Pankaj (00:00)
Imagine building a company for nearly a decade. You take it from scrappy idea in Edinburgh to a household name. Literally. Millions of people use your product every football Sunday. Then one day your company gets acquired for half a billion dollars. Champagne moment, right? Let’s pop that bubbly. Not so fast, unfortunately. This time you walk away with nothing. Not because the deal was small, but because of a handful of clauses buried in term sheets you signed earlier. Liquidation preferences.

And something called drag along rights. and it turns out some of the executives running the company on your behalf did just fine themselves. This is the story of FanDuel. It’s one of the most instructive cautionary tales in startup history. Let’s get into it.

Welcome back to another episode of Letters of Intent, the podcast for dealmakers and risk takers. Today we’re doing a deep dive into how a nearly $600 million acquisition left founders, rank and file employees with zero dollars, and exactly what current founders should do differently, starting with the next term sheet you sign. So let’s go back to the beginning here. FanDuel, as many of you guys have heard about it, it’s been marketed forever. They probably spent millions and millions of dollars on marketing.

It was founded in 2009 in Edinburgh, Scotland, as a daily fantasy sports company, going head to head with its American rival DraftKings. Between 2009 and 2014, the company raised $88 million. Then in 2015, it landed a huge Series E round, $275 million from a group that included KKR, Shamrock Ventures, which is Disney’s family investment office, plus Google NBC and other institutional backers. The round valued FanDuel at one point at $2 billion on paper.

A unicorn. However, that series E turned out to be the company’s last equity round. After that, FanDuel raised two more rounds at convertible notes, pushing total financing to around $444 million. But underneath that impressive headline, the business was burning cash at alarming rates. And by 2017, FanDuel’s annual revenue was about $124 million.

While his marketing spend alone was reportedly around $400 million, largely from bruising customer acquisition war with DraftKings. With the cash running low, the board brought in a new CEO to try to stabilize things. Later that year, FanDuels and DraftKings attempted to merge, which would have been an obvious move to stop both companies from hemorrhaging money and other resources, but the regulators blocked the merger on antitrust grounds.

With few options left, an offer came in from Paddy Power and Betfair, an Irish bookmaker now known as Flutter Entertainment. Four hundred and sixty five million dollars paid in stock, not cash. Once you count for how the deal was structured, it’s often cited as a five hundred and fifty eight or five hundred and fifty nine million dollar transaction, and that number’s important for later.

But FanDuel was also carrying roughly one hundred and fifty eight million dollars in debt and that had to be cleared before the deal could close. And crucially, two lead investors had a liquidation preference entitling them to the first five hundred and fifty nine million dollars of any sale. There’s that number. The offer didn’t clear the bar, so common stockholders, founders, and employees were left with nothing.

So let’s unpack how this deal was structured and what happened exactly that led these founders and many common shareholders to be left with nothing.

So the first concept you want to understand is liquidation preference. When VCs or private equity firms invest in a preferred stock, they typically negotiate the right to be paid back first. That’s a liquidation preference. When you have liquidity, you want to get payback first. That’s why these people put the money in, they want to get it out. And it’s oftentimes a multiple of the investment. So before any money flows into the common stockholders, in FanDuel’s case, two investors had a combined preference covering the first

$559 million of proceeds. Everyone else was behind them in line. So that means they get the first $559 million. That’s out. Important number. Second, drag-along rights. This is the part people often miss. Even though the deal was terrible for common shareholders, the founders couldn’t simply refuse it. Two major investors, reportedly holding around 21 and 15% of the preferred shares, were designated dragging shareholders. It means they dragged everyone along under the company’s agreements.

Drag-along rights let the defined majority of preferred shareholders forced everyone else, including founders and employees holding common stock, to accept the sale on terms negotiated, whether they liked it or not. That’s what drag-along rights mean. Third, this is the part that should really make founders sit up.

The CEO brought in to steer FanDuel through this crisis had previously worked at KKR, one of their investors, the biggest investors, one of their two lead investors, enforcing the liquidation preference.

So when the sale went through, that CEO reportedly received a payout package worth more than $11 million. The company’s chief legal officer reportedly made around six million dollars. And the broader executive team split payouts reported as high as $13 million in golden parachute earnout arrangements. Again, this is all stuff that I’ve seen online. I’m not actually saying whether it’s true or false. That’s what I’ve seen. With commentary around the deal describing the management carve out in the neighborhood of $30 million in total. Meanwhile, common stockholders got zero.

So while investors were making tons of money and the management was compensated very nicely for shepherding the company through the deal, The employees, whose sweat equity built the company, were left out entirely. It’s worth noting that the group of roughly 100 former FanDuel employees sued over the outcome in 2020, alleging the deal was structured unfairly. As of 2022, an appeals ruling said they were not gonna win and they were unsuccessful in that appeal. So

that matters because it tells you that these outcomes aren’t easily reversed after the fact through litigation. What matters more are the protections you built in before these deals are made. So it’s tempting to cast this purely as investors versus founders, but there’s more nuance here. Venture capital operates on a power law model. This is something you all have to understand. This is the way of the world.

And you gotta be really aware of this before you get into bed with a venture capitalist. That means that they bet knowing that most bets are gonna fail. And a fund’s returns depend on one or two huge winners. So downside protection through liquidation preferences is standard practice, not necessarily villainy. It’s done all the time. But it’s worth noting that one of the FanDuel lead investors, KKR, is a private equity firm, not a traditional venture fund. Private equity tends to seek more control and more structured downside

protection than early stage VCs typically do. A meaningful different incentive set than most founders assume they’re negotiating against when they take a growth round. So think about that when a growth round, well if you’re looking at PE, they actually are gonna be a little bit more aggressive with those terms and you got to be watching out for that. The bigger failure here was the conflict of interest baked into the leadership.

When your CEO previously worked for the investor holding the liquidation preference that determines whether you get paid, and that CEO personally profits handsomely from the deal that pays common stockholders nothing, that’s just not an unfortunate market outcome. That’s a structural misalignment that the board should have addressed with independent oversight. So what’s next? What should founders do? So let’s make this practical. Here’s what to watch for starting with your next round. Number one.

Model your exit waterfall before you sign anything at multiple exit prices. And this is what AI is great for nowadays. Definitely leverage, Claude or ChatGPT to help you with this. There’s also great sites out there that will help you with this modeling. But it’s important to understand what do exits look like at different valuations and different exit points. So you want to include mediocre outcomes and not just optimistic outcomes. If a realistic, unglamorous exit price leaves common shareholders at zero, that needs to be fixed before you sign, not discovered

after an acquisition offer lands. Number two, understand your liquidation preference stack in full. The multiple, whether it’s participating or non-participating, and how it accumulates across every round you’ve raised. Push hard for one times non participating preferences.

The stack that looked reasonable in your Series A can actually become lethal once three or four more rounds are stacked on top of it. Number three, pay very close attention to drag-along rights and who actually holds them. Know exactly what percentage of preferred shares can force a sale and under what conditions. If a small number of investors can compel a transaction, regardless of what founders or the broader shareholder base want, you have effectively cede control of your own exit, even if you still hold a board seat. Four.

Watch for conflicts of interest in your own leadership team and board. If an executive has close professional ties to a major investor, especially one with a large liquidation preference, that’s not automatically disqualifying. But it should trigger extra scrutiny, ideally from independent board members who don’t have a stake in favoring the investor’s payout.

Number five, scrutinize management carve outs and transaction bonuses whenever a sale is on the table. These arrangements can create a situation where the people negotiating the deal on the company’s behalf are financially incentivized to get it done rather than whether it’s good for the common stockholders. Insist on transparency around any such carve out before the board approves the transaction. Six, don’t raise more than your realistic exit range can support. And don’t assume a big headline valuation protects you.

FanDuel raised over $400 million in total financing and still needed a $555 million exit just to get common stockholders to break even. Bigger rounds raise the bar that you have to clear, not just your runway.

Number seven, be honest with your employees about what their equity is actually worth under different scenarios. Legal opacity around cap tables is common, but it’s not fair. And as FanDuel shows, courts may not fix your issue after the fact.

If you’re an employee anywhere, ask directly about the liquidation preference and don’t assume a big valuation means a big option value. Number eight, get independent counsel, not the firm your lead investor recommends, and have them walk you through the total preference stack and drag along thresholds and any change of control payouts to management, every single round. These are the clauses that don’t matter until the day they determine whether you get paid at all.

So what’s the lesson here? The lesson is that FanDuel isn’t just a liquidation preferences or dangerous story, though they are. It’s that a big exit number in a headline tells you almost nothing about who actually got paid. The real story lives in the preference stack, the drag along clauses, and sometimes in quiet side arrangements for the people running the deal.

None of that is illegal or even necessarily unusual, but all that is negotiable before you sign and almost impossible to fix afterwards. If you’re building a company right now, do the unglamorous work, model the waterfall, understand who can force a sale, watch for conflicts of interest in your own leadership and be honest with the people betting their careers on your equity.

So that’s the show for today, everyone. I hope this was useful. If it was, send it to a founder that you know that is trying to raise their next round. Until next time, I’m Pankaj Raval, founder of Carbon Law Group, and this is Letters of Intent.