In pursuit of simplicity – deal structures in early stage investing and beyond.

Complex deal structures, despite the need for powerful and inventive minds, probably distort the real risk profile of an investment and may well damage investor returns in the long run.

I’m guilty of it: ‘how can I protect the downside here’, ‘how can I solve x or y to satisfy Management and keep the risk reward profile right?’  The hours that it takes to work through these structures could be better spent understanding the business. Oh, and let’s not forget the legal fees involved. Anyway, the deal gets done and everyone puts the legal docs in the drawer and forgets about them.

Fast forward 2 or 3 years to the next funding round. There’s another negotiation, the position of the business determines who has the upper hand in discussions, Founders/Management or Investors. But at that stage what happened at stage one may now be totally irrelevant (milestones hit/missed and ratchets kicking in or not), and the various parties all look to solve new problems, often layered. Mish-mash on top of the original ones. Resulting in more complexity (and legal fees!).

Rinse, repeat, throw in a transaction or two, a share for share exchange, some more different share classes (no-one remembers why they were created but we’re all sure it was important…). Now the waterfall in the Articles stretches to 5 pages and comes with an incomprehensible spreadsheet to work out who gets what at which exit valuation (good luck if you have any EIS/VCT money caught up in the structure as well). Even then, when you do get to sell the business and all stakeholders come to terms with what it all means, there’s more horse trading to help get it over the line. Whilst the he history matters, it doesn’t change the value of the business at the end, only who gets what.

Benefits?

Are there any upsides to the complexity? One argument is that you learn more about the team as you work through challenges: How commercial are they? What are they worried about? What motivates them? How good is their attention to detail? Do they understand what the implications of various elements are? Do they get the most out of advisors by recognising their weaknesses?

As part of the process of getting to know a team, these questions certainly have their place, but you could get to them much more quickly whilst learning more about the business in the process.

In the end, early stage investing is about weighing up the risk and reward balance along with everything that entails. If you have to reduce the risk by structuring deals in certain ways, you are already planning for the worst, but in reality, the likely value if it doesn’t work out is probably nil, so why waste the time?

This is particularly true in VC fund structures, where the returns are generated by outperformance of 20% of the portfolio. The PE model is of course different, more driven by IRR’s so cash in and cash out timing is more important, which the structure can help with.

Ultimately as the risk and reward balance narrows, the structure needs to be stronger, ‘locking in’ more value, but at the early stages of a company’s development, generally this is a false sense of security.

There will always be companies that fail, unpleasant as it may be for all involved, and there may well be value in the remnants, but the people who may be able to salvage any (the management team) have probably already been disincentivized by such structures and so you get into a downward spiral.

Of our time?

At the start of the Covid-19 lockdown in March, there were rumors of very aggressive structures being offered to businesses that were raising funds and with a short term scarcity in options some had to accept – looking back, this feels like particularly bad timing, exacerbated by the general fear of the unknown. The economic environment, although still challenging, now feels more stable, a new normal is in place and there is plenty of fundraising across the board. Raising funds now in the same situation would probably attract different results.

Does oversupply lead to softer terms?

Maybe, but there is also something about the history of the industry that feeds into this. There is certainly no lack of cash in the ecosystem at the moment, in fact, according to Prequin, there is about £9bn of dry powder available to VC funds in the UK at the moment. Compare that to the £30m available in 1979 and 1980, then the industry really has come a long way.

Combined with this scarcity of capital, a lot of the early UK Venture Capital market was borne out of the 3i model and early private equity model, which, in turn drove much of the early UK VC firms. It was not unusual to see structures once built by former employees of 3i with the focus on reducing the downside of the deal and therefore leading to a proliferation of debt laden structures and aggressive preferences. The line between PE and VC in the UK was certainly a bit greyer.

Returns

Does all this hard work and intricacy improve returns? The answer to that is ‘it depends’, to a classic 80:20 VC no, but to later stage growth VCs it probably does. No matter what, the process eats time that should be spent on developing, growing, building, selling and creating value for all stakeholders.

Ultimately, simplicity should drive alignment between all parties, focus on the positivity of the future and therefore maximise returns for everyone concerned.

I’ll do well to remind myself of this the next time I try and solve a problem with complexity.