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Aug 9, 2023

The Case of the In-law Investors

Episode Summary

JJ, a Threshold Venture Fellow at Stanford, has in-laws who want to pull money from their retirement fund to participate in a “friends and family” allocation in JJ's seed round. Heidi sets JJ straight about the ins and outs of seed investing — and suggests at least one way to reward his in-laws for their support without putting them at risk.

Full Transcript

HEIDI: Welcome to The Startup Solution, and “The Case of the In-law Investors.” 

Hello. I'm Heidi Roizen from Threshold Ventures. The Startup Solution is a podcast where we unpack the “oh shit” moments faced by entrepreneurs and then find the best ways to get through those moments alive — and with a little luck, maybe even better off. 

Today’s episode is not about an “oh shit” moment after it takes place. Instead, it’s about one that we averted before the entrepreneur set it in motion. I’m hoping that by unpacking this one up front, I might help you avoid it in the future as well.

In my job at Threshold Ventures, I work with many budding entrepreneurs, including a dozen Stanford grad students each year. In that program, which is called the Threshold Venture Fellows, we spend time dissecting entrepreneurial war stories in the hopes of learning from the successes as well as from the failures. 

A number of these students do go on to start companies, and I joke with them that they have a lifetime credit to call the Heidi Hotline for advice. 

One such former student — let’s call him JJ — recently took advantage of that to ask me for advice about spreading the good fortune of his soon-to-be seed round. 

AUTOMATED VOICE: You have one new voicemail.

JJ’s VOICE: Hey, Heidi, it's JJ. I have some good news I wanted to share with you. So after all the hustling I've been doing the last several weeks, it's starting to pay off. I just signed a term sheet for my seed round and there was something I wanted to run by you. So I was talking to one of my neighbors the other day and he mentioned that when his brother was raising money for his company, he invested some of it and when his brother sold he made hundreds of thousands on it. It seemed like a good way to to share the wealth and it really got me thinking that I would like to do the same with my friends and my family. You know especially my in-laws — they've been super helpful with our kids. You know Deepa and I have both been working really hard to get this off the ground, and my in-laws — they're retired now, they don't really have a ton of money, but I think they could tap into their 401k and I I think they're also willing to take out a second mortgage on their house. I just feel like this is a once in a lifetime opportunity and I would really hate for them to miss out. I would just love to know what you think about this and what advice you might give. If you have a chance, give me a call back. I would appreciate it. Thanks. 

HEIDI: And thus begins “The Case of the In-law Investors.”

Ah, JJ, what a sweet, thoughtful idea. But based on my experience, what a bad, bad idea.

Look — I so appreciate JJ’s desire to share his potential wealth — and there are some great ways of doing so. But I am not a fan of doing what he’s asking about.

Luckily, this isn’t a proverbial “oh shit” moment for JJ yet. But I’ve seen these sorts of things turn into some of the worst “oh shit” situations entrepreneurs ever face, because they can become very bad and very personal. 

And I’d like for JJ — and his in-laws — to avoid anything like that. 

So let’s unpack why these “friends and family” investment rounds might turn out badly, and then talk about other ways to meet JJ’s goal.

Let’s start with survivorship bias. 

You’ve probably heard the term before, but just to recap: Survivorship bias is when you consider a data set without realizing that it is already net of a group who failed some prior test. 

When you go to a Silicon Valley cocktail party and someone brags about making a killing on a seed deal, like JJ’s neighbor did, it makes it sound awfully tempting to try your hand at seed investing, too. 

The problem is, people at cocktail parties generally don’t go around boasting about all the money they’ve lost in seed deals. So, if you are only relying on the positive stories to gauge your odds of success, 

you’re going to overestimate your chances of bagging a winner.

While it’s hard to get exact numbers on seed failure rates, various analytical firms like Crunchbase and CBInsights have taken a whack at coming up with the numbers. If you use my “highly sophisticated” research methodology (that is, googling “percent of seed deals that fail”) you will find a range of estimates between 50 and 75%. Let me repeat that: between 50 and 75% of seed companies fail. That is, they fail after they raised their seed round — the type of round JJ’s in-laws would be participating in.

So, no matter how optimistic you are, the odds are against you. Would you recommend any other investments to your in-laws with more than half a chance of losing all their money? I don't think so.

Look, I don’t want to dampen JJ’s enthusiasm about his startup, and I certainly wish him the best with it. But if you’re an entrepreneur, do you really want even more pressure on top of what you already feel by taking money from family or friends? 

Money that would disappear in a bad outcome?

Unfortunately, I’ve seen a number of founders in anguish because of having done exactly that. I’ve seen entrepreneurs spend years trying to pay those losses back personally, in the hopes of repairing those relationships. I’ve seen people lose their homes. And worst of all, I’ve seen families and friendships destroyed over these losses. 

If you ask me, entrepreneurship is hard enough without this extra burden.

But if I haven’t convinced you yet, here’s something else to consider:

Seed shares are highly illiquid investments. What that means is, if one of your in-laws ends up in the hospital and needs that money to cover expenses, they probably can’t get it out. 

Most investment rounds come with limitations on who an investor can subsequently sell their shares to. It’s not a liquid market, and sometimes no buyer will be available. So the money is stuck.

In tougher economies, even a successful seed investment might take seven to ten years before you see your returns. Given that JJ’s in-laws are already retired, is this really the right place for them to park a lot of funds?

There’s yet another quirk to consider in seed investing, and this one is a little complicated, so bear with me for some groundwork here. 

Generally speaking, private company shares are not all the same. 

Every round a company takes is usually led by a new investor and freshly negotiated as to price and terms. Even existing investors, if they lead a new round, will negotiate the best terms they can, based on the market for that stock at that time. And so should the entrepreneur on the other side of the table. 

That’s how markets work and there is nothing wrong with that.

After a seed round is closed — through the seven-to-ten years it usually takes for that startup to grow and achieve an outcome — there will also likely be ups and downs. The company will experience them. The market will experience them. Sometimes that will happen at the same time.

And how many rounds will your startup eventually raise? 

There is no set rule, because every business model requires different levels of capital. I can say though, from my experience as a VC for over 20 years, that most companies require at least three to four rounds. I’ve even seen some go on to a dozen or more before they get acquired or go public — and generate that magical outcome people like to brag about at cocktail parties. 

The point is, if you get stuck needing to fund-raise in either a bad company cycle, or a bad market cycle — or both — this may result in your agreeing to tougher terms to get that capital. 

For example, you might agree to a term that means that the last money in will get its money out first (which in VC talk is called a “senior liquidation preference”). On top of that, you might agree that the new investor will also be entitled to a guaranteed 2x or 3x on their money in any outcome positive enough to deliver that (which is called, not surprisingly, a multiple). 

In even worse times, you might only be able to raise money in a construct called a “cram-down round,” or with a term called a “pay to play provision,” which basically means that, in order for prior investors to protect their investments’ value, they have put up additional capital in this new round as well.

Let me pause for a moment here to say, again, that there is nothing inherently wrong with any of these terms. Remember: the entrepreneur and the prior investors (who usually have some voting rights as to whether or not to take any new capital) can choose to turn these down. 

But, these terms tend to get negotiated when lighter investment terms are not attractive enough to raise that needed capital. These terms are sweeteners to entice dollars to come in, and they usually continue to be sweetened until they succeed at doing so. 

Because usually, in these cases, entrepreneurs need that capital to stay in business. And in the end, even tough terms are more desirable than not raising money at all and going out of business.

And this is important for a seed investor to understand, because some of those tougher terms may impact their investment as well — and to counteract that, they may need to also put more money in. 

Now, professional investors, like me, realize that, and plan accordingly.

In fact, when a firm like ours makes an investment, we also estimate how much more we might need for that company in the future, and we earmark that amount in a pool of capital we reserve for future investments.

While we don’t commit to future investments up front, and only make our decisions at the time each round comes together, we do this so we have the capital available when these opportunities or needs arise — and as we’ve learned, they often do.

There are no hard and fast rules about how big each reserve should be, but in my experience, investors may be asked to contribute a third to half again as much as they originally put in to support the company through its subsequent rounds. 

Of course, investors can always choose not to invest. In a good market and company performance situation, all that likely means is that their percentage ownership will go down as more shares are issued and sold — but as long as their share price goes up even more, they’ll still make money in the end. 

However, in tougher times, and especially if pay-to-play provisions are the only way to entice new investors, prior investors may be further hampered from success unless they have the additional capital to “pull their investment up,” as the jargon goes.

By the way, I apologize for all the jargon in this episode. But I am using phrases like “pay-to-play,” “cram-down-rounds,” and “liquidation preferences” so that you at least know what terms to research if you do want to learn more.

Anyway, back to JJ’s inlaws: If I take a stab at what I think JJ’s in-laws should plan to reserve for these future rounds, I’d put it at about 30-40% more than their original investment, considering it’s a seed stage deal. 

And that presents a problem, because, if they stretched to come up with the initial amount in the first place, how are they going to come up with that much more?

And one more thing before I let this go — and it’s a special kick in the face for seed investors. If JJ’s in-laws used their 401k money to make that investment, and then they end up losing their money, they can’t even benefit from writing off the loss. Generally — and check with your accountant on this — you can’t claim a capital loss from a retirement account. 

So yeah, there’s also that.

At this point you are probably realizing that I really don’t like JJ’s idea of having his in-laws invest. 

And yeah, I really don’t.

Now, of course, I’ve seen some people hit some big wins with seed investing, and I’m not opposed to seed investing in general. It’s just that I’ve also seen many others lose money, and for some of those, it was money they couldn’t afford to lose. 

So is there anything JJ can do? 

Well, gifting shares to others is often a popular way to go, as your shares are usually valued pretty low at a company’s seed stage. You can give up to $16,000 of value to another person each year without any tax implications to either you or them. You can give even more, though some additional paperwork is needed and other rules apply, so call your accountant before you finalize anything. Also, there’s an additional resource: it’s the IRS website. Yeah, I know — but it’s full of great and official information about gifting stock.

If you do take this route, that stock still might go to zero in a bad outcome, but at least your in-laws didn’t mortgage their house or drain their 401ks to buy it.

So to boil it all down:

When anyone asks me whether they should make a seed investment, I tell them to do so only if it is — number one — money they can afford to lose; number two — money they don’t mind tying up for seven years or more; and — number three — that they have enough additional money to put about half again as much in a future round if the opportunity or need arises. 

And when an entrepreneur asks me if they should encourage their friends and family to invest in their startup, I cover not only all the above, but I also urge them to consider how they would feel if all those people lost all that money as a result of their startup failing. To me, that is the most important question of all.

And that concludes “The Case of the In-law Investors.” For the record, this situation is real, but JJ is a composite. And no startups were exposed or harmed in the recording of this podcast.

Thanks for listening to this episode of “The Startup Solution,” a podcast from the venture capital firm Threshold Ventures. We hope you have enjoyed this episode, and if you did, please leave a rating or review in your favorite podcast app. I’m Heidi Roizen.

Further Reading

Terrific article from personal experience with angel investing from Gus Bessalel

Good summary on gift taxing including equity gifts  

IRS website on gift taxes

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