One of the recurring problems we see with Latin American startups at Magma Partners is founders with too little equity. In the past two weeks, I’ve seen three cases where the full time founding team has 7%, 10% and 25% ownership after only one round of fundraising. Two companies had raised less than $100k, one had raised ~$200k. When we see companies with this structure, we tell the founders directly that it makes their company uninvestable. It’s especially true if the founders think they’ll need to raise even more money in the future, or plan to move to the United States. Every company is different, but founders should have at least ~70% at this stage, or even more if they plan to compete on the world stage.
We see five common causes:
- No Vesting – Cofounders who have left own significant equity
- “Part time cofounders” – People who aren’t full time who own significant equity
- “Advisors” – Companies with large numbers of “advisors” or “advisors” with significant of equity
- Unsophisticated investors – Raising money from people who view startup investing like investing in private equity or small businesses
- Investor Malice
Let’s unpack each one.
Every startup needs to have vesting. I prefer the standard four year vesting with a one year cliff, but I care less about the actual vesting terms and more about the fact that there’s a plan in place that punishes founders for leaving the business and rewards the founders who are working full time and can be implemented without a fight if one founder decides to leave.
Many Latin American founders don’t have vesting, either because they haven’t heard of it before, or because they don’t like the idea of having to give their shares back if they leave. They usually think backwards: that they’ll be the ones to leave, not their cofounders and want to protect themselves.
“Part Time cofounders”
Many businesses start with part time cofounders. And that’s ok. But if after being in business for 12+ months, having a bit of revenue and actively looking for funding, there’s still multiple “part time cofounders” on the team, they’re probably not cofounders and shouldn’t have equal, or more, equity than the founders working full time. We’ve seen many cases where there are 3-6 “part time cofounders,” who might have even come up with the idea, with more than 50% of the equity. That doesn’t work. Private investors won’t invest.
This goes hand in hand with part time cofounders. We’ve seen many cases where the person who had the original startup idea is an “advisor” who has at least 30% of the business, many times 50% and even 70%. That can be an ok strategy to start a business that won’t need private capital, but not when you need outside investors. Ideas are a dime a dozen. We invest in teams, not ideas. So it’s not ok to have an “advisor” who isn’t working full time with significant equity.
US industry standard is .5%-2%. Sometimes, in very rare, early stage cases, top notch superstar advisors can reach 5%.
We’ve also seen cases where startups have 5-10 “advisors” who each have 2-5%, making them uninvestable.
US style VC and angel investing is new to Latin America. Many Latin American tech investors are coming from family offices or the corporate world, leading them to behave like private equity or small business investors or work with lawyers who are working on their first venture deal. PE style startup investors push for control and 40%+ equity for small amounts of money.
As Andres Barreto, a partner at Colombia based Social Atom Ventures, put it:
Most of the ridiculous terms offered by LATAM VCs are more a result of inadequate venture law counsel than malice
— Andres Barreto (@andresbarreto) August 2, 2016
Daniel Palacio, founder of Authy, one of Colombia’s startups to be acquired by a US startup hit the nail on the head:
VC’s fear the unknown so in Latam they pick the harshest terms in case they are challenged.
— danielpalacio (@danielpalacio) August 3, 2016
We see a special version of this problem with startups backed by accelerators, especially in Chile and Brazil, that use convertible notes that convert with series A sized rounds and are not willing to convert when a smaller venture firm is willing to invest, but doesn’t hit the series A automatic conversion threshold. We even saw an accelerator that had a perpetual option to convert at any time, which makes a company completely uninvestable.
The good news is that we don’t see investor malice very often at this stage. We see investor malice more often in Latin America when investors push startups to take more money than they should and start to spend it quickly in hopes they experience massive growth, rather than doing what’s best for the company: finding product market fit.
How to Make it Better
The good news is that most of the problems are attributable to inexperience and lack of information, rather than malice. As more Latin American startups find success outside both inside and outside of Latin America and get funding in the US, they’ll bring back more knowledge. As more Latin American lawyers work on venture deals, they’ll get more experience. As private equity and corporate investors miss out on the best deals that are going to US style investors, they’ll realize its in their self interest to become better actors.
Investor behavior is getting better, but can be improved by more investor transparency and entrepreneurs sharing more information with each other.