The Souq.com deal was great for the news media cycle, but was it so great for the investors?

In tech, these types of events are fraught with palace intrigue that everyone, myself included, just loves. Across the region, this deal fueled a broad, multi-medium and fairly analytical public response, a crowd-sourced investigative journalism of sorts where no aspect of the discussion was ’off-the-table’. 

But one interesting storyline that emerged had particular resonance with me: the idea that in this situation, there was inequality on payouts to shareholders.

The suspicion here is, according to insiders, that some investors received proceeds disproportionate to their percentage holding in the company. In other words, some people owned more than what we thought they owned, and others didn’t own what they may have thought they owned.

This is an entirely common phenomenon in the world of tech investing. Companies raise money through multiple successive fundraising rounds, and often there are different rules that apply to different shareholders.

Essentially it happens like this: a company starts out as a group of partners wanting to build a product or a service together. The partners split the ownership of that company amongst themselves. At that point, they all hold common shares in the company. Once the product is built, maybe with some early sales traction, the partners go out to raise money from investors. The investors agree to buy into the company by injecting new money at an agreed price and terms. 

The value proposition between founders and investors for traditional, asset-driven business goes something like this:

1. I, as investor, put in $100

2. $100 is the full amount of money that goes into this enterprise

3. I therefore own 100 percent of the enterprise

4. Of that $100 the enterprise pays a salary to the founder/employee, and maybe gives a minority amount of ‘sweat’ equity

Venture investing upended this, creating a formula better suited for aggressive growth, but also shifting the paradigms of control and risk sharing,:

1. One and two as above

2. However, I, as the original investor, am only going to own 20-25 percent of the enterprise

3. Therefore the founder retains enough ownership to be able to sell more of the company to raise more money in the future

4. The founder is going to do this a few more times, injecting fuel as he/she/they aggressively grows the company

5. Each successive round, the founder dilutes him/herself (and in fact the other investors) more and more, but the additional capital allows the company to grow very quickly

6. If the company becomes Uber or Careem, all stakeholders have done very well

7. Despite all this dilution, the founder is still going to own a significant percentage of the company (ideally 15-20 percent at the time of IPO or trade sale), so they remain highly motivated and incentivized to continue running the business post sale

Pies and waterfalls

Largely because of this fundamental shift in the founder/investor relationship, whereby founders retained so much ownership initially, investors started adopting the position that their investment would require more legal protections.

This has resulted in atypical ownership structure that functions more like a waterfall than as pie slices.

In a ‘pie slice’ exit scenario, all holders own an equal class of shares, so payments are made according to who owns what percentage. This is how people understand ownership to work intuitively.

In reality, most VC exit scenarios play out more like a ‘waterfall’ - payments are made in sequence: one investor gets paid first, another gets paid second, so on and so forth. At the end, whatever remains is distributed to everyone on a pro-rata basis. This effectively means that ownership in these companies is more like debt: certain investors are senior to others and therefore get paid first.

Ratchets and preferences

Primarily the distribution process happens through issuing preferred shares, which often include two types of terms: liquidity preferences and ratchets.

Ratchets kick in when a company raises money at a lower valuation than a previous funding round. Liquidity preferences apply if a company sells itself and pays out investors with the proceeds.

Let’s say an investor puts in $25 for 25 percent of the company, so it’s worth $100. If the company then goes and raises money at a $50 valuation (a down round), that $25 investment is now worth $12.50. A ratchet forces the partners to hand over shares until the investor’s stake is again worth $25 at the new valuation (so the investor now owns 50 percent of the company).

Now say the down round never happened, but the company is bought for a $25 valuation. With 25 percent of the company, the investor should only get $6.25 for the sale. But she has a 1.0x liquidity preference, meaning in a liquidity event such as a sale they have to receive at least the equivalent of investment back. The investor will get $25 (equal to 1.0x the initial investment) and the founder will get nothing (despite on paper owning 75 percent of the shares of the company).

It’s not always win-win

Companies that pursue venture funding often end up raising money through successive funding rounds where they offer investors increasingly protective terms, round after round.

The Series A investor might have a 1.0x liquidity preference, the Series B investor might have a 1.2x liquidity preference, Series C might have 1.5x. And the Series C will have to be paid out before Series B, who is before Series A.

For companies that have grown robustly over their lifespan, despite this preferential payout sequence, everyone does well. The returns would vastly exceed the liquidity preference multiples, so there would be plenty available for the common shareholders. Because the common shareholders will have often invested at the lowest valuations, they will see the highest returns.

The problem arises in examples where company valuations have decreased from round-to-round. Theranos, the revolutionary thumb-prick blood diagnostics company, reached a valuation of $8 billion before falling from grace. After concerns around test accuracy and misrepresentation surfaced, the market speculated that the company’s value had fallen to as low as $800 million. At that time the founder retained 50 percent of the equity of the company and full operational control. Logic would hold that she should have still been worth $400 million, which is not bad. But due to the liquidity preferences she had given investors, in reality she was effectively worth nothing on paper.

Square, a US-based payments company issued shares at $15.46 before publicly listing at $9. However, the investors who had participated in the preceding round had a ratchet provision that guaranteed them a 1.2x return, meaning that they were entitled to be issued an additional 10 million shares at the time of the IPO at the expense of earlier investors on the cap table. 

What might have gone down in Souq.com?

In the case of Souq.com, the prevailing belief is that the valuation of the sale was less than the valuation at the end of the preceding funding round.

Therefore, if liquidity preferences existed for later stage investors, which is highly likely to have been the case, they would have kicked-in, reducing the proportion of proceeds received by those who hold shares at the bottom of the waterfall (Louis Lebbos did a good job exploring this topic specifically).

It is interesting to consider how this may have impacted management’s decision-making in pursuing this deal.

Let’s say, hypothetically, that Amazon offered a significant number of Amazon shares to incentivize the management to stick around after the acquisition. This type of thing is common in trade sales. If the management was aware that their existing shares were at the bottom of the waterfall, they would potentially have been more interested in those Amazon shares than even the headline sale price itself. Amazon’s share price has jumped almost 10 percent since the day of the announcement, meaning were this the strategy, it would have paid off so far.

Lesson is: fund smart

I’ve seen a number of instances of how companies’ behavior can be shaped by these types of terms. One company still at an early stage had issued multiple classes of preferred shares, posing a challenge for future fundraising. Another turned down an acquisition because the offer didn’t get all the way through their investors’ liquidity preferences, therefore leaving nothing for the management. Yet another suffered from a major conflict with existing shareholders when it tried to issue preferred shares to a later investor.

On the investor side, we see an increasing number of investors participating directly in early stage tech companies, as opposed to going through managed funds. For investors to “fund smart,” they need to get educated. Events like Angel Rising, hosted by Venturesouq and StartAD on NYU Abu Dhabi’s campus, is a good, free way to get educated. Before an investment is made, it is essential that investors understand these mechanics and how they impact companies, other investors and themselves.