The true tragedy at Pandora Media is not that the stock traded below its IPO price within 24 hours (though investors who bought shares in the secondary market on the first day may disagree). Rather, it’s that the founder (who was one of three co-founders) holds only 2.25% of the outstanding shares. Meanwhile, two venture capitalists, both of whom are former Wall-Streeters, individually own over 20% each. Pandora is not making its founder, or the people who work there, wealthy. But it has turned out to be a very lucrative investment for the venture capitalists who took the company public.
Aren’t startups that make real products/services supposed to make their founders wealthy, not their financiers? What happened here?
Pandora launched in 2000, during the height of the tech boom, and has followed a long and circuitous path to becoming the
$2 billion plus $1.75 billion company it is today. The business required a lot of outside capital, necessary to negotiate and acquire rights to music content and to build out its streaming capability. In addition, they have a large team of music analysts on staff to catalog tracks as part of the Music Genome project. Two of the co-founders (Will Glaser and Jon Kraft), left Pandora after the tech-wreck and the company required many successive rounds of financing to stay afloat. Pandora had a number of near-death experiences as the business model changed from subscription to advertising, and their focus shifted from serving music retailers to subscribers. It would have been easy to write them off about a dozen times over the years, but they managed to survive and go public in the end. It is a remarkable testament to their perseverance that they are now a business that has built a service offering a unique blend of algorithmic and curated content, combining both crowd-sourcing and expert analysis. And they have a devoted subscriber base that is growing.
How then, to explain the fact that a co-founder who has been at the company for twelve years, through numerous ups and downs, ends up with a minute share of the firm, while the financial sponsors walk away with many multiples of their investment?
As many entrepreneurs in the tech space already know, capital infusions almost always require giving up equity. And when a company requires several capital infusions, it means that equity is spread even thinner. But when a company is in danger of folding, lifeline capital infusions require deals that, in retrospect, may seem horribly one-sided (rarely in the founders’ favor).
There are mitigating circumstances, of course, and we’re not saying that Pandora’s founders are guilty of making horrendous deals – they likely did what they had to in order do keep the company afloat. Nor are we saying nice guys finish last (even though we think Tim Westergren is one of the nicest founders we’ve ever had the pleasure of meeting). We also recognize that Pandora’s trajectory is not one that other startups will necessarily follow. It’s just an illustration of one particular outcome, one which was spectacularly unfavorable to the founders monetarily.
So what should founders do?
The first thing is to understand the value and cost of venture capital financing. As a startup founder, you want your idea and work to reward you. If your business is as good as you believe it is, equity capital may turn out to be very expensive. Debt, could easily make more financial sense and leave you with more control of your company. It’s also important to understand the parameters of the deal you’re offered. Learn to read term sheets and, as always, get more than one quote. For instance, aggressive deal terms can dilute founders to a surprising extent. A few years of 8% coupons on compounding cumulative preferred can quickly add up. That said, there are certain advantages to working with a good VC. Some of the best can help you develop your business by providing good advice, and if they have a large following, help launch your product or service. A good VC’s experience and timely assistance can be invaluable. For example, it’s the VCs who suggested Pandora switch to a advertising model and get out of the subscription radio game.
As a founder, it’s important to understand that venture capital firms are not your friends. In fact, some of the more aggressive outfits will not balk at taking advantage of founders who don’t have a strong grasp on how to structure a capital deal. Pandora’s story underscores the need for entrepreneurs to have expert legal and financial advice in place early on in the game, so they can protect their personal interests when VC firms come calling. Ideally, this should come from an independent advisory firm that does not have a brokerage or investment banking arm which may be more interested in maintaining a continuing relationship with VCs.
Shameless plug: We can’t pass up the opportunity to say that Washington Square Capital Management was founded precisely so we could provide unbiased advice on investments and financial planning to our clients. As an added kicker, we enjoy working with entrepreneurs and technologists so much, we waive our minimum investment requirements. To get a flavor, read our post on Personal Finance 101 for Aspiring and Successful Entrepreneurs. To learn more, reach out to us via e-mail (info at wsqcapital dot com) or call us at +1-646-619-1156.
Image credit: F.S. Church
As of this article’s publication date, Washington Square Capital Management and its clients do not hold positions in either company, this may be subject to change. We may in the future acquire positions in other companies mentioned in this post. This article is not a recommendation to buy, sell or hold any securities mentioned.