This is the first blog in a short series from DSW Ventures on structuring a venture deal, whether as investor or founder.
The focus of this blog is on leverage and its role in a venture capital funding structure. While we have our own structuring preferences, who’s investing and specific circumstances matter.
First principles: what is leverage and why is it relevant to venture deals?
Leverage is some form of fixed return to an investor or lender. Its purpose is generally to increase the return to the equity shareholders in an upside scenario. A new investor is offered an instrument which is safer than pure equity by partly denominating the security as debt-like. In return for getting a more secure position, the new investors take a lower percentage in the business, and therefore less of the upside.
A quick illustration: VC offers £1m for 25% of a scale-up, a pre-money valuation of £3m. The founders are disappointed and counter with a one-times preferred return on the £1m (a “participating” liquidation preference), plus a 15% share in the equity. Note to reader: there’s no easy calculation to trade off these alternative structures; the main consideration is how likely the investor is to get their preferred return. That’s partly a matter of guesswork.
A quick glance at the above would encourage any founder to use leverage – when the business fulfils it’s potential with a huge exit the founder is much better off right? But most exits are not at the higher values shown toward the right of the graph. Most scale-ups that don’t outright fail will exit for some discount to the entry value or maybe a modest profit. So let’s revisit that graph – focussing on the majority of outcomes:
So the founders end up worse off – and yes, the graph doesn’t lie; when the business exits for below the preferred return the founders get nothing.
Less regularly the founders enjoy a real super-profit from leverage. Just how lucky do they feel when negotiating the investment?
What are the primary considerations when negotiating leverage?
Simplicity: pure equity structures are easy for everyone to understand and produce a single valuation number. Future investors have less to get their heads round, and precludes long debates about how the preferred returns rank against one another.
Tax: EIS and VCT investors have their own tax parameters which don’t allow for some leveraged structures.
Common interests: as the illustration shows, in low-value exit scenarios the founders don’t have much skin in the game. At the same exit value, the investors may get their money back with a small profit. Should they risk it all to allow the founders (who have clearly underperformed) time to make some return? Or cash in to salvage the investment? It makes for an interesting board meeting.
thevc.com captured the dynamics in this well-observed comic strip (this was 20 years ago; read the rest of thevc.com archives and you’ll see that, iPhones aside, the VC industry hasn’t changed all that much).
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If we had to sum up the DSW Ventures approach, it would be to keep structures simple – parties should be driven by the same economics. Leverage may have a part to play in bridging expectations on valuations but it works better in more developed scale-ups.
And for any investors or founder teams who are new to the game – get some advice!
In my next post, I will be looking at incentivisation of management teams using share options and what is required to properly enfranchise a team. For early-stage founders, it’s always more than you think…
Partner, DSW Ventures