Getting more by giving up more

Rick Segal mentions the odious practice of some VCs to insist on participating preferred shares when they make an investment. As he explains, it can drive a wedge between the interests of investors and entrepreneurs, and leave company founders with little financial motivation to make a company successful (unless it can be a home run on a Barry Bonds scale).

As a VC, Rick says he will typically ask for non-participating preferred shares, which are much more reasonable. Tech Capital Partners in Waterloo goes a step further and will make an investment in exchange for common shares. There aren't many VCs who will do that, but for an entrepreneur it is usually ideal. You and your VC both own the exact same stock and will share the same reward down the road.

What this usually means is that you will have to give up a bigger piece of the company -- or at least, what seems today to be a bigger piece. That's why Tech Capital usually wants 50% of a company when making an initial investment. It sounds like a lot, especially if you have other offers that apparently ask for a much smaller percentage. But the important number isn't how much you're giving up now, but how much you'll get in the future.

Founders generally have an aversion to giving up a lot of their company. Of all the terms in a proposed financing, the percentage and the valuation are the two that grab entrepreneurs' attention. But they can be very misleading. You can create a spreadsheet and run a bunch of 'what-ifs' comparing what you'll end up with under various scenarios under common share, non-participating preferred, and participating preferred offers. Giving up what seems to be a bigger piece of your company will often actually give you a bigger return when there's money to be divided up.

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