This article was originally posted in Hungarian on the Award-winning Startupdate.hu blog on the 27th of May, 2013.
I know I’m going to make some European investors furious with the following ideas – but I COULDN’T CARE LESS! Consider the following story: You go from one investor to the other for months and months. You have already given up and started over ten times. You have already experienced that the only thing they can offer you is, in plain English, their big freakin’ cluelessness. You have seen it all, you have talked to everybody… And then all of a sudden one of them makes up his mind and gives you an indicative offer (basically the preliminary to a term sheet). You keep looking at it, sniffing at it, you do not dare to really believe in it – an investment of almost $200K … They do not even claim a majority stake. But they do want decision control in the Board of Directors, i.e. they require majority control in spite of their minority stake. Should you sign it or not?
Here’s what you should do with it, and you can read this as a fundamental startup commandment that comes before the Biblical ten: you grab the piece of paper, pour octane 98 petrol on it and burn it. You watch closely and make sure that the wind does not blow away even a small piece as this is shit is infectious. After all of it has been burnt you should pour holy water on it and cover it under a thick layer of salt (sanctified again, if possible). Then you should dig a six feet deep pit, throw the goo into it (use rubber gloves) and fill the hole with a few cubic feet of concrete. After it solidifies you crave in ‘Gate to Hell‘. Why? So that it does not even occur to you to sign it even in your most desperate, perspectiveless startupper moment haunted by the darkest depression! You should never give up control under any circumstances in the first investment round of a startup!
Why do investors want control?
Great question (not only because I asked it). Theoretically, your success is in their interest. You push the business forward, they give you the dough and the experience. Why the heck do they ask for control? So that you are not leaving for good with their money? No, that is covered by other sections of the term sheet. So that you are not buying a Ferrari? That is excluded somewhere else, as well. So that they can supervise your fragile little company? No, they can do so with their minority stake and via the Supervisory Board. Cold, cold, cold. So that they can sell the company if there is a buyer around? No, there is a mutual drag-along and the tag-along. So that you can not play around with your shares? You can’t do that anyway as they are subject to protective provisions. So that they can raise capital? It’s getting warmer … So that they can replace the management? Even warmer … So that they can take over the control when the company does not run well? Colder again … If the company does not manage to raise the next round then it dies, goes down the sewer, game over, end, finito, konec, shop closed anyway. In that case the founders work for free – why replace them? With no money who would they find anyway. So that they can replace and dilute the founders in case the business does take off? Bingo! This is the only situation when they are interested to take the control away from the founders. The investor requiring majority control at a seed stage startup would like to replace the management at some point at his own will. And he is gonna raise capital when changing the management. If the business is running like hell he’s gonna do so from his own fund or from related interest groups – as this brings a multimillion dollar windfall profit for him.
It is extremely rare that a startup founder is equally good at bootstrapping and is able to become a legendary CEO at the other end of the world, in an economy unknown to him, running an operation of 500+ employees. This all does not mean that you as a founder may never quit or you can not employ a professional management when you feel you can’t keep up with the pace of the game any more. If I hit the jackpot I would seriously consider to pass the CEO position to someone with more experience managing 500 Americans. But I would do so from a good negotiating position and I would have a saying in choosing the right person and the conditions of changing the management. Not to mention that a capital raise with further dilution wouldn’t be possible without me. If you pass over the control you are going to be a passenger on your own skateboard and you’ll be able to follow the events as a by-stander only. The day will come when you are no longer CEO anymore and you will not even have any influence on who takes your seat. You will have no right to control, replace, dismiss or manage her. You will be a passenger. Just another shareholder.
And this is just the beginning
If you have the control, you will not be able to dilute the investor, as you have no money as opposed to him. On top of that he is protected by the rights that come with the Preferred Stocks (Protective provisions). You are not protected by anything like this as you own Common Stocks. (That is a different series of stocks, with no extra rights.) The biggest danger in giving up control over the board is not even losing the CEO position (as the real value is in the shares, not in the position) but get diluted as a founder. The company raises money, you get diluted according to the raised capital and the premoney of the given round. If there is a 50-million-dollar worth business then what will someone do who can cut out a stake legally and brutally cheap? They will cut out a stake legally and brutally cheap – to your disadvantage.
It is still not over
The situation is not good even if your investor is the True Incarnation of Kindness, Love and Selfless Honor. As discussed elsewhere, you will need more investment rounds and the second round will almost certainly not come from local sources. How motivated do you think a foreign investor will be to put their money into a company controlled by a local investor until the end of time? Yes, until the end of time, as pay-to-play is very rare in Central European term sheets. Let’s cut it short: you won’t have a second round, period. Not ‘probably not’. Absofuckinlutely not. So your control-addict investor will lose out, too – although this has never held back most of them from taking control – no matter if they had wanted to dilute you or not originally. (They did want to replace the management, otherwise they wouldn’t have wanted majority control.)
Now honestly, use your common sense and imagine the following situation: The Director of the Board or the owner of an investment fund gets home and their partner is asking ‘How was your day, Darling?’ To which he replies: ‘Oh, my Dear, I can’t believe my eyes, you know there is this startup who acquired 10 million users in a year, this Jeff / Steve / Johnny fellow really got everything right and now he received a $50 million exit offer from an American investor. We could dilute him as we are in control so that we could make ten million dollars immediately and totally legally but there is such a thing as business ethics, so we won’t do it.’ Partner goes: ‘Of course not, Honey Bunny, you are not that type of a person. How could we live with that ten million dollars on our account if this poor kid has worked so hard for it?’ … This conversation will clearly go like this I’m absolutely sure … and that no Central European investor would even contemplate the ifs – if they can legally make tens of millions of dollars.
But if you have a healthy amount of mistrust in you then remember: petrol (octane 98), sanctified water, salt, concrete. We DO NOT give up governing control at the first investment round. Never! It’s your company, your effort, your traction! Based on what logic should it be controlled by someone else? There are enough people in this industry with shaking hands – your hands should not shake. If you were given a term sheet, sooner or later more of them will follow. Also investment money is around, there are few projects – good startups are contested over. Don’t let the control go. They will finish you off big time – but they will let you work a couple of years for them before doing so. Now that will be a moment when you are in the spotlight and all eyes are on you … Trust me, it really hurts to fall down to ground zero from there. Patience: there are good investors who understand what level of control makes sense for them. They are not in majority, though.
I really appreciate if you guys share this. Feel free putting your comments as well.