A financing to exit cap table breakdown
I wrote previously about the various ways to be wrong in investing here:
And I wrote about investing in turbulent markets here:
But there is one thing I wanted to call out specifically, which is probably the most painful way to be wrong: When you invest early in a company and it ends up being very successful, but you don’t see any real returns.
I think the first thought for many people is: ah, you must have sold secondary too early. The reality is that that is usually not a mistake at all. Exiting positions gradually at specific, pre-defined thresholds is just savvy early stage investing.
The real issues come with mispricing and over financing.
Let’s go through an example:
- Seed: invest $250k into a $2M round at $10M post-money
- Series A: the company raises a $10M at $50M
- Series B: the company raises a $50M Series B at $300M (at $1M of revenue)
- Series C: the company raises $200M at $1.5Bn (at $15M of revenue)
- You can walk through the spreadsheet here
This looks like a 85x+ return on paper - you turned a $250k investment into upwards of $20M and you’re excited to see this thing exit at at least double that (that is the target return of the newest investor and they certainly know what they’re doing). But then… disaster strikes: multiples shrink back down from 100x revenue to a measly 10x revenue, and top line growth also gets hit. Even though the company grew from $500k to $10M revenue (20x!!) in just 3 years, growth has slowed to 80% and the company is only going to do $18M of revenue next year on higher than expected burn.
While there are a handful of founding teams who could make this work and properly manage burn while effectively growing into the valuation, statistically this is not one of those teams. And now you’re looking at a business that, on a good day, is actually worth $200M.
The only problem is that you invested first… so you sit on the bottom of the capitalization stack and your liquidation preferences are below hundreds of millions of others. If the company gets acquired now, then you’ll get $0. Only the latest round investors will get their money back and hopefully the founders will get some sort of carveout or earnout. All of a sudden your 85x+ gets written down to 0x - you had some great MOIC but the conversion to DPI is looking dismal. More likely what happens is that the company is forced into a downround scenario.
It’s important to recognize that pretty much every downround is unique: there are a lot of ways to skin a cat (a fitting metaphor here), so in this theoretical example we’ll stick to the general themes in a downround and use illustrative numbers. (Note for the sticklers: for simplicity we’re assuming no option pool increases in any of the rounds.)
What most likely happens in this downround is some sort of pay-to-play, meaning that in order to maintain your ownership level, you’ll need to write another check. Let’s assume the company needs $25M. The post money will collapse down to $150M, the options will get wiped out and your $250k investment became a $350k investment (an additional $100k required to invest to protect any ownership). This is assuming you have the $100k available (which, if it was an SPV or a rolling fund, then you probably don’t), and even if you raise another SPV, you can run into legal issues because this new group of SPV investors effectively wipe out the first group of SPV investors by using their investment rights. It’s possible to navigate this, but will require waivers from every single initial SPV investor. At the end of this transaction recap, you’re sitting at ~5x.
This is not the worst place to be, but the company still has a long, tough road ahead to exit and you now understand that writeups aren’t everything, so have lost confidence in the meaning of this 5x on paper.
This is your investment in the context of the cap table and how it changes through each financing:
It’s not the worst situation, but it’s a realistic one and it is painful.
Let’s rewind for a minute and go through a couple different versions of history… what if you had sold secondary along the way? (assuming there was an opportunity) Let’s say you programmatically sell 25% of your initial stake at each of A, B and C rounds, and hold the remainder for the long term exit.
That 86x+ sure felt good on paper, but that 25x+ cash in the bank feels a whole lot better. If you effectively executed this strategy, most likely you realized a better return than anyone else who invested in the company. Note that I didn’t make the unrealistic assumption of timing the secondary sales at the top of the market and instead assumed a linear sell-down strategy that one could implement and stick to.
Ultimately venture building and investing is about maintaining an up-and-to-the-right trajectory for as long as possible (not about getting out of great companies with impeccable market timing). Operational and market hiccups happen along the way, so the key is to make sure that those bumps do not cause too much damage to the company’s capitalization, culture or long-term prospects. This is not a business for short term optimization.
Let’s run through another scenario: a more conservative financing trajectory with a reasonable but still impressive exit at $250M.
Scenario 3 might be a lot less exciting, but it looks pretty attractive to me.
If you’re thinking:
- What about the founders?
- In scenarios 1 and 2, I would, as an early investor, strongly encourage them to sell meaningful secondary along the way. Their new investors are swinging for the fences only, which can create real misalignment with founders for whom a $25M windfall would be life-changing.
- But you *need* 50x-100x returns to really make money in this business.
- If that is the case then either A) you’re delusional about how much money people make in this business, or B) your fund model needs a major overhaul.
The most important takeaway:
While investing in the top 1-2 companies of each generation justifies any entry price, you cannot effectively drive returns while operating under that assumption. Let those outliers be an upside, not a necessity. Most *great* companies go through ups and downs, market cycles and operational challenges on their way to successful outcomes. In addition, building and exiting a $250M business is EXTREMELY difficult - ask anyone who has done it. You need to make sure that the financing of a company maintains upside optionality and doesn’t push founders (or early investors) into a corner where the success of the business does not result in the success of the early shareholders.
And of course, the main point of the exercise is the exercise itself - understanding and gaining intuition around these sequential preferred stock transactions makes us all better investors, operators and stewards of capital.
Detailed calculations can be found here: https://docs.google.com/spreadsheets/d/18Z5DNoOrzde4kwJSWu5SSXu86RqIzh0_/edit?usp=sharing&ouid=114625196600448749152&rtpof=true&sd=true
(Forgive any mistakes - this scratchwork was done at 1am)
