We keep running into clients asking what the big differences are between financing a startup in Silicon Valley and Europe. In this post we wanted to highlight a couple of these differences.
You should be aware that many seed financings in Europe are structured as tranche deals. This means the VC releases money only if certain milestones or KPIs are satisfied, indicating that a seed round is essentially similar to multiple different financings. The VC exclusively determines whether the startup hit the milestone.
European style tranche deals have a negative impact on company valuations and the dynamic between entrepreneur and VC. For example, tranche financing locks in previous valuations in a changing world. Practically speaking, each tranche is a mini round and, from the perspective of entrepreneur, the right to look at other funding options and setting valuations are limited or blocked by the tranche structure. As mentioned above, tranches lock in entrepreneurs with one VC for the cycle of financing and give funds extra leverage. In Silicon Valley, entrepreneurs have significant negotiating and bargaining power to prevent such situations. Instead of locking entrepreneurs into tranches, the market prefers to do multiple separate rounds via convertible notes, SAFES, or series seed.
One of the more shocking differences is the shape of the cap tables prior to Series A financing. The dirty secret in European funded startups prior to Series A is that funds take large equity pieces. We have seen a cap table where a EU VC took 35 % of the capitalization in a seed round. We have also seen a EU VC take up to 49% of the capitalization of a startup promising to release shares if milestones or next financing are achieved. These large equity stakes combined with a participating liquidation preference or liquidation participation (2X or 3 X), economically causes the EU VC to realize huge exits, leaving nothing or almost nothing for founders. Furthermore, such severely disproportionate capitalization tables of EU companies are red flags for US investors who read a bad cap table as a sign of weakness of the entrepreneurs and pass on investment opportunities even in the best companies.
Unfavorable founder cap tables are caused by the fact that many VC are former Private Equity investors and structure their investments with a PE perspective. Also, this dynamic in the cap table can be caused by the underdevelopment of the EU VC market as compared to the US ecosystem. American startups have more healthy cap tables with founders preserving up to 80% of the equity in the company pre Series A.
Another feature of European venture deals is that EU VCs frequently request founder penalty clauses in financing documents. In a standard scenario, a financial penalty is triggered if a founder stops serving on the board of company, decides to give up on the startup and/or does not reach certain milestones. It is understandable that investors want to create certain incentives to motivate a good team to work, but attaching financial penalties to founders who do not believe in the project and want to walk away is inequitable. We have seen the penalty clause used to deter a company from taking money from Valley investors who where disliked by the EU VC. Seriously.
Valley investors prefer to avoid such sketchy investors who only play lip service to the concept of doing good and doing well. The use of contractual penalties to keep founders in line stems from cultural difference between the USA and Europe. In the USA, and especially in the Valley, there is a different concept of work ethic and a startup as a lifestyle vs. a real job with a pay out very long down the road.
Role of the lawyer
The role of lawyers in venture deals in Europe and the US also varies. First of all, everybody has a lawyer when doing an equity financing in the US. In Europe, many times to save costs startups and their founders negotiate an equity deal by themselves, discovering many traps and/or mistakes later down the road. Secondly, lawyers in the US represent the startup, not the investor, because of malpractice concerns and professional responsibility rules. In Europe on the other hand, it is often the case that the VC’s lawyer represents both parties without blinking an eye or obtaining a proper conflict of interest waiver from the parties involved. Thirdly, lawyers in the US are open to being paid in equity (shares, options to purchase shares), while in Europe this is non-standard approach. Taking equity can reduce legal costs for startups and solidify a relationship with super star lawyers or law firms. Finally, the role of a lawyer in the US is to document the transaction and assist in the negotiations, while many times in European deals the lawyers are additional parties with egos that prolong negotiations or even prevent a deal from closing.