Beware of using deal structure to protect your startup’s valuation

Scott Orn leverages his extensive venture capital experience from Lighthouse Capital and Hambrecht & Quist. With a track record of over 100 investments ranging from seed to Series A and beyond in startups, including notable deals with Angie’s List and Impossible Foods, Scott brings invaluable insights into financing strategies for emerging companies. His strategic role in scaling Kruze Consulting across major U.S. startup hubs underscores his expertise in guiding startups through complex financial landscapes.

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Published: November 24, 2024

A hot topic today with venture capitalists and entrepreneurs is the danger of using deal structure to protect your startup’s valuation. We see this happening all too often, so let’s take a look at it.

The temptation of a high valuation

As a founder, it’s natural to want to feel like your company is worth a lot – whether it’s a $500 million valuation or, ideally, a $1 billion valuation. But here’s the thing: Valuation isn’t everything. Sometimes the way founders pursue these big numbers can come back to haunt them down the road.

Many entrepreneurs who, out of ego or pressure to look successful, can push for a valuation that may look good in the headlines but isn’t sustainable or healthy for the company in the long run. In some cases, VCs might even play along and offer a higher valuation than they think the company is worth, but with a lot of hidden terms and surprises that ultimately protect their investment – not yours.

So, what’s going on here? Let’s break it down.

Risky deal structures VCs use to protect their return

To give founders a higher valuation, VCs sometimes load up the deal with complex structures that can drastically change the financial dynamics of the company. These could include things like:

Compounding interest on preferred stock that converts into more equity
Reset clauses that lower the valuation of the company if certain targets aren’t hit
Anti-dilution provisions that give investors a way to protect their ownership percentage if new rounds come in at a lower valuation

While these terms might sound good in the moment (especially when you’re chasing that big headline valuation), they can quickly backfire and turn into a “debt-like” structure that actually reduces the company’s value and makes future fundraising extremely difficult.

Debt disguised as equity

Some investors might use what looks like equity but is actually a debt structure with very high interest rates and strong preferences – essentially giving them a “super-preference” in case of liquidation. This is common with firms that call themselves “late-stage investors,” but their structure closely resembles debt, even though it’s technically equity.

Some examples of debt disguised as equity include:

Convertible preferred stock with a high interest rate. This preferred stock converts into equity a a future financing round, but the accrued interest gets converted into additional shares, providing the VC with more equity than initially agreed. The high interest rate effectively acts as a debt obligation.
A convertible note that converts to equity at a discounted price with forced conversion terms. If your startup doesn’t hit certain milestones or deadlines, the note converts to equity at a much lower valuation than expect, and again the VC gets more equity than they would have otherwise.
Preferred stock with a high interest-bearing component. The investor charges a high interest rate (like 8-10 percent) on the preferred stock, and when the preferred stock is converted to common stock, the accrued interest has to be paid in cash or added to the equity conversion.
Anti-dilution provisions with reset clauses. A VC invests in your startup at a high valuation, but the deal includes an anti-dilution clause that adjusts their equity stake if you raise funds later at a lower valuation (a down round). The VC gets more equity than they originally agreed to, even though they didn’t put in more capital.

The problem with debt disguised as equity? It’s toxic for the company. When you have a debt-like structure sitting on top of your startup’s capital stack, it becomes very difficult to raise money in future rounds. New investors don’t want to put fresh capital into a company if most of it is just going to pay back existing debt holders. They want to know their investment will help the company grow and increase in value – not just go toward paying off the previous investors.

The end result: A company that’s not fundable

If you have this “debt equity” hanging over your company, it will be hard, if not impossible, to raise additional capital. And when the current investors realize the company is weighed down by this debt overhang, they may decide to walk away, leaving you with a company that is technically insolvent or not fundable anymore.

It’s a sad reality that we’ve seen time and again. One moment, you’re reading about a hot startup in TechCrunch; the next, you hear the company has collapsed. But when you dig deeper, it’s often because the startup had a toxic capital structure – too much debt disguised as equity, making it difficult to raise new funds or operate effectively.

Keep it simple

The solution is simple: keep it simple. Don’t get caught up in structuring your deals in complex ways just to protect your valuation. Sure, a big number might sound appealing, but in most cases, it’s not worth it if the terms are stacked against you. Instead, you should:

Take the valuation you can negotiate. Don’t overcomplicate it.
Stick with plain vanilla equity. The simpler, the better.
Check your ego at the door. Building a successful startup is more about executing and creating something valuable than just inflating your valuation to impress others.
Let the investors do the financial gymnastics. You should be focusing on building a great product, hiring good people, and scaling the business. Leave the complex deal structuring to the investors who are experts in that space.

Focus on your business, not deal structure

As a founder, your focus should always be on building a strong, sustainable business. Chasing a high valuation with complex deal structures can end up being more of a burden than an asset. The reality is, the higher the valuation and the more complicated the terms, the harder it will be to raise money in the future. Stay grounded, don’t get caught up in the ego-driven push for big valuations, and make sure that your deal structures are designed for long-term growth – not short-term headlines.

If you have any other questions on deal structure, startup investing, or startup accounting, please contact us. You can also follow our YouTube channel and our blog for information about accounting, finance, HR, and taxes for startups!