half and give it to them at this time and make no promises yourself either.
I think you're mistaken. The title of the article is
"The Tricks Investors Use Against Founders". I'm a founder, working on attracting Private equity from investors, and trying to make sure I don't get tricked. I think that this advice is for me!
Corruption in investing doesn't just hurt founders. It hurts everyone in the end.
Every time one of these articles about "how investors screw founders" or "how employee stock option are never going to pay out", the pool of employable staff are a little more likely to say "These stock options are worth nothing to me but a lottery ticket, so I'm not going to work hard at this job beyond my salary, and maybe I'll get my win for getting some sliver of equity if the company goes big on someone else's effort or sheer luck." In the end, in a den of thieves no one puts in an honest day's work, and nobody wins.
Bootstrap your business with your own money and your own customers' money, and leave the sharks behind.
So, what's the best solution here? To pay $39 and buy "Private Equity Secrets Revealed" eBook or to hire a seasoned lawyer? And then, how much are you going to end up paying the lawyer? Are the lawyers going to pull the same tricks on you as well?
"While you have very limited sources of potential funding, we have virtually unlimited investment opportunities"
Interestingly, in his interview on Mixergy [1], Oren Klaff (author of Pitch Anything) describes money as the ultimate commodity. You can get money anywhere, there's only one of ME.
He discusses this as "prizing". It's definitely worth a look (the book is also pretty interesting).
Seems to me that an undergraduate Econ education (or equivilant) would go a long way in seeing through some of these. These look like questions I've seen on exams.
PE investors buy mature companies and extract profits via cost cutting, mergers/acquisitions, re-organizations. A PE firm may buy a paper manufacturing company if they thought they could increase profits by cutting unnecessary costs.
angels/VCs fund growing companies and extract profits as the company value grows and is to sold to a company or the public market. A VC would never fund a paper manufacturing company unless this were a wholly new way of making paper and had potential to transform the entire industry.
Are you sure the article didn't just flip the relevance bit for you when you read "investors are looking for good companies with low risk, not great companies with high risk"?
The stuff in there about how earnouts are structured seems germane. I have friends who have sold tech startups where earnout structure was a material issue.
Even if this article isn't directly relevant to startups, I think it's useful to startup founders to see the type of games investors can play. Some people don't have the YC team making sure they don't get screwed.
Brad Feld's blog should be the first thing you read if you get a term sheet (or even better - if you start trying to raise $). He helps explain these things in plain english and what they look like in lawyer terms as well.
One of the cardinal rules of software development I've decided over the years is to seek to reduce complexity and reduce risk. With respect to entrepreneurship I go in with a similar philosophy. Therefore as a general rule I think it's wise to avoid outside investment. Because it exposes you to unnecessary additional complexity, risk and sleaze. If you can start and grow a business without it, strongly prefer to do so.
* Note that I speak in general terms. I love YC and trust PG so they would be an exceptional case where it can be a clear net win.
Am I the only one in 2011 who just isn't interested in an ebook? I have a Kindle - can't really bond with it. I have an iPad - can't bond with it either for books or long reading sessions.
I would buy the printed copy of this and read it but I won't buy the ebook. I just like printed books better.
Also, if the PE firm is using a 20% discount rate to evaluate the merits of vendor finance, they are likely fooling themselves more than they are fooling the founders.