Founder – Investor Alignment

To improve the chances of achieving the best outcomes, it is imperative to establish alignment between the founding team and supporting investors in high-potential startups who raise money.

What are Investors’ Goals in a Startup?

Applied to the world of startups, investors win when they make a good return on their investments, and they have the opportunity to diversify their risk by placing bets on multiple startups to increase their chances of success.

When choosing investments, sophisticated investors look at many options and pick just a few. They want those few to succeed! That is how they get the returns they seek, so they are looking to select investment opportunities they see as winners.

Investors get a winning return on their investment by having the startup ownership interest (e.g., stock) that they own become very valuable as the startup successfully develops. This value is typically realized via an “exit” when their stock is sold to an acquiring company or in an initial public offering (IPO). The difference between the price the investors paid for their stock and the price at which it is sold represents their capital gains, the source of the “return” part of return on investment. Early-stage investors are looking to make multiples of their money invested.

What are Startup Founders/Executive Leaders’ Goals in a Startup?

In addition to the intrinsic satisfaction of building something extraordinary and successful, startup founders/leaders win by getting paid for their work, building their resumes with accomplishments, and hopefully having their stock/stock options make money upon a successful exit.

While founders and startup teams have more ways to win in the context of the startup than investors do, they cannot easily diversify their risk across multiple startups at the same time, so they are, in some sense, diversifying their risk by getting multiple streams of value within a single startup.

What is Founder-Investor Alignment, and Why is it important?

Alignment of interests means that when one side succeeds, so does the other. It is a win-win scenario. It is also the scenario that maximizes the chances of success by minimizing unnecessary and distracting suspicion and conflict.

Misalignment of interests means that when one side wins, the other loses. A lack of interest alignment in a startup can lead to abuse, turnover, and disappointing outcomes. Avoiding the downsides of misalignment is why investors and founders should and usually do share the goal of having aligned interests to maximize the chances of good outcomes for both sides.  

What Is the Essential Lever that Creates Founder-Investor Interests Alignment?

So, when we look at the goals of investors and startup leaders, where is the overlap? It is really in a single place which is the money made when the startup achieves an exit. Specifically, that money-making mechanism is the value of the stock when the startup is sold either to another acquiring company or to the public via an IPO. 

Therefore, managing the relative value of crucial team leaders’ multiple streams of value is really what we are talking about when we say we are seeking founder-investor alignment. As mentioned earlier, because startup teams have multiple ways to win, to achieve alignment of interests with investors, it is imperative that startup leaders also win under the same conditions as the investors. In other words, the startup leaders need to have an ownership stake in the startup, just like the investors. This usually takes the form of either founders’ common stock or startup leaders’ common stock options (the right to purchase a share of stock at a pre-determined price). If the startup leaders hold a sufficiently large percentage of the startup’s stock, then the startup leaders will receive a nice amount of cash at the same time as the investors do (upon exit). And that simultaneous success is what we call alignment!

The key to remember is that it is in both the investors’ and the startup leaders’/founders’ interests to have alignment.

• For startup leaders with high-potential companies that need capital investment, it is critical to capture the attention and support of investors who want the company to grow and succeed, and have the financial resources to provide the necessary capital to make that possible.
  
  
• For investors, it is imperative to find startups led by teams with the drive, creativity, and ability to execute that can successfully convert that capital investment into ever-increasing company value, which is ultimately realized at the point of exit.

This overlap means that during investment terms negotiations, investors will look at the stake in the company’s cap table that individual founders and startup leaders have. It needs to be substantial enough and with long enough vesting to mean that the management team is incentivized to build and realize value the same way the investors will. While sophisticated investors absolutely want to “buy low” and get a good deal on the stock price that they invest at, they also want to be sure that management has enough of a cap table interest to be excited about the possibilities of an exit.

At each company stage (pre-seed, seed, Series A, B, C, etc.), there are norms around what investors expect will provide enough of an incentive for various members of the management team, including founders, CEO, other C-level leaders, and, to a lesser degree, the rest of the team. This means that investors will carefully look at who owns how much on the cap table with an eye toward seeing multiple team leaders with a stake and ensuring that they have a reason to stick around (vesting!) to continue to build the company’s value. It also means they will advocate for a sufficiently large pool of available options to be deployed as the company grows its team. Finally, sometimes there is a need for refresh options to ensure that the dilution does not reduce the startup founders’ and executives’ stake in an exit scenario to the point where little incentive remains to achieve a good outcome. All of these dimensions will be one of the most focused on elements of a fundraising negotiation via discussions of valuation, vesting of at least part of existing equity stakes, and option pool size.