A subtle shift in the power dynamics of venture-backed startups: towards employees.
Welcome to issue #40 of next big thing.
Footwork’s crossed 1 year, my daughter’s over 5 months old, and I’m eager to find a “new normal” in which I carve out time to write regularly, even if some pieces are less polished than I’d like them to be. As always, I’d love your feedback, and a big thank you to all who reach out to keep encouraging me. It helps a great deal.
Last year, my good friend Jack Altman, co-founder and CEO at Lattice, tweeted the following:
As I spent time in board meetings and observed fundraising processes happen over the past year, I found Jack’s tweet to be prescient. It does feel like employees at venture-backed startups hold more power than ever. And what’s unfolding is that employee power has alignment with the interests of some venture capitalists.
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The Right Valuation and Dilution Matter to Employees
In December, Retool, a software company enabling companies to build internal tools, announced their Series C with a blog post titled Raising less money at lower valuations. The post is worth the 4 minute read. While the $1.85 billion valuation that Retool commanded in this round may or may not be viewed as “low” in the future, what was notable about the financing was that it was only $20M in size, far smaller than the average round raised at that type of valuation.
Cooley’s Trends data is a helpful resource to get a sense of the latest in venture-backed startup financings; it shows that in December 2021 the median technology Series C round was $54.1M at a median pre-money valuation of $406.3M, and the median Series D was a $110M round at a pre-money valuation of $720M. The Retool Series C was a smaller round at a higher valuation than those medians, but, most notably, would have led to around 1% in total dilution to all existing shareholders, vs. the median round in these Cooley figures that led to more than 10% dilution.
The Retool post offers an explanation as to why both the valuation and dilution numbers matter to employees, by comparing the financial outcomes for employees at Coinbase and Uber (Coinbase employees had more upside because of lower private valuations), and Retool and Snowflake (Retool employees have more upside because of less total dilution — 9% vs. 60% — during a comparable valuation gain).
In short, when a private company raises less capital at lower valuations, employees have the chance for more upside if the company succeeds. Retool summarized their fundraising strategy as:
Raise at the right valuation, not the highest valuation possible
Raise the least amount possible to achieve our goals
Align with investors who put the team first
Those first two points run counter to the prevailing narrative around venture fundraisings over the past decade, where more capital at higher valuations was celebrated by founders and the ecosystem, and touted to attract new employees.
But times are changing. It’s not just Retool flaunting a right valuation to recruit talent. One of the highest-valued private technology companies, grocery delivery service Instacart, announced last month that it has cut its valuation 40%, from $38 billion to $24 billion. To be more specific, the 409A share price (or value of a share of common stock) went down in its most recent third party analysis, such that the company is now valued at $24 billion. Yet Instacart made this news public, specifically in an attempt to make its stock awards more enticing for employees, as they’re more likely to be in the money and lucrative as the company grows. Clearly the company must feel the valuation is on the minds of existing employees and new hires, especially due to the decrease in technology company multiples in the public markets since November 2021. As TechCrunch posits, will Instacart kick off a trend?
… And Also to Some VCs
One constituent that should be happy about a trend of lower private valuations is the venture capital industry. The past several years have been characterized by higher and higher private company valuations, which, when the public markets for tech companies reset over the past few months, left venture capital investors that had invested in later stage private rounds in the red on these investments. In other words, not dissimilar from the issues that employees face due to higher private valuations.
Not all venture capitalists are created equally, however. This is where the third point in Retool’s fundraising strategy is important: “align with investors who put the team first.” In general, a lower valuation for an initial investment is beneficial to the VCs investing, for it leads to a higher potential return on that investment. But, there are VCs out there who, once invested, care about maximizing the valuation at subsequent rounds, for it boosts their own carrying value on the investment, and thus perhaps their ability to raise new funds from limited partners. There are also VCs who, due to their fund sizes being large, need to invest as much capital as possible in a company, and thus prioritize their own capital deployment over minimizing a company’s dilution. These factors, and more, can run counter to the interests of current and potential employees.
When we at Footwork were negotiating a recent term sheet, we proactively discussed with the founders what the valuation and dilution would mean for existing employees and how it would be perceived by potential hires. We brought up that our objective is not to deploy as much capital as possible in the company; our focus is making initial investments solely at the early-stage, and while we hope to earn the right to invest our pro rata in subsequent rounds, our initial investment will get diluted in those rounds alongside founders and existing employees. We focused on having a right valuation at this round, one that feels fair given the company’s stage, that should enable the company to be able to raise the next round by hitting a set of milestones, and that should lead to a lot of upside for us all if the company is successful.
Employees Have More to Lose
For founders, these are important conversations to have with your major investors, especially in a world where power continues to shift towards employees, and employee-VC alignment may be just as important as founder-investor fit. The volatility in the current macroeconomic environment only serves to heighten the importance of this alignment, for while the examples above are focused on the upside for employees in a company’s success scenario, the downside for employees can be high when a company doesn’t succeed.
Take the highest profile startup implosion in recent weeks, one-click-checkout software company Fast, as an example. As the company confronted a high burn and dwindling cash reserves, it made the decision to shut down, leaving many employees suddenly without jobs and salaries, let alone zero value of their equity grants. Fast angel investor Brian Rumao summarized his learnings from the experience in a transparent thread, including the following:
Talented people have many options on where to channel their hard work, time, and effort. Founders and investors that are paying attention to what they want will win in today’s startup battleground.
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I'd like to see more companies use an employee ownership model. Even though people think founders and capitalists "take on risk", their risk of failing relative to an employees risk is incomparable. Most employees live paycheck to paycheck. They take on the opportunity cost of taking one job instead of another and it's rare they get fairly compensated for production and execution.
Awesome content. Thank you!