The Deal Structure Conundrum

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Fundraising is a topic that has followed me over the last couple of years.

I worked directly on numerous financing rounds for companies, ranging from a ‘traditional’ seed round for an early-stage business to to one of Germany’s biggest Series A rounds ever. I wrote about the topic on LinkedIn, touching on creative ideas such as OpCo-PropCo models for real estate businesses or insurance companies for PE firms. And lastly, it’s also something that I covered in the newsletter in The Reality of Family Office Fundraising.

Hence, it is not surprising that (prospective) entrepreneurs reach out to get my opinion. Whether it is a serial entrepreneur looking to start their next project, or an investor-turned-operator looking to buy a company with external funding - they thought of a new, unique way to get the funding they want at better-than-regular terms, and want my view (and approval).

But when they hear my answer, they are often disappointed: Because in my view, most complex, unusual structures for a company or a financing round just aren’t worth the time and effort. Once I have the chance to explain, many see the light. Some don’t - at least not for a while, until they realize that a ‘standard’ structure might actually be the better way to go.

So today, let’s explain why I think that’s the case - looking at three categories where founders try to ‘optimize’: Deal Structure, Control, and Monetization & Exit.

Deal Structure

There’s two types of “deals” that we see most often:

Venture capital: Unproven, innovative business models that require working capital to fund a company’s losses until it can reach milestones and/or profitability. Capital is typically raised in a primary transaction for the purpose of financing (operating) losses. Founders retain the majority of their business, but give up certain control rights. (Practical example: A founder raising 1M€ at a 4M€ valuation to fund the team and tech spend of their new AI venture.)

Private equity: Proven, profitable business models. Capital is often raised for the purpose of a secondary transaction, i.e. buying shares from existing investors, though it might involve some ‘primary’ to fund growth. Founders might retain substantial day-to-day control, but they only own a minority stake in the business. (Practical example: The world of search funds, where a (serial) entrepreneur looks to acquire and run an established profitable business. Investor capital funds the acquisition, but the entrepreneur receives a 20-30% stake for their efforts as day-to-day manager.)

If your deal fits into one of these categories, that’s great. Things should (from a structural standpoint) be easy, especially in the case of serial founders. If your deal doesn’t quite fit those categories (i.e. a start-up in a market that might not be big enough for a Power Law-worthy exit, or starting a new business with a ‘boring’ business model), fundraising might be more challenging, but once again, it’s not impossible for an experienced individual.

But more often than not, the founders that ask us for our opinion find themselves in a third category: Combining the venture capital and private equity model in a way that benefits the founders but disadvantages the investors.

One example is VC cases that are actually PE deals. Take the e-commerce roll-ups of the 2019-2021 period: They raised capital from investors to buy e-commerce businesses, created little to no synergies, and hoped to make them more valuable through the combination of debt and multiple arbitrage. The basis on which they raised money from investors, in my view, made little financial sense. At their core, they were PE deals where investors should retain 50-80% of shares for providing the capital to enable acquisitions, but instead, they were structured like VC deals: Founders would give up minority stakes (10-30%) to raise capital at a valuation that was, in return, based on how much EBITDA they’d only be able to buy with the raised financing. I personally find it unsurprising that most of those VC-backed roll-ups are no longer around.

And then there’s PE deals that try to price themselves like VC deals. Here, it’s less the serial founders, but more the investors-turned-operators that are ‘guilty’. They look to do what is clearly a traditional PE deal (i.e. some sort of services or craftsmen roll-up) that should be structured accordingly, i.e.where founders have operating control but investors typically have a majority stake (50-80%). But instead of settling what might be a fair 50:50 split, they try to over-optimize - looking to, once again, give investors just a 10-20% stake with little to no control rights (more on that in the next category), despite the fact that they couldn’t progress with their deal without that capital.

If you get started on your fundraise and you can raise money at such founder-friendly terms, by all means, go for it. But if you don’t succeed, be mindful that the issue might not be your business case but your desired Deal Structure. And in that case, the issue might not (just) be an unfair structure, but also a non-standard structure that might make it hard for an investor to categorize you - is it a VC deal? A PE deal? If they’re unsure, the easiest choice for them might just be to discard your deal.

Control 

Whether it’s a serial founder who had bad experiences with control rights in their earlier ventures, or a former investor who saw their power - both groups want to be subject to a smallest degree of investor control.

To a degree, I can understand that: Over the years, I’ve gone from VC optimist to VC pessimist to VC realist. I’ve seen terrible VCs using their control rights to push founders to measures that no rational investor would support, and there were admittedly some cases where I had to push founders in less-than-ideal directions through the use of our contractual control rights.

But let’s think about ‘off the shelf’ structures in venture capital: Investors are looking to acquire minority stakes in fast-growing companies, leaving a majority of day-to-day control to the founders. The control that they want to retain is (in theory) to protect themselves, i.e. when it comes to financial decisions (like a budget) or transactional matters (an exit or a financing round). To do so, they want to be informed (reporting rights or an observer seat), they want to influence decisions (board seat), and they want to block measures that might damage the value of their shares (i.e. exit approval). In the ideal world, an investor trusts the founder(s) to make the right decisions in the daily business, and only intervenes when they feel like it is required to protect the company (and thus, the value of their shares).

Since we’re not always in an ideal world, our serial founder might want to avoid the risk that a minority investor starts to get involved beyond that line, like an investor asking for a majority of board seats or a blanket veto power.There, I share their sentiment. But there’s also many things that I don’t find unreasonable at all - to name two examples:

• Investor Reporting: I am shocked how little accountability some serial founders are willing to offer - often refusing to provide any transparency or ongoing reporting. In doing so, they often keep bad news to themselves until it is too late. More than once have I gotten a call from a company without information rights just a week before running out of money, which could’ve been easily avoided with a monthly or even quarterly update. Even more so, they fail to see that reporting might actually offer benefits, i.e. by giving the founder the chance to ask for help from their investors.
  

• Protection Rights: Many serial entrepreneurs want to raise money without liquidation preferences, especially after such protection measures might’ve hurt their own exit in the past. However, they fail to understand that (regular, non-participating) liquidation preferences are there for a reason: If you raised 1M from an investor at 4M pre/5M post without a liquidation preference, you could technically turn around the next day, liquidate the business, and take home your pro-rata share of the 1M - definitely not the intended measure.

In my view, it simply comes down to founder-friendly, yet ‘market standard’ measures: A 1x liquidation preference, investor consent on an annual budget without few or no ongoing additional approvals, a board that (at least in early stages) is controlled by the founders, and of course, an ongoing reporting that doesn’t put substantial time pressure on the team. Everything beyond that can be optimized, but is it needed? In my view, no. Keep the market-standard terms, and instead optimize for valuation or a higher salary. 

Monetization & Exit

Some relevant points for this category overlap with the two prior ones: An exit with a PE-like case but a VC-like Deal Structure is obviously much more lucrative to the founder than one with an (appropriate) PE-like Deal Structure. Likewise, a less-ideal exit without a Control right such as a liquidation preference might still net a founder a considerable sum.

So what else might be relevant? Two things come to mind:

Timing: First of all, deciding if there is going to be a monetization event (or an exit). No matter if angel, family office or institutional fund - all investors want (some of) their money back at some point, which might also manifest itself in provisions such as a board majority (or even a later-stage investor) being able to force an exit. Many founders don’t want any such pressure, causing them to remove rights that might force them to sell, or that might limit or block dividends/buybacks.

Process and Negotiations: If there is an exit process, there might be the question of how it is structured. Is it run by the board (if there is one)? Is it run by a committee of founder and investor(s)? Or is it run just by the investor? Is there an M&A advisor - and if so, are they representing all shareholders? That point also extends to Negotiations - which might be once again run by a group or committee that represents all shareholders, or might be somewhat fragmented.

When it comes to serial founders, once again, they like to retain a degree of control beyond what might be ‘market standard’. To give some examples I’ve experienced:

On Timing, there are countless examples of PE roll-ups looking to become the next HoldCo. Inspired by examples such as Buffett or Constellation Software, they want to raise money to buy companies across varying sectors, and never sell - while of course extracting a meaningful management fee for your services along the way (I’m looking at you, Ackman.)

On Process and Negotiations, it’s a founder’s full control of when and how monetization takes place. Thanks to loose shareholder agreements, I’ve seen founders liquidate companies at massive profit to themselves (instead of investors). I’ve seen founders use a company’s liquidity for shareholder loans that only served their own interests. And I’ve seen exits with low valuations but substantial retention packages for founders and management (but not the employees, somehow).

Once again, the intention of a serial founder here might be to protect them from prior companies where they might’ve been wronged by their investors. But in doing so, founders often forget the central tenet of any founder-investor relationship: That they should be aligned in their interests, and not opposed - and that a company should be set up in a way where all parties, founder, employee or investor, should benefit equally when things go well.

Don’t Stand In Your Own Way

Let us end in a little anecdote.

I recently met an extremely successful serial entrepreneur, faced with exactly the situation at hand: For their first venture, they had to deal with unhelpful investors that caused more damage than help, yet they still made substantial returns on the back of their hard work. There was no way that they’d voluntarily give up any leeway to their investors on the points mentioned here. And given their track record, I actually believe that they’d be able to raise money with few or no strings attached.

Yet I still advised them against it - and recommended that they should instead just opt for a ‘market standard’ structure. In their case, I was convinced that if they used a regular yet still founder-friendly structure (see above - minimal control rights, no veto rights for investors outside of very large decisions, etc.), they could easily raise their (substantial!) financing goal in a short amount of time. If they would instead decide to go for the ‘no strings attached’ structure, that would still be possible - but it would likely take much, much longer.

And especially if they can raise money at very founder-friendly terms, going a bit further to remove all control criteria, which might actually block you later from raising even larger (institutional) sums, simply did not seem worth it to be - financially, and in regards to the value of their time.

So to end with a final recommendation: Don’t try to reinvent the wheel.As I wrote in a recent article, we are lucky that the days of founder-hostile investors are (luckily) over, and that especially experienced entrepreneurs can warrant what I deem to be attractive terms. So instead of trying to over-optimize on terms, on control rights, heed my advice - just take the money, and get started on what you really want to do. And that’s to build a successful business.

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