There was a good blogosphere discussion this weekend on liquidation preferences during seed and VC investments. Fred Wilson once again has the best thoughts on participating preferred on his blog. It’s a great read for anyone negotiating with an investor for their first fund raising round on what participating preferred is and also links to explanations on liquidation preferences.
Update – Upon rereading my post and being contacted by Gabriel (who I am about to mention) I’d really like to point out that I’m not trying to personally attack him. It sounds like he’s a very, very smart guy who has built a few businesses to the point where he is able to be an angel investor. This is no small feat! Furthermore, promoting entrepreneurship and making angel investments is something that should be celebrated, not attacked. I do have some issues with his post on liquidation preferences in angel rounds, though.
During this discussion I came upon what I thought was going to be informative post on liquidation preferences by an angel investor in PA, Gabriel Weinberg. He links to a few spreadsheets in his post that supposedly make the case that it’s cool to take an angel investment with a 2x liquidation preference. He makes the points in these sheets that as an investor, with a 2x liquidation preference he can make a 15% IRR even if he invests in a company who’s value drops from $3 million at his investment to a $1 million exit 5 years later. That is one of the largest mis-alignments of interest between an investor and an entrepreneur that I can imagine.
He also seems to think that later round investors will be ok allowing him, the earliest investor, to keep his out of whack liquidation preference AND not insist on having one themselves. There is no chance a good investor will allow this. In fact, having out of the norm terms (like aggressive liquidation preferences) have a very high % chance of torpedoing your company’s ability to raise capital from a sophisticated investor. When the VC firms I worked for saw aggressive terms like these in seed investments, we usually passed on the investment right away. This is because it is a sign that you are going to have to deal with an unsophisticated angel investor, and most VCs would rather have a lobotomy than waste time negotiating with an angel who thinks they know what they are doing but don’t.
To illustrate my point that unsophisticated angel investors with large liquidation preferences are dangerous, I’ll share a story of a deal-gone-bad: I saw a company’s angel investors blow up an investment that would have been GREAT for the company and entrepreneur. Basically, the angels would have had to have lost their super-liquidation preferences. The company was cash flow break-even, but could have used my fund’s $10 million investment to grow to potentially be a $100 million plus company – but because the original investors were sitting pretty on a cute little return (very safe at this point, since the company could generate cash by stopping investing in growth) with their preferred structure, so they rejected the investment. Note that this crushed the entrepreneur’s dreams of growing his really great company into a big firm in the next couple of years. And my firm wasted a lot of time negotiating with these investors. I still feel really bad for the entrepreneur.
There are only two times it makes sense to accept over a 1x liquidation preference:
- The investors are letting you cash out at the time of the investment (i.e. the money they are investing is going into your pocket.)
- This is a B or C round and your company is having real problems. VCs will sometimes then insist on punitive terms to try to make up for the fact that they know their initial investment(s) in your company are likely to not produce returns.
VCs for a long time highly encouraged convert investing by angel investors. Angel investors have been clamoring for more respect and believe that they should be encouraged to invest in preferred stock with a valuation, instead of investing in convertible debt that turns into whatever the next round’s structure is at a discount.
Update: There was an issue with the model shared in Gabriel’s post, but he has since removed the problem. I believe it is dangerous to let non-sophisticated investors into Microsoft Excel, and seeing his Google Spreadsheet I’m going to extend that thought to include all cloud-based spreadsheet applications. In the model he shares, he has invested $50k as part of a $500k round in a startup. In his final scenario, he sells the company on the downside for $1 million and somehow gets back $164,167. 16% of the total returns! How the heck is he going to do that when he only put in 10% of the initial investment? Are the other investors in the $500k round going to say, “Hey Gabriel, you get paid first and we’ll just split up whatever is left over?” No. They are going to split the proceeds up according to the % of preferred that was invested, giving him a max of 10% of the return – i.e. he invested 10% of the initial investment so he’ll only get back 10% of the proceeds, since 100% of the proceeds are going to the investors in this scenario.
I present this as a compelling reason to get unsophisticated angels back into investing in converts.
Update: I was too harsh in my original post. I’ve had an email communication with Gabriel and I think he’s trying to do what is best. I also think he’s trying to help companies grow. His post was intended as a “hey I want to hear people’s opinions” and was not a license for me to be nasty. I was mean spirited in my original version of this post, which isn’t cool. I’d like to apologize to him.
I do very strongly believe that liquidation pref’s are an area where it is easy for entrepreneurs and investors to get out of alignment. I think that strong belief carried over into a morning where I didn’t have my usual cups of coffee at home (due to the boil water order here in Boston). To be clear, while I do think there are times when a multiple liquidation pref works for everyone (see my point one and two above, plus for some growth stage investments) I’m not a fan of it for seed stage investments where the startup will be likely to seek further funding.
Very cool basic dilution/ownership model for venture capital rounds. Founders – keep in mind there are likely some terms that will trick up the VC’s preferred stock ownership, but this is a cool tool. I haven’t spent enough time with it to “break” it but I think it will suit the vast majority of typical venture investments at an illustrative level.
Using the power of Google Analytics, it’s easy for me to see which Startable blog posts were the most read in 2009. Keep in mind that I’m merely looking at the number of views, so stuff posted earlier in the year has a distinct advantage of making it to the top.
10. The hidden cost of down rounds – the antidilution provision. When venture backed companies’ values drop, the pain is not felt evenly amongst the shareholders. With venture backed companies’ valuations falling like rocks due to the financial turmoil and bad-economy-induced-missed projections, I’m not surprised that this post got a lot of traction.
9. 4 Ways to generate business ideas. Prasad’s post on idea generation and ways to come up with innovative businesses and solutions still attracts good traffic to Startable.
8. The Entrepreneur in Residence. The first in a three part series explaining what an entrepreneur in residence does at a venture capital firm. The follow up posts talk about how to deal with an EIR and how to meet with one. I think this post will continue to get good traffic; it is actually the number one search term driving traffic to Startable.
7. MBAs and Startups. Right when I was fresh from leaving venture capital and starting actually doing the entrepreneurial thing, I responded to a Dharmesh Shah post on 10 things MBA school won’t teach you. Now that I’ve been a “real” entrepreneur for the past 6 months, I agree with what I wrote. This post also had a bit of a TechCrunch boost.
6. Early stage venture capital valuations. Right after I left venture capital I felt that I could reveal the truth (as I saw it) on how VCs value startups. VCs have a target ownership, and the more you raise the higher valuation you startup will get. I continue to stand by this.
5. So you want to be a junior VC. My advice to someone who emailed me asking for tips on interviewing for a non-partner position at a venture capital fund.
4. Angel groups are professionalizing and I’m not sure VCs realize it. I was pretty impressed after attending a meeting of the Northeast ACA (Angel Capital Association.) This isn’t a meeting most venture capitalists get to attend, and I was pretty shocked at the level of sophistication. Angel groups are really getting good. Somehow this post got a lot of stumbleupon love.
3. The venture capital investment memo. Since I worked at a few funds, I thought it would be fun to compile the “average” investment memo put together during the investment process at a venture firm. I get good monthly search traffic to this post.
2. Leaving venture capital. Well, this is when I officially announced I was leaving Atlas Venture. I guess people wanted to read about it!
1. It’s not me it’s you, the real reason many startups can’t raise venture capital. Many, many startups are rejected by venture capitalists for the simple reason that the VC doesn’t have confidence in the founder. However, this is rarely communicated. I list some tips that the founder can use to tell if they are the problem.
Wow, so I’ve written a lot this year. Hopefully I’ll continue to have some good content going forward. I am always available over email or twitter, so don’t feel bad reaching out.
Happy New Years!!
Great post by Mark Suster on when, if and how startup founders should be allowed to take money off the table before their starup has reached a real exit. Mark’s basic thesis is that it is sometimes a great idea for startup founders to sell some of their equity to their investors. He discusses his own experiences and suggests how he would have managed his own companies differently and/or not sold them when he did. His post is well reasoned and is worth reading. He does suggest a few scenarios where this makes sense and should be allowed, including the founder having been with the company for a certain number of years, limiting the $ amount to something reasonable, etc.
What I’ve seen is that early-stage VCs with big funds are not against buying common stock from founders, when the startup is doing well. As I’ve mentioned in my startup valuation post, VCs are always thinking in terms of their percentage ownership. When the company is doing great and VCs with deep pockets are already investors and want to increase their ownership, so if that means potentially buying stock from founders you may be in luck.
One of the other funds I worked for, Summit Partners, made a living off of buying stock from founders. It worked pretty well, since Summit liked investing in companies that were profitable and growing – and hence didn’t really need traditional venture capital to grow the business. Founder liquidity was the general excuse Summit used to get into some great companies.
I’m not at all against the idea of founders taking some money off of the table, provided the company is doing well and provided they continue to own enough of the company to continue to care about its success and work hard to keep it growing. I do think this would be a real advantage of selecting a larger sized fund as your initial venture capital investor. Smaller investors may not have the additional cash reserves available to both fund some liquidity and also continue to have enough in reserve to fund the company’s growth.
Mark MacLeod pointed me to a recent publication by Fenwick & West (a well known tech law firm) on the increasing number of down rounds for venture funded companies. According to Fenwick, for the past two quarters, “down rounds” have exceeded “up rounds” when venture backed companies are raising follow on financing. To go into a little more depth here, a down round is when a company that has already raised venture capital raises additional capital (another “round”) at a valuation that is lower than the valuation from the previous round. In other words, the company is worth LESS than it was after the completion of its last fund raise. So, for the past couple of quarters, many previously venture backed companies are falling in value.
Why 2009 Q2 valuations are falling
The decrease in valuation for these companies has averaged about -50% for the past three quarters – a pretty hefty drop. This is probably caused by a few horrible issues converging all at once: 1) the NASDAQ is off by 30%ish from its two year high, and was at one point 50%ish off its high – obviously valuations for private technology companies are going to be impacted; 2) the difficult market conditions have made it harder for venture backed companies to achieve their goals and hit their value creation milestones, therefore many of them have probably failed to really move the needle on their valuation in the positive direction; and 3) there is less venture capital floating around, so as supply of follow on financing drops valuations should follow downwards.
The hidden cost of a down round for a venture funded company – anti-dilution provisions
The problem with a decreased valuation, from the startup founder’s perspective, is that the venture capitalists are going to significantly increase their ownership in the business at the expense of the company’s management team. Not only is the price per share that the VCs are investing in down (thus they buy more of the company) but they also will benefit from a standard term in venture capital fund raising – the anti-dilution provision.
The anti-dilution provision is intended to protect the investor in the event of a down round by resetting the conversion price from the VC’s previous investment(s) in the company. This provision resets (much like a “do over”) the price paid per share from a previous investment to the new price per share, or to a calculated price per share in between the previously paid price per share and the new, lower share price paid by the investors in the current round.
I’ll run through a quick mathematical exercise so you can see the impact of a down round on a company with a “weighted average” anti-dilution provision. This is the standard anti dilution provision, and is much more founder friendly than its less standard cousin, the “full ratchet” antidilution provision.
For this example, let’s assume your startup has raised a Series A with the following terms:
$5 million from VCs at a $5 million pre-money valuation. This means the investors own half the company, and management owns the other half. Also, let’s assume that there are 10 million shares outstanding, so the investors own 5,000,000 and management owns the same. Thus, the price per share is $1.00. Post money, after the Series A, is $10 million.
The company needs another $5 million.
Up round – Say that everything is great, and the company is able to raise capital at $2.00 a share. Ownership post financing will be:
When your startup is raising venture capital or an angel financing round you will have plenty of tough points that need to be negotiated. Some of these are easy for a founder to understand, such as valuation or number of board seats. Other points will represent more of a challenge and startup CEO will be at a significant disadvantage vs. and experienced investor – even if the startup CEO has raised capital in the past. An investor, be it a VC or an active angel investor, will simply have executed more private capital rounds than the typical CEO, and thus will better understand the terminology and implications of different deal terms. Thus,
You will need an experienced lawyer on your side when raising venture or angel financing
Your attorney needs to be up to speed on current standard “best practices” for deal structures and terms. These terms tend to change over time based on IRS and SEC rulings, crazy (highly publicized) happenings at other venture backed companies, industry-wide investor vs. entrepreneur power dynamics, etc. If your lawyer hasn’t done a number of private, VC investments recently they are likely to be behind the curve. Some deal terms, such as a strategic investor demanding a last look on any acquisition offers on the startup or certain blocking rights held by your preferred shareholders, can make selling the company or raising the next round of financing difficult to impossible. You need someone experienced looking for these sorts of issues on your side!
Some key terms you need to be very involved with – in particular the company’s valuation and the vesting schedule for the current employees’ shares (there are obviously other items – consult your attorney!) You will need to discuss these sorts of items directly with the investor. That’s not to say that you shouldn’t get advice from your advisers… but these are issues you need to deal with directly with the investor. If these negotiations become testy, well, that’s too bad. As the leader of your company talking to investors these items are your responsibility, and they are also things that you can easily understand without a law degree.
Your attorney should be a hammer (or shield) in negotiating (some) tough points during your financing
For more complicated/technical issues you need your attorney’s advice. You can (and should) let your attorney negotiate with the investors’ counsel directly on a number of these points – mainly the smaller technical points (this usually happens in the stock purchase agreement drafting stage, less so during the term sheet stage). There will likely be some major items that you will need to get involved with. If these issues are ones that are technical in nature than you should use your lawyer as a hammer and say “my attorney will not allow me to accept that term.” I’m not talking about points like valuation – who gives a crap what an attorney’s position is on that. I’m specifically referencing technical provisions of preferred stock or convertible notes or certain things like items in an indemnification agreement. An investor should not get too annoyed if your HIGHLY EXPERIENCED attorney thinks a particular provision is non-standard or that it will likely cause issues in your next round of financing. (However, if an inexperienced company counsel is making mountains out of molehills then you are simply wasting the investors’ time and money.)
Preserving a positive relationship with your potential investor is critical. But, this should not mean that you get screwed over during the investment process. Seek advice from the right lawyer early in the process. Break the points that you want to negotiate into two different buckets: 1) the items you need to have a fair deal – things like valuation, board representation, etc. and 2) items that you need to have a legally intelligent financing. Use the lawyer as a shield when negotiating the legal points, and use the confidence that you have in your startup in negotiating the first category of points.
I think I’m going to do a whole post later on attorney management. You don’t want your lawyer derailing your transaction or running up outrageous fees. However, you need to make sure your interests (and the interests of your employee-shareholders) are correctly represented. I’m going to try to put some ideas on this in a post later, but I’d welcome any ideas on this topic in the comments!