In 2003, Elizabeth Holmes, a Stanford dropout, became the founder and CEO of a hugely successful biotech company called Theranos. By 2015, Holmes had topped Forbes magazine’s list of the “Richest Self-made Women”. Forbes valued Holmes’ net worth at $4.5 billion, with Theranos valued at over $9 billion. However, Forbes has recently revealed that it has significantly amended its estimate of Holmes’ wealth, now re-valuing her net worth at “nothing”. Furthermore, Theranos is now only valued at $800 million, a significant drop from $9 billion, due to on-going federal investigations into the company and questions as to the safety of what it is doing. Below, we set out five lessons startup founders can learn from the unfolding situation.

1. Try to Avoid Issuing Preference Shares in Your Company

Holmes’ company is still worth $800 million, and she still has over 50 per cent of the shares in Theranos. So why isn’t she worth $400 million (i.e. 50 per cent of $800 million)? The answer is that Holmes only has ordinary shares in the company and issued preference shares to external investors in exchange for a capital injection of over $720 million. Consequently, in the case of a liquidation event, the preference shareholders will be repaid their money, before the ordinary shareholders (including Holmes) get anything.

When raising capital, always try to avoid having to issue preference shares unless you have to. Venture capitalists will typically require preference shares but as a rule, you should always begin by offering ordinary shares to non-venture capitalists.

2. If You Have to Issue Preference Shares, Keep the Liquidation Preference as Low as Possible

Preference shares generally attract a particular type of liquidation preference. In the Australian market, the most common liquidation preference is a 1x purchase price preference. So, if a liquidation event occurs, the preference shareholder will receive the amount of money he or she invested into the company (assuming there are sufficient funds) before ordinary shareholders get anything.

Less commonly (at least within Australia), a shareholder may be entitled to a higher liquidation preference. For example, if a shareholder is entitled to a 2x purchase price preference then, if a liquidation event occurs, that preference shareholder would be entitled to receive twice the amount of their investment before ordinary shareholders receive anything. It is, therefore, less likely for ordinary shareholders to receive all of their investment back. Accordingly, you should try to keep the liquidation preference as low as possible if you do have to issue preference shares.

3. Retain Control of the Decision-Making Process

If you do raise capital, ensure you retain control over the decision-making process and can determine the day-to-day operations of the company. As a founder, you are probably best placed to know how to run the company and what the business needs. You do not want an external investor/investors taking a majority stake in the company and telling you what to do or, even worse, terminating your position. You particularly do not want to be terminated if you have vesting shares that are still subject to vesting provisions as this could mean you lose some (or all) of your shares. As such, you should make sure that there is a well-drafted shareholders agreement in place that allows you to control the board (and board decisions) and general meetings (and members’ decisions). A well-drafted Agreement also prevents external investors doing something which may adversely affect you.

4. Be Careful of Vesting Shares and Vesting Provisions

Founders seemingly hold the majority of the company’s value as they can run the business and have developed its intellectual property. Investors will not then want the founders to leave after a capital injection because if they cannot find suitable replacements, the business may quickly become worthless. Accordingly, investors, particularly venture capitalists, will want the company’s founders to be locked in to the business for a period after their investment (generally four years). They do this by making the founders’ shares subject to vesting provisions. Such vesting provisions typically dictate that if the founder leaves the company within the vesting period, they will have to sell some or all of their shares back to the company. When the shares are offered to a replacement, they can then run the business in the absence of the founder.

While this is a good idea in that it incentivises the founder to stay and help grow the company, and provides the investor with security, it does attract some risks for the founder. It is critical to look at the terms of the vesting agreement and consider:

  • What is considered to be a leaver event?
  • Is there a concept of good leaver and bad leaver?
  • The price you will receive for the shares you have to sell.
  • Do you get a higher price if you leave the company for a good leaver event?

If you leave the company during the vesting period due to a good leaver event, then ideally you want to receive fair market value for your shares. If you leave because of a bad leaver event, then it is standard to receive a discounted price (generally around 80% of fair market value). You want to avoid providing an investor with the power to terminate you and force you to sell your shares.

5. Avoid Bad Press

One of the main reasons Theranos is struggling at the moment is that it is under federal investigation, and people are questioning the safety of what it does. Although Theranos is strongly refuting any claims against it, the bad press is evidently affecting business. People do not want to deal with a company that is perhaps dangerous and is under investigation.

Running a legitimate business and complying with all applicable laws is the best way to avoid bad press – something easier said than done as many rules and regulations can apply. Furthermore, very few businesses, especially in the early stages, can afford to engage a compliance team to ensure everything is correctly performed. As a starting point, however, ensure you seek legal advice as to whether or not you are required to have any licences or authorisations to conduct your business. Implement systems and processes to remind you to complete, file, update or review particular documents. Arguably most importantly, surround yourself with talented people and advisors who are experts in their area and whom you can rely on to help you with compliance.

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If you need assistance with business structuring and capital raising, get in touch with one of our startup lawyers to discuss your business requirements and legal needs on 1300 544 755.

Jill McKnight

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