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The importance of honoring pro-rata agreements

aaronkharris.com

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Re: The importance of honoring pro-rata agreements

#51

Post by 7Figures2Commas »

tptacek wrote: post #26
7Figures2Commas wrote: post #22

Earlier quoted context omitted.

> It's possible to behave ethically in a fallen world. You're absolutely right. It is. But as an investor, you are bound to get hurt if you assume that everybody you're conducting business with will do so. Again, you can either deal with the world as it exists, or lament the fact that it isn't perfect. In boxing, fighters are instructed to protect themselves at all times. That approach is a decent one outside of the…

What parts of your life are subject to ethics, then? Is it just investment, or are there are other circumstances where you feel like you have to choose between ethics and the law of the jungle?

> ...are there are other circumstances where you feel like you have to choose between ethics and the law of the jungle?

I can choose to conduct myself in an ethical manner. I can't assume you will do the same. Get it?

If you go through life under the mistaken assumption that nobody is willing to hit below the belt, and you never take action to prevent and defend against such blows, you will eventually be hurt. There's nothing wrong with accepting the fact that some folks will play dirty, and please don't fall into the trap of believing that taking action to protect your interests requires you to play dirty too. It doesn't.

Once again, if you acknowledge the motivations of other individuals and the pressures they might come under, you are less likely to be caught off guard by actions they might take in response to them. If you adjust your behavior accordingly, you can often incentivize them to do the right thing when they otherwise wouldn't had you acted passively and/or obliviously.

Re: The importance of honoring pro-rata agreements

#52

Post by nordsieck »

tomp wrote: post #29
tptacek wrote: post #24

Earlier quoted context omitted.

Yes? I'm still not clear on why this is difficult. The reality is that the decision is probably never between the future of the company and honoring your promises. It would be irrational for an early investor to allow the company to die in order to preserve their percentage stake in a zeroed-out investment. The behavior contemplated in this blog post isn't that dilemma. It's "this conversation with early investors is…

That - obviously. What I have in mind as the dilemma is exactly the fact that is is rational for the early investor to accept the terms of the latter round, which is why they are likely to get screwed . The dilemma of the founder, to me, seems to be whether (1) to go along with whatever terms the latter investors propose, even though you know it's not fair to the early investors, because you know that it's rational f…

"(2) to stick out with the early investors and only accept further investment provided they honour your agreement (and not try to strong-arm the early investor in giving up their rights), even though it's not rational for you (the founder) or your company to do so (however, it's rational for you+early investor)."

The rationality of ethics depends on everyone believing they are part of a multi-round game.

Hint: even if you think you are playing a single round game, you probably aren't.

Re: The importance of honoring pro-rata agreements

#53

Post by akharris »

7Figures2Commas wrote: post #20
jpeg_hero wrote: post #5

laughing at the default variables in the spreadsheet. ludicrous the idea that you can get a 50x return by owning a 1% of a company that was seeded at a $10m valuation. ....and lets just assume a $1B exit for arguments sake! haha, this guy must be raising money for a seed fund or something. -- oh yeah, and the fact that prorata shares actually cost you something, you don't get them for free as Aaron seems to think.

Yes, the numbers are absurd. I feel sorry for LPs in any seed fund run by somebody who is handing out $10 million valuations. As for the $1 billion exit, according to CB Insights, in 2013, 19 tech companies went public or were acquired at a billion-plus valuation. That represents slightly more than 1% of all exits. Over 70% of the exits were under $200 million. So any angel banking on billion dollar exits would proba…

See Paul's comment above - not really sure why this is absurd. The vast majority of venture returns are in the extreme long tail outcomes.

Re: The importance of honoring pro-rata agreements

#54

Post by tptacek »

7Figures2Commas wrote: post #51
tptacek wrote: post #26

Earlier quoted context omitted.

What parts of your life are subject to ethics, then? Is it just investment, or are there are other circumstances where you feel like you have to choose between ethics and the law of the jungle?

> ...are there are other circumstances where you feel like you have to choose between ethics and the law of the jungle? I can choose to conduct myself in an ethical manner. I can't assume you will do the same. Get it? If you go through life under the mistaken assumption that nobody is willing to hit below the belt, and you never take action to prevent and defend against such blows, you will eventually be hurt. There'…

Am I misreading you? It sounded like earlier you were saying that it's justifiable to ruthlessly renege on agreements because if you don't, you're sure to take losses. If that wasn't what you were saying, I made a mistake, and apologize.

Re: The importance of honoring pro-rata agreements

#55

Post by otakucode »

austenallred wrote: post #2

I've seen this a couple times where the onus is mostly on the later-stage investors. They know the terms, and they know exactly what they need to say to lock out the earlier stage investors and take over a bigger portion of the round, so they start pushing levers to see what they can get to move, playing on the FUD of the founders that they might not be able to raise from somewhere else. What a terrible place to be p…

I wouldn't be surprised if this sort of thing were a test. If you're not willing to screw over the earlier investors, you are clearly not ready to manage a large company. Large companies run on 'if I don't do it a competitor will and then we'll lose', not on being good people. Especially considering that white collar crime is very rarely punished, and then only with a slap on the wrist, such crime is expected in such circles.

Re: The importance of honoring pro-rata agreements

#56

Post by 7Figures2Commas »

akharris wrote: post #53
7Figures2Commas wrote: post #20

Earlier quoted context omitted.

Yes, the numbers are absurd. I feel sorry for LPs in any seed fund run by somebody who is handing out $10 million valuations. As for the $1 billion exit, according to CB Insights, in 2013, 19 tech companies went public or were acquired at a billion-plus valuation. That represents slightly more than 1% of all exits. Over 70% of the exits were under $200 million. So any angel banking on billion dollar exits would proba…

See Paul's comment above - not really sure why this is absurd. The vast majority of venture returns are in the extreme long tail outcomes.

The rule of thumb is that 20% of a venture fund's investments produce 80% of the returns. Outside of the top performing funds, those returns are generally not eye-popping.

The economics of a seed stage fund differ from a traditional venture fund. Stakes are a lot smaller and the number of portfolio companies is a lot larger. Maintaining a stake can be difficult, even with pro rata rights, because the cost of participating in future financings can be too high.

Valuation is absolutely crucial to successful startup investing at the seed stage. A seed stage fund that hands out $10 million valuations like candy is not likely to be very successful. Based on the percentages, a seed stage fund that has several hundred companies in its portfolio is still unlikely to see a billion dollar exit. According to CB Insights, 45% of exits in 2013 were at valuations under $50 million. Do the math. If you invest at bloated valuations at the seed stage, you're not statistically likely to produce great returns when all is said and done, even if you are better than most at selecting companies that have liquidation events (most don't obviously).

Re: The importance of honoring pro-rata agreements

#57

Post by 7Figures2Commas »

tptacek wrote: post #54
7Figures2Commas wrote: post #51

Earlier quoted context omitted.

> ...are there are other circumstances where you feel like you have to choose between ethics and the law of the jungle? I can choose to conduct myself in an ethical manner. I can't assume you will do the same. Get it? If you go through life under the mistaken assumption that nobody is willing to hit below the belt, and you never take action to prevent and defend against such blows, you will eventually be hurt. There'…

Am I misreading you? It sounded like earlier you were saying that it's justifiable to ruthlessly renege on agreements because if you don't, you're sure to take losses. If that wasn't what you were saying, I made a mistake, and apologize.

To be fair, I can see how my original comment could be misread. I wasn't endorsing the behavior being discussed, I was simply trying to convey the idea that investors should accept reality: most founders are going to pick and choose their battles. Realistic investors shouldn't expect founders to go to bat for them unless they have an incentive to.

Example: if you invested $25K in a $250,000 seed round and haven't talked to the founder in six months, don't be surprised if he doesn't fight tooth and nail for your pro rata rights.

Re: The importance of honoring pro-rata agreements

#58

Post by ScottBurson »

7Figures2Commas wrote: post #8
austenallred wrote: post #2

I've seen this a couple times where the onus is mostly on the later-stage investors. They know the terms, and they know exactly what they need to say to lock out the earlier stage investors and take over a bigger portion of the round, so they start pushing levers to see what they can get to move, playing on the FUD of the founders that they might not be able to raise from somewhere else. What a terrible place to be p…

Founders realistically have to pick and choose their battles. If a founder raises a seed round from 10 investors who each invest a five figure amount, and eight of those 10 investors do little to nothing after writing a check, it's difficult to expect the founder to go to bat for them if push comes to shove.

If you want to write a contract to the effect that the investor retains pro rata rights provided he/she does X, Y, and Z, you can certainly do that. If the contract doesn't say that, then that wasn't your agreement.

-- Ah, I understand. Your comment is addressed to the seed investors, not to the founders. As such, it's a fair point. The question of how the investors should behave is not what we're discussing, though.

Re: The importance of honoring pro-rata agreements

#59

Post by 3pt14159 »

founder6564 wrote: post #14
3pt14159 wrote: post #12

Earlier quoted context omitted.

Can you share the rough deal size and investor payback? Most investors have 1x liquidation preference, and I can totally see them getting at least that, even if they didn't write it into the contract; but if they are asking for more than 3 or 4x on a short term deal, then they're just being greedy.

I would like to keep it confidential, since my investors likely read HN. Deal size was above 5 million but less than 10 million. They are pure common, no liquidation preference or anything like that. For all intents and purposes they hold the same shares and rights as myself. They invested more than they would receive in a sale under pro-rata terms, so they would have a loss, but still a partial return on investment.…

Well here is the truth of the matter: If your investors get their money back you'll probably get investors again. If your investors do not get their money back, it will be much harder to raise next time.
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