The Valuation Trap – Part 2, a Dog in the Manger

Ondřej Fryc

January 16th, 2019

Reflex Capital → Blog → The Valuation Trap – Part 2, a Dog in the Manger

I trusted their talk about how they had the same interest with me, how they would never block anything, and how it all was a pure formality. Bullshit. Quid pro quo. High valuations mean high risks and more extensive veto rights.

I’ll tell you a couple of stories.

Story 1. Mall.cz. A major global financial crisis occurred in 2008, and moreover, we screwed SAP implementation. The investors said, “Do not expect any more funding from us. You’re on your own.” Well, we would have expected our partners to stay with us in good and bad … but at least, they would not torpedo our efforts to save the business. Us, founders, had to once again bet everything on the company, we pledged our houses … and saved the company. It grew again, yet we still needed more cash. One of our investors was willing to support us again. The second investor, however, said that not only he would not invest any more money (he lost his biggest LP due to the crisis), but that his stake shall not be diluted should anyone else invest! “We have a veto right to any funding, so unless you guys keep our stake at where it is now, we will not give you our consent.” That was obviously unacceptable for our lead investor who said they would rather let us go bankrupt than succumb to such a blackmail.

Story 2. A global startup success story, a company most of you know. At the beginning, they took money from an investor who got a blocking right to everything. Moreover, he always had ill manners. In the board discussions, he would attack the founder with open vulgarisms. There were several exit talks of the company to big multi-billion players. And now imagine a stakeholder who says to the prospective buyers: “Boys, I have the rights to block it all, so you shall give me more money than to the founders, otherwise go home.” No kidding. As a result, no exit discussions ever progressed.

Veto rights are a standard part of most investment contracts. The investor gets the right to veto any important decisions, for example any other funding, M&A, but often also ordinary business decisions such as senior hires and their compensation packages. On the one hand, no problem with that, he has more experience, so can help avoid fatal errors. But there is also the flip-side. To understand the risks, it helps to know, how an ordinary investment manager job actually looks like. In the vast majority of cases such a wealthy-looking guy is not an entrepreneur like you. He often is just a corporate soldier. A person who works for his salary, and, similarly as in a corporation, his main interest is not to make bold decisions, but not to make mistakes. He fears to be fired. And what is the best strategy to not make mistakes? To assume no responsibility, to decide nothing. So, it is quite common for an entrepreneur to send a so-called “consent letter” to hire a super-employee with whom he felt in love. (By the way, just the constant stress to exactly fulfill all your obligations of the hundred-page investment contract … but that’s elaborated on elsewhere). And after a few iterations, a month went by and although the investor (or his legal department) finally releases the written consent, the love is lost and the guy is already employed somewhere else. Or, you arrange to acquire your competitor, agree on everything, pay due diligence process, prepare contracts, etc., the investor will “support you” all the time (“Great idea, we shall formally approve it after everything is ready”), yet when there’s the time, he doesn’t have the balls and you will not get the approval. True story.

One does not read these things in the PR texts about successful investments and it’s easy to listen to the Sirens. They always sing beautifully, wearing golden robes and waving big valuations. However, it is extremely important for you to have investors on your side, your blood, your values, same motivations. They shall be with you in good and bad and have the balls to make courageous decisions. Veto rights in the contract and their potential unscrupulous enforcement are far more important for the future of your company than if the investor has 12% or 18% stake in your company.

Disclaimer: Of course, not all investors are alike. Many are not corporate soldiers, many can assume risks and have genuine interest to help you. And also it would be naive to think someone would bet on you big bucks without any veto rights. The point of this article is, that founders tend to be blindfolded with the valuation… whilst there are much more important things to look for.

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