If you are trying to raise capital you would no doubt have heard of Participation Rights in venture capital financing. These are typically the right to receive the original investment plus share in the remaining proceeds as common shareholders (straight participating) or the more onerous multiple participating structure that gives the investor back a multiple of their investment before the founders see anything and then further allows the investor to share in the remaining proceeds.
What is this means in most startup exits that are not multiples on the original investment is that the Founders and employees with shares can effectively end up with very little or nothing. This is an asymmetric risk, as founders and employees tend to take a pay cut combined with emotional, personal and career risk (these are often forgotten elements at the start of an investment).
Why Accept Participation Rights?
Participation rights are designed to protect venture capital funds, by trying to ensure that they receive their target investment return first, however why do they often try and receive more than just their investment and why shouldn’t they just share the risk with the founders of not getting back their investment? This purely comes down to two key factors:
1) Over reliance by the fund on finding the big ticket Unicorn exit,
2) Lack of competition during the investment round.
On point 1 – VC funds that are looking for the 1-2 ventures in their portfolio that will make substantial returns will look to extract as much as possible from a few investments. VC funds that take less of a Unicorn approach to investment may be better suited as looking for a 20%-30% IRR on their investment (which ironically is probably far better than the vast majority of VC funds’ returns in any case).
On point 2 – Australia has much lower competition than overseas markets due to slow investor processes, poor appetite for risk and a lack of urgency. Poor competition in capital raising rounds allows VC firms to add onerous terms and conditions that effectively can strip the founders of any meaningful returns on exit.
Alternative to participation rights would usually include raising capital direct from private investors or larger corporates (known as Strategic Investors sometimes) that take a longer term outlook and value the investment on a strategic basis. Remember VC funds rarely see strategic value and are effectively short-term investors (even if they exit after 5-7 years their whole strategy is around extracting multiples of their investment).
Convertible notes are an effective capital raising instrument and allows for investors to recoup their investment capital plus a coupon (or interest) plus a discount if converting to equity at a later capital raising. Australian investors have historically not shown significant interest in convertible notes which is a little unusual given their common use in Silicon Valley and European venture funds. This might be due to a lack of sophistication and limited competition to date in venture capital financing in Australia that has allowed funds to take quite onerous terms (compared arguably, to a similar investment in an overseas market).
Capital Raising Process and Negotiation
Look at terms as being equally important as the investment size and valuation – poor terms can leave you with nothing (not to mention when combined with lack of board control, veto rights and low value add that most VCs offer) or very little for your hard work.
Investors will say they need to be rewarded for their risk – the right outcome is a sharing of the risk and the right reward/motivation for founders under a range of possible exit outcomes. Investor favourable investments and terms sound great for the fund but can result in low motivation and implosion of the venture as founders will often walk away when they realise they will get nothing in lower performing venture outcome situations. Ideally you want founders to keep on delivering and even trying to pivot the business under tough situations and possibly delivering value even under adverse business situations.
What can you do as a Founder?
Look at the investment terms, negotiate the whole investment rather than the headline valuation and dollar injection. Look to create a competitive processes and consider alternative instruments.