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You can own too much

I was getting an update on a company I know recently when I realized that the investors owned too much of the company for their own good.

Now, as an investor, you might think that you want to own as much as possible.  And, of course, the entreprenur wants to hold on to as much ownership as they can.  If the VCs do own too much, you can run into several problems:

  • The more commonly known issue is that if the investor owns too much of a company, there isn't enough equity left to properly motivate the entrepreneurial management.  If you are asking management to work start-up hours and forego market rate salaries and compensation, you probably have to offer them reasonable equity stakes so that they can share in the upside that they help create.  If the investors own too much of the company (maybe more than 80%), there is no way to have enough equity left to motivate the team except in very rare situations (companies that have raised huge amounts of cash where everyone agrees that the outcome is also very huge).
  • A separate issue has to do with large investor ownership getting in the way of follow-on financing.  A mature company (in terms of investment and age) that is a bit behind in terms of company development (maybe because a business model was switched one time along the way) may be in the situation where the investors own too much.  In this case, the investors own enough of the company (and probably at too high of a valuation) that it is hard to attract outside capital.  If there is investment interest, it may be at a lower valuation than the previous round.  The existing investors won't be happy about that.  However, if the investors do an 'inside round' and invest in the company without a new investor coming in, their ownership may not go up a commensurate amount because they hit the ceiling where they dilute management's upside too much.  Nothing is worse than doing an inside round at a company and, due to option pool expansion, owning less after the round than you owned before.

These types of situations often lead to companies being sold 'before their time.'  As a VC, you may prefer to sell the company rather than do one of those inside rounds where your ownership drops.  The only thing which may keep you from this is if you believe that the future upside is so big that it is worth the short term hit on ownership.  But, you have to convince your skeptical partners of this as well.

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Comments

TypeKey seems to no longer work to authenticate commenters for my blog. I'm working on that. In the meantime, I am posting a comment I received from my friend Christoph on this post:

Hi Mike,


I really liked your blog post. It would have made sense, though, to touch the subject of ratchets. To have investors and entrepreneurs aligned the ratchets need to be mutual and not one-sided as they normally are. I have also come across some term sheets lately where the milestones defined for the one-sided ratchet were at least in one decisive point under the full control of the investors. One-sided ratchets just create unnecessary tensions and should disappear.


best regards,


Christoph

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