Q: There are a lot of examples of VCs taking advantage of entrepreneurs. What are some examples of entrepreneurs taking advantage of VCs?
I can name a few. But, it mostly comes into play in small-scale stuff:
- In a small acquisition, not paying investors 1x or 2x or whatever the notes state. Or variants hereof. Convertible notes become a sucker bet in small M&A in many cases. Investors that took a risk on founders in good faith get paid out nothing, when they could have at least gotten their money back. Yes, acquirers want the money to go to the employees more than the investors. But not at least paying your investors back if you can isn’t cool.
- Not honoring commitments to early investors. Not honoring terms of notes. Not honoring pro rata rights. Amending notes in a negative way without the consent of the noteholders, or most of the noteholders. Removing pro-rata rights from early investors without telling them. Net net, a lot of early investors’ rights can be removed. At least tell them.
- Issuing very large equity grants to themselves, creating high un-agreed dilution. This can be OK if it’s disclosed and done in the right way (e.g., additional grants after 3-4 years). But when done to rework an agreed-upon cap table, it’s too greedy.
- Taking cash out of the company for themselves without disclosure or agreement. This is not THAT uncommon. Sigh. When you are bootstrapped, do what you want. But it’s not a piggybank once you get investors to entrust you with outside capital.
- Gaming the terms and valuation with The Next Investor. Ultimately, the New Investor and the Founders can game VC terms in many ways to disadvantage the last guys. You can cancel the option pool and reissue it right after the deal closes. You can subordinate the early stock in unanticipated ways. A New Investor can do this all and bribe / grant the founders extra equity to smooth it over, while only the earlier investors suffer. This is kind of common in companies that have some traction, have something, but are struggling.
- Not been fully honest about secondary liquidity. Founders sometimes hide that they are taking some of the money in a round out for themselves. Sometimes they fully hide it. Other times, they disclose it, but only at the very end as investors are about to wire — or already have. Again, secondary liquidity done right can be great. But it can also be done in a way to rip off investors.
- Manipulating the financials to close a round. This is more common than it should be. Booking junk revenue. Accelerating revenue you shouldn’t be accelerating. Saying deals are closed that aren’t … quite closed. Etc. Too much of this happens in the run up to a Series A round in particular.
- Not caring (enough) when you raise at a high valuation. Look, not every venture deal works out. But once you raise at a high valuation, you really can’t check out. It’s you saying you are going to build a $1B+ outcome … or at least do everything possible to try. Checking out after a big round isn’t really honoring the social contract in a deal.
This stuff isn’t ultra common, but it’s not as uncommon as you might think. I know of several pre-nicorns that basically wiped out the stakes of seed investors in collaboration with Big, Later VCs.
The best remedy is having at least one investor on the board to represent this group of investors. At least there’s a witness then. Even if you are outvoted.
(note: an updated SaaStr Classic answer)
greater fool image from here
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Jason Lemkin, Khareem Sudlow
