Lemon Tree, Very Pretty

The Market for “Lemons” is a seminal economics paper by Nobel Prize winner George Akerlof  about used cars. Imagine that there are only two kinds of used cars: quality used cars and “lemons”, i.e., cars that, despite outward appearances, are in poor condition. Quality cars are worth $2000, but lemons are worth just $1000. Sellers know whether their cars are lemons or non-lemons — but buyers have no way of determining whether a car is a lemon or non-lemon. As a buyer, what would you offer for a given used car?512px-Lemon_with_white_background

You would probably be hesitant to offer significantly more than $1000, since you would regret spending more than $1000 only to find you had bought a lemon. On the other hand, as a seller, you would refuse to sell a non-lemon for a mere $1000, since you know that quality used cars are worth $2000. As a result, due to “information asymmetry”, the only transactions that take place are those involving lemons!

Sometimes, the market for start-ups is a bit like the market for used cars.

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Liquidation Preferences

As shareholders of startups, we all know how it’s supposed to work. We make an investment. The company grows. The company is acquired or goes public. Our initial investment yields a stupendous return.

Let’s do the math! Suppose we invest $25K at a $2.5M valuation. We own 1% of the company. A few years later, it is sold for $100M. We get 1% of $100M = $1M; a remarkable 40x our initial investment. Yay!

But, what if the company is sold for only $1M? Then, we get just 1% of $1M = $10K. Not so good, but it’s not like the math is any different. Right?

Well, that depends. Were there any liquidation preferences?

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Bridges Need Blueprints

Over the last year, I’ve observed a recurring pattern:

Unfinished highway bridges, Czech republic

  • A pre-revenue (or low-revenue) start-up pitches an exciting new product or service. The start-up asks for a seed investment, with a budget showing that the new capital will provide approximately 18 months of runway. Projections show the start-up achieving target metrics for revenue, active users, customers, or the like within a year. After those milestones are reached, the start-up plans to raise additional financing at a significantly higher valuation.
  • The team is impressive, the market seems substantial, and due diligence indicates that potential customers are eager to work with the start-up. Investors invest.
  • 15 months later, the start-up is back. Everything is going great — but the software development scheduled slipped and the pilot customer loves the product but can’t make a decision on a purchase because of a management transition. The company’s success is inevitable. It just needs more time — and, therefore, more capital. Would the initial investors please provide a “bridge” investment?

My question is always “A bridge to where, exactly?”

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