Yesterday’s post on Most Founders that Raise Venture Capital Don’t Make Any Money prompted a number of comments and questions. One of the popular questions was “why?” If a startup raises millions of dollars of institutional capital, why would a founder not make any money? Here are three reasons:
- Stacked Preferences – Most venture investments are either participating or non-participating preferred equity such that investors get their money back first in the event of a sale. For example, if the startup raises $25 million in capital and ends up exiting for $20 million, the $20 million would go to the investors and the founders wouldn’t make anything (unless there was a carve out or incentive plan to join the new company). The more money the startup raises, the higher the bar to sell where everyone is happy.
- Down Round – If a startup raises a round at a valuation lower than the previous round, a variety of anti-dilution clauses kick in that “true up” the previous investors’ quantity of shares to reflect their previous investment in the context of the new, lower valuation. Depending on how much lower the valuation, these anti-dilution measures can completely wipe out the common shareholders including the founders.
- Bankruptcy – Not all venture-backed startups succeed, and a small percentage go bankrupt even after raising institutional capital. With a bankruptcy, shareholders are wiped out, including the founders.
A general rule is that if the startup sells for 3x the amount of money raised, things are usually OK for the founders. If the startup sells for 10x the amount of money raised, things are great for the founders.
Most founders don’t make any money after raising a venture round and these are a few reasons why.
What else? What are some more reasons founders might not make any money after raising venture capital?
One thought on “3 Reasons Founders Might Not Make Any Money After Raising Venture Capital”
I believe a significant reason founders don’t make any money from venture capital (and let’s include all management with equity too) is raising VC before really nailing product market fit. Given there are also usually 2 significant business pivots along the way (could be product, the market, the team, sales model, etc) it’s also tempting to raise VC during these pivots to fund new outcomes. But pivots take time to work through and many start-ups raise Series As and Bs during these pivots at less than ideal terms because you can’t put on the brakes completely from growing….existing investors won’t accept that. This is compounded by the need for even more capital to scale coming out of a successful pivot. The preference stack through these funding rounds prevent a meaningful return for the founder even though the business may be growing and finally hitting its stride. Factor in IRR goals for the VC and the founder likely runs out of time to grow out of the preference stack to really get in the money. The lesson is don’t raise VC right out of the gate (or even at all if you can do it) and only do it when you’ve really nailed product market fit, you understand the VC’s IRR goals clearly, and future pivots are enhancements to your business model, not complete overhauls.