Tuesday, April 29, 2008

Learn something new every day: startup funding

I learned something new a week or so ago about venture capitalists and startup funding. It was an uncomfortable nugget of information, but I now understand more about the dynamics of a previous employer.

I've worked at three startups over my career - five if you count small self-sustained groups within larger organizations. It's one aspect of test engineering. If you're building a new widget, you have to test it a LOT. Perhaps that's a subject of a separate post.

One of those startups spent money like it was going out of style: buying expensive equipment, relocation packages for people that weren't really suited for the job, building a brand new building. This profligate burn rate was a primary cause of the company's death. I had heard from several people in management that the board of directors encouraged the spending. The reasoning was that if you spend enough money then eventually you'll solve the problem. It's a quasi-statistical approach to R&D.

But in a conversation I had with a CEO of another startup I found an ulterior motive, the "slash and burn" method. It probably only works with a management team that isn't that bright, but that describes that particular company well. It goes like this:
  1. The board of directors is composed primarily of the initial investors in the company. They've invested money and own a certain percentage of the company.
  2. All startups go through multiple rounds of funding. In each round, the company's value is estimated based on certain milestones: design wins at major customers, working prototypes, improvements to the production process, etc. Based on that estimate, the new share price is set and investors get a number of shares based on how much they invest at that price.
  3. If the company spent it's previous funds without hitting certain milestones, then its valuation will not be as high.
  4. So, when the company goes looking for another round of funding, the investors can invest more money in the company at a better rate. This is good for the investors - they'll own a higher percentage of the company - but bad for the employees, because they're stock options are now worth less through dilution of the value.

So, if the board can convince the management team to wastefully spend cash, then (assuming the company succeeds of course), the board can end up making a lot more money in the end. It's kind of perverse, but true.

No comments: