Key Moments
Understanding Investor Terms & Incentives || Rookie Mistakes with Dalton Caldwell and Michael Seibel
Y CombinatorKey Moments
Investors may offer seemingly good valuations, but hidden terms and conditions can significantly disadvantage founders, leading to loss of control or unfavorable outcomes.
Key Insights
Founders should prioritize understanding the terms and conditions of a funding deal as much as valuation and amount raised because certain clauses can harm them regardless of how high the valuation is.
Terms like 'participating preferred' and 'super pro rata' are often used by investors as negotiation tools, and founders may concede them without fully grasping their implications.
Giving up board control can lead to founders being fired, even in rounds as small as $1 million, highlighting a significant risk beyond perceived financial gains.
Investors specializing in high-growth, billion-dollar outcomes may offer better terms than those optimizing for smaller exits (e.g., $10-20 million), who structure deals around these lower targets.
When an investor says, 'Come back when you find a lead,' it often translates to a 'no,' serving as a free option for them to invest later if a strong lead emerges, without commitment.
Modern seed funds, with obligations to their LPs and internal ownership targets (e.g., 10%), have stronger incentives to encourage founders to raise more money, even if not optimal for the company's growth.
Beyond valuation: The hidden dangers in funding terms
Founders often focus heavily on achieving a high valuation and securing a significant amount of money during fundraising, a common mistake highlighted by Y Combinator partners Dalton Caldwell and Michael Seibel. However, they emphasize that the 'terms' of a funding deal are just as critical, if not more so. Investors, aware of founders' desires for high valuations and positive press, may concede on these points. In return, they often ask for a variety of other terms, some of which are deeply technical 'inside baseball' jargon like 'participating preferred' or 'super pro rata.' Founders who agree to these without full comprehension can face severe consequences later, even with a high valuation. These terms can include clauses that significantly disadvantage the company or founder, irrespective of the initial valuation.
The risk of losing board control
A particularly stark example of a dangerous term is giving up board control. Founders can agree to terms that allow investors to gain control of the board, potentially leading to the founder being fired. This can happen even in relatively small funding rounds, such as raising just $1 million. The core issue is that founders are often negotiating against experienced investors who engage in these deals daily. For a first-time founder, trying to outmaneuver a seasoned investor is a losing proposition. Using standard, well-vetted legal documentation and working with lawyers experienced in startup financing are crucial steps to prevent founders from being exploited in these negotiations.
Aligning with investors focused on massive growth
The type of investor can significantly shape the terms offered and the desired outcome for the company. Investors who have track records of funding companies that become billion-dollar successes are generally more inclined to offer founder-friendly terms because their model relies on massive growth. In contrast, some investors may structure deals optimized for smaller exits, such as a $10-20 million sale. In international contexts, this is common, not necessarily because investors are intentionally malicious, but because they may lack experience with billion-dollar outcomes and thus optimize for scenarios where a company only sells for a modest amount, ensuring their fund's survival. founders can get better terms by raising money from investors who have backed companies that achieved significant scale.
Decoding the 'come back when you find a lead' tactic
A common phrase founders hear is, 'We love your company; come back when you find a lead investor, and we might allocate some capital.' Caldwell and Seibel explain that this is often a polite way of saying 'no.' If a company finds a lead investor who commits to the full round, that lead typically wants to secure their desired ownership percentage, which often means not allowing other investors to fill the remaining allocation. Other investors would normally be eager to join alongside a strong lead. When someone uses this line, they are essentially securing a free option: if the founder finds a great lead investor, the secondary investor can then choose to invest on better terms or potentially capitalize on the founder's success without having taken any risk upfront. If no lead is found, they simply pass on investing without having explicitly rejected the company.
When investors push for more money
The dynamics of fundraising can also lead to misaligned incentives. While investors generally seek large outcomes, their incentives at different stages can vary. For very early-stage companies, saying what founders want to hear might be a strategy to build mindshare for future investment, especially if they can't fund them now. However, for companies they intend to fund, investors often encourage faster growth, suggesting increased spending on sales and marketing, even if revenues seem flat. This push for aggressive growth can stem from the investor's need to hit their own fund's targets. A key misalignment occurs when an investor prefers a company to grow rapidly but perhaps not achieve profitability, whereas a founder might see profitability as a positive outcome. The professionalization of seed funds, with their obligations to Limited Partners (LPs) and target ownership percentages (like wanting to own precisely 10% of a company), creates a stronger incentive for them to push founders to raise more money than might be strictly necessary.
Understanding the VC sales pitch
Michael Seibel likens the investor's influence to a job application process: if a company applies to Facebook, the company might say, 'Great, now go get offers from Google and Apple, and then come back.' This isn't a genuine offer; it's a way to defer commitment and gain leverage. Investors, like companies in any negotiation, have their own goals and incentives. Founders need to recognize that investors are not purely altruistic but are running a business with specific agendas. When hearing a pitch or offer, smart founders take a moment to consider the investor's perspective and underlying rationales, rather than accepting statements at face value. Recognizing these incentives is key to navigating fundraising negotiations effectively.
Mentioned in This Episode
●Companies
●Concepts
●People Referenced
Common Questions
A significant rookie mistake is focusing solely on valuation and not understanding the other terms in a funding deal, which can negatively impact founders even with a high valuation. Giving up board control or complex terms like participating preferred and super pro rata without full comprehension can also lead to detrimental outcomes.
Topics
Mentioned in this video
Used as an analogy for an employer asking a job applicant to secure offers from other companies before committing.
Mentioned as an example of a company with a strong job offer, used to illustrate a point about investor 'come back later' tactics.
Mentioned alongside Google as an example of a company offering a job, highlighting the conditional nature of some investor responses.
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