Opinion: No, scoring an exit does not necessarily make you wealthy


Jonathan Klinger wrote a very interesting Facebook post (in Hebrew) for the entrepreneurial and investment community so that they would know for a moment how it feels from the other side. I am eager to explain this post in a bit more depth so that you can understand the mistakes you have already made when you were running in all directions to get investments on certain terms.

First of all, it is important to say that we really like Kira Radinsky. The entrepreneurial community to which Kira has contributed so much (lectures, mentoring, stage appearances, and interviews) appreciates the few who are willing to donate their time, and embraces her for her success today, too. Personally, I welcome every exit in which a woman is involved, but that’s a different subject that will have to wait for a future post. We also especially like the investors who appeared in this case, at least the ones we are familiar with. We know that their aim is to maximize their profit, and from our acquaintance with some of them, those are the market conditions, not something exceptional for the industry.

This exit, however, can exemplify the problems with today’s complex investment contracts in Israel (everywhere, actually – isn’t that true?), and it is important for entrepreneurs, before they rush to leave their jobs and begin the next startup, to take into account another significant aspect in their considerations before they take this road.

Again, this story is not intended as a criticism of Kira. On the contrary, Kira is one of the few women in recent years to achieve an exit with a large international company. I think that’s amazing, and worthy of praise.

Many entrepreneurs are far from being the multi-millionaires reported by the press after their exits

Klinger says that the newspaper gave the following figures: “According to the Registrar of Companies, she (Radinsky) and Zakai-Or have 16% of the company’s capital, and according to a $40 million value for the deal, each of them will get about $6 million, NIS 25 million (gross, before tax) – not bad at all for a 30 year-old.”

To understand the mistake made in the Globes story (we hope they correct the Hebrew story quickly) as written in Klinger’s post, and the figures explained by Jonathan, it is important to comprehend several important clauses in investment agreements and in the structure of companies. When a startup raises its first money – the “seed” money you are familiar with – it distributes the shares for the money equally, meaning that in the event of an exit, the profits will be distributed according to the size of the stake in the company (minus tax, of course).

The financing round in which the venture capital funds enter the investment is appropriately called the A round. In this round, shares of a different sort are created – preferred shares (such as A shares). These shares confer rights on their holders in any way imaginable, or any way that the investors can think of, and are arranged in the company articles of association. Some preferred shares confer voting rights, and some give preference in the distribution of profits, dividends, and what is called “liquidation preference.” There are other kinds, but these are the most common ones.

Actually, the word “preferred” is a sign that you should run for cover, or at least try to bargain over the terms. Don’t forget – these agreements are designed to maximize the profits of the parties who sign them. Bargain by yourselves over your terms and don’t accept every condition, especially not a veto condition and financial conditions you’ll later regret.

Yes, sometimes it’s not worth getting the money, even if it costs you the life of the startup – it’s really that bad.

Multiplying the profit

Now comes the difficult legal wording, but let’s keep it simple and stick to the nitty gritty. There are some who will choose the right of way, meaning that they can make back their investment first, and only after that is the money divided between everyone. There are others for whom that is not enough – they get a return on their investment, and then the money is divided again between everyone. That means first they get their investment back with a return, and then they make more profit according to their stake in the company.

But wait – that’s not all.

Unfortunately, there are also some who want a multiple on their investment. This means that if they invest one million, they first get two million before the money is divided between everyone – or three million (according to the stipulated multiple). Only then is the money divided.

What does this mean? It means that they did their calculation according to the figures they obtained, in which the value of the deal and the valuation of the company was $40 million. The Marker, incidentally, reported $20 million, we (Geektime) think the amount was lower, but we can argue until Doomsday about who is right. Another important figure is that the total investment obtained by the company before the exit was $5.3 million.

That same newspaper assumed that if Radinsky has 16% of the company shares, she gets 16% of the profit from the exit. But the newspaper is wrong

Klinger continues: “A look at the file shows that there are two kinds of preferred shares in the company – A preferred shares and A1 preferred shares – and one type of ordinary shares. The company has 2.73 million A and A1 preferred shares, while each of the founders has 750,000 ordinary shares.”

Do you remember what we said before about preferred shares? This is where they do their dirty work. As Adv. Klinger puts it: “For unknown reasons, the articles of association themselves are absent form the company file, so it is impossible to see exactly what extra rights are conferred by A and A1 preferred shares, but the usual practice is that the first of all, the investors in the last round get their investment back ($4 million), then the investors in the first and second rounds get their money back (another $5.4 million), and then, everyone shares the $14 million or less remaining (depending on whether you accept the Marker’s figures, Globes’ figures, or our figures) equally.” (Incidentally, this may be incorrect, and the preferred shares conferred only voting rights, for example, but judging by what we know about the Israeli VC market, Klinger’s calculations are correct.)

Let’s calculate – each of the founders has 16% of the all the shares (approximately), which is about $2 million before tax, depending on the extra rights, and depending on all sorts of other things. Now, don’t forget that some of the payment is undoubtedly in shares, and another part is also contingent on the founders staying in the specific job for several years. On the other hand, the founders’ contracts might also include bonuses, not just the proceeds from their shares.

Fortunately, in this case, Kira will probably become a millionaire, but a multi-millionaire? It doesn’t look like it. The funds, on the other hand, whose job, again, is to maximize their investment, will do quite nicely, thank you, but I’m not the only one who ever wrote that the venture capital model is defective in many cases.

What have we learned from this?

When you found a company, divide the shares among you, and put the options to one side for employees and consultants, don’t get carried away and start distributing shares without counting them, as quite a few entrepreneurs do. You’ll pay later for these mistakes when you go to cash the check. In any case, only a really small proportion of the companies achieve an exit, so if you become one of them, shouldn’t the years you spent in the startup be worthwhile? Think about the salary you lost, the hours, your family, the outings you didn’t have, your life, your children.

If they were lucky, and there weren’t too many financing rounds, the entrepreneurs in an exit do wind up with quite a bit of money, but in practice, in most cases? It won’t even pay for an apartment in Tel Aviv without a mortgage. That’s pretty depressing, isn’t it?       


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