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24 April 2017

Last in, first out: should new money be treated better than old money?

Bradley Hardiman, investment manager at Cambridge Enterprise, considers the effects of late-stage funding rounds on early-stage investors.

Author: Bradley Hardiman, investment manager at Cambridge Enterprise

As a seed fund, bringing in external investors in later rounds is a fundamental part of our business. In fact, it is common for additional investors to join in later rounds of investment in a company.

New investors are a good thing. Even with the strongest will, investors who have lived and breathed a company can go native – I know I do, regularly. New investors bring fresh perspective on the company’s progress, the market opportunity and competition and, perhaps most importantly, the valuation of the company.

Adding new investors also makes everyone’s money go further. While some investors have deeper pockets than others, all have a finite amount they can invest in any one company. Bringing in more investors means that each one commits less of his or her maximum during each round. This gives the company added security that, providing all goes well, funding will be there for the company in the future.

Additional investors can also bring in additional expertise and new contacts critical to the company at that particular stage.

But there can be a downside to adding investors in later rounds.

All too often late-stage investors insist on adding more layers of preference. We have companies in our portfolio that have ordinary shares, A prefs, B prefs, C, D and even E prefs.

At the very least, it is hideously complicated to work out who gets what in the event of an exit. The “cash waterfall” – as Excel spreadsheets detailing payments are known – becomes a cash hydroelectric power plant on the scale of the Hoover dam, the construction of which led to at least 112 deaths).

I like to keep things simple – and I would hate for anyone to die during the construction of an Excel spreadsheet. But these layers of preference for late-stage investors can have a very negative impact. By the time all of them have been paid out, there is precious little left for the early-stage investors, let alone the founders.

As I have written in Cambridge Enterprise blog entries, Cambridge Enterprise Seed Funds actively avoid preference shares. We believe they disincentivise founders. When later-stage investors add layers of preference over early-stage investors, this is a very bitter pill to swallow.

If a company has gone through turbulent times, and there has been an “adjustment”, it is understandable that the new money would have different rights attached and a new class of shares has to be created. I get that.

However, a lot of incoming investors insist on the creation of new share classes, even when the rights are exactly the same as the existing investor shares. They do this so that they will be first in line when it comes to getting proceeds of an exit. The justification for this position is what I do not understand.

All investors, both early and late, have the same drivers. So why is it that we regularly have situations where some investors are disadvantaged by others? Most early-stage investors are unable to invest round after round after round and cannot influence the terms of the later-stage investments. We have to rely on late-stage investors being reasonable when it comes to following early-stage money.

Is this too much to ask? Perhaps. Several business angels I know will only invest in companies that require relatively small amounts of total investment, which can be covered by angels over the lifetime of the company. They operate this way because they do not want institutional investors coming in later and wiping them out.

Whether this mindset grows out of personal experiences or is based on unfounded rumours hardly matters. What is worrying is the fact that it exists. The perception colours the way we can form the businesses that we create.

Forming a business and developing its strategy should not be based on whether it will be funded by angels or by VCs. Strategy should be governed by what is best for the business, not by what funding is available.

There have been times when late-stage investors did not get their own way. I have known cases where incoming investors have insisted on an extra layer of preference over existing investors, as they have a habit of doing. The existing investors, not wanting their shares disadvantaged, decided to come up with the entire round themselves, on exactly the same terms as the earlier rounds.

In cases like this, the spurned investor loses the time and effort they expended on due diligence, and the company misses out on the advantages of bringing in new money. Not exactly a win-win situation and all because an investor wants a disproportionate advantage that is pervasive in the industry.

Just because something is accepted, does not mean it is acceptable.

As an industry, we need founders. We also need early-stage investors. When you disincentivise these investors by squeezing them under layers of preference, you run the risk of losing them from the ecosystem altogether.

I will make an analogy to the quote often misattributed to Albert Einstein about the danger of removing bees from the planet. If you do, it is warned, the death of man will follow just four years later.

Early-stage investors are like the bees – furry, hardworking, colony-dwelling, cute but with a sting in the tail, willing to die to protect their brood and sometimes petty enough to do so just to cause some pain.

Remove them from the investment ecosystem and late-stage investors will have nothing to invest in. If that happens, I doubt they would last even four years. So please, bee friendly (sorry) to early-stage investors as well as founders, as they ensure that there will be good things to invest in in the future.

– This is an edited version of an article that first appeared in Cambridge Enterprise’s blog. It has been republished with permission from the author.

Copyright Mawsonia Limited 2010. Please don´t cut articles from or the PDF and redistribute by email or post to the web without written permission.

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