Most people think founders and investors are true partners. This post will tell you it’s rarely so. It will tell you they take advantage of the situation whenever possible. In the process you will hear a famous love story, learn why restaurants hate JustEat and how Japan became an economic superpower. In the end you will understand one of the hardest dilemmas for founders and investors. Understanding is power. Use it.
He held the world’s most powerful object in his hands. Soon everyone would bow to his will. Including a very special person.
He lifted his arms high and placed the crown on his own head. A new emperor was born. The year was 1804. The man was Napoleon Bonaparte.
Nine years earlier, Napoleon had met Josephine. Josephine was sophisticated and beautiful. She knew it. Men wanted her more than she wanted them.
Napoleon was one of many men adoring Josephine. But Napoleon wasn’t special. Or rather, he had not yet become special. From the viewpoint of Josephine, he was just another man with potential.
But Napoleon was determined to prove exactly how special he was. So he embarked on a long and expensive journey of romantic pursuit. And Josephine took advantage. She enjoyed an asymmetric relationship of power. But she later learned it wouldn’t last.
As time went by Josephine felt a change. But what really scared her was this: she knew Napoleon felt it too.
What changed was the power profile of their relationship. In the beginning she held all the power. She had status and beauty. Napoleon had nothing. Just ambition. She didn’t value it much.
But as time went by, her beauty faded. At the same time, Napoleon was transforming ambition into tangible power. He was quickly becoming the most powerful man in France.
During the early pursuit of Josephine, Napoleon was extremely attentive to her needs. He wrote love letters, bought expensive gifts and kept away from other women. Josephine didn’t return the favor. She kept all her admirers and happily received without giving much in return.
But after the power had shifted, Napoleon started taking advantage. He took mistresses and ignored her. Josephine was powerless.
The shifting nature of power asymmetry
The problem of asymmetric power exists everywhere. Two parties benefit from a relationship. But one party benefits most in the beginning. The other party benefits most later.
Like Hotels.com and JustEat. In the beginning they needed hotels and restaurants more than the hotels and restaurants needed them. So hotels and restaurants commanded opportunistic terms. At some point the table turned. It was payback time.
Or like countries locked into producer – consumer relationships. US consumers wanted cheap goods. Japan was willing to produce them at low costs. US benefitted in the beginning. Japan grew strong and started outcompeting US companies with Toyota, Mitsubishi and Sony.
Power asymmetry between investors and startups
In the beginning, investors have all the power. Very few people are willing to invest in early startups. But hordes of hopeful founders are starting them. In the beginning, the founders need the investors more than the investors need the startups. So many investors take advantage.
What happens is this: A startup gets angel funding. Or an institutional seed round. The process is hard. The founders get rejected by almost everyone. In the end someone offers the founders a term sheet. The terms reflect the asymmetry of power. It can be liquidation preferences, options, discounts on valuations, veto rights, board control, getting the startup to pay for due diligence fees etc. The startup often have no choice but to accept the terms. However, many founders never forget the unfairness.
But then sometimes this happens: The startup finds product market fit. A big VC firm approaches the founders. The founders want the new and big investor onboard. But they also want to minimize dilution and loss of control. The founders and new investor meet. And during these meetings the new investor will put the founders in a dilemma.
The new investor will look at the cap table. Then they’ll ask a sneaky question: What is your relationship to your existing investors? It’s like a new girlfriend asking, so what is your relationship to your ex? It’s a toxic question.
The founders really want the big investor onboard. And they haven’t forgotten the unfair terms by their first investor. The founders don’t feel they owe the investor anything. In fact, they feel the investor got more than deserved. It’s a dangerous cocktail.
The cocktail creates an impulse. The impulse is to help the new investors get favorable terms in order to secure the deal. Even if this means to disregard the interests of their existing investors.
I have seen it. Many times. I have even participated myself. It’s a systemic part of startups funding. And everyone will experience it at some point. To each actor I will provide the following thoughts:
Founders: The situation reflects fundamental moral. Do you really want to be a person who forgets and even punishes the ones who trusted and believed in you when no one else did? Or will you be someone who put your business partners first and display the grace of caring for their interests as well? Also, do you really want to burn bridges? Earning back the trust of someone who you screwed over is hard.
Early stage investors: The big number of startups seeking seed funding makes it easy to be a jerk. But to provide startups with funding is to provide a service. Good service will make happy customers. Happy customers are good business. Especially if one of these startups grows and meet late stage investors. Wouldn’t it be nice to know that the founders felt a true responsibility to care for your interests because you had treated them fair?
Later stage investors: Early stage investors are an important source of deal flow. They take risks before anyone else. They might not command the same power as you. But to squeeze them hard will hurt yourself in the end. Also, remember that there might be even later stage investors after you. Do you really want show the founders that it’s okay to squeeze the existing investors?
- The power relationship between startups and investors is asymmetric over time.
- The asymmetry creates incentive for opportunistic behavior at different stages in the relationship.
- Founders, early stage investors and late stage investors should be very careful about optimizing for the short term.
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