May 4th, 2007
As usual, there were many mind-expanding comments this week—here are some of the very best.
The very lucky winner of this week’s mug for great contributions in the field of venture hacking is indicated with a subtle ball of fire.
“Anonymous” discusses his experience with getting vested for time served and how his investors “poked out” two of the company’s co-founders:
“In my first institutional round we successfully got founder vesting put in… with a year’s worth of credit and a monthly vesting rather than an annual cliff. The company was at about 16 months old. At the time, we thought we were losers and just got ripped off but in hindsight that was a genius move. When the lead VC moved to poke out two of our 3 co-founders, that vesting took away some of the sting. Having the [credit] makes them think twice about having to spend the cash to move you out. In the end, we ended up with about 12% of the company fully diluted per founder. That’s pretty damn good, especially when we were at a $650M valuation when we got poked out.
If you are EBITDA negative, you need to expect to see [vesting] in the deal. I would highly encourage you to try and fight for the value you’ve created as much as possible and look down the road at ways in which you can preserve as much of that value as possible. If you are close to break even or EBITDA positive, this should be a non-issue.”
Yokum Taku, a lawyer, mentions that co-founders can negotiate their vesting agreements before they raise financing—this provides extra leverage in the Series A negotiation:
“Negotiation microhack on vesting:
When the company is newly incorporated and founders shares are being issued (well before the VC Series A financing), consider hard-wiring some of the suggestions (vesting for time served, various acceleration provisions, etc.) into the Founders Restricted Stock Purchase Agreements.
Obviously, all of the provisions of the Founders Restricted Stock Purchase Agreements can (and will be) superceded by the Series A documents, but there’s a possibility that if you lead with something that is not outrageous in terms of vesting and acceleration, it might survive the Series A financing.
One ploy involves a response to the VCs along the lines of “Well – those vesting (and lack of acceleration) provisions are different from what the [fill in number greater than two] founders originally agreed upon. It took us several screaming matches to agree on upon these terms when we issued founders stock and there was a certain level of distrust during these arguments. I don’t know if I have the stomach to go back to [fill in name of potentially unstable founder least savvy about VC terms] to explain why we want to change what we agreed upon. He doesn’t really want to take your money in the first place, and it’ll push him over the edge. He/she’ll think that I’m trying to screw him/her over and may blow up the deal.
Typical legal disclaimers apply to this comment.”
“ds” says that high valuation seed financings can cause problems:
“I like [convertible debt] for the reason that it preserves upside for the angels that are taking the first layer of risk. I have seen a fair number of deals where price-insensitive angels put some $ into a company on a fairly high valuation.
Later, in the first institutional round, the VC takes a clinical look at the business and puts a different (lower) valuation on it. In that case, no one is happy…the entrepreneur feels he has done a lot of work and is moving backwards, the angel feels like he has taken risk and gotten stuffed, and the VC feels (to the extent that they feel) like they are dealing with unsophisticated operators.
[Convertible debt] is a neat structure to avoid this problem.”
Yokum Taku, a lawyer, considers whether convertible debt goes in the pre-money or post-money:
“One corollary to the Option Pool Shuffle is “What’s in the fully-diluted shares outstanding if you have convertible notes or warrants outstanding?” The issue is whether shares issuable upon conversion of a convertible bridge note or warrants issued in connection with the bridge should be considered part of the pre-money fully-diluted shares outstanding in calculating price per share of the Series A. Remember, more fully-diluted shares outstanding drives the Series A price per share down, resulting in more dilution to the founders.
Given that many companies are doing convertible note bridge financings as their seed round, this seems to come up relatively often.
VCs will take the position that all of the shares issuable upon the conversion of the bridge note and any warrants granted will be part of the denominator for calculating the price per share of the Series A.
At first glance, it seems like there is a good argument on behalf of the company that the shares issuable upon the bridge note are no different from shares issued in the Series A, and should not be included in the pre-money fully-diluted shares outstanding. In addition, warrants issued in connection with the note typically have an exercise price equal to the Series A price, so these warrants are not dilutive like cheap founders common shares.
The response from the VC is (1) the money from the bridge is gone and the value created by that money is reflected in the pre-money valuation, so the shares issuable upon conversion of the bridge count against fully-diluted shares, (2) in any event, there is a conversion discount on the note conversion so these shares are dilutive to the Series A, and (3) even though the warrants aren’t dilutive today with an exercise price at the Series A price, they will be dilutive in the future in the next round of financing, so the pre-Series A investors should bear that dilution.
Of course, with respect to (1), if there is still money in the bank at the time of Series A, perhaps some portion of the shares issuable upon conversion of the bridge should be taken out of the pre-money fully-diluted share number to the extent of the money left in the bank.
And with respect to (2), perhaps the discount portion of the conversion shares should be included in the pre-money fully-diluted share number, but the rest (to the extent there is money left in the bank) should not.
Finally, with respect to (3), perhaps the warrant overhang is not too different from multiple closings on a Series A round, where the price is set at the first closing, and second closings seem to go on for long periods of time after the first closing at the same price per share as the first closing.
I’d be curious in the VC reaction to this, because the last time I tried this, I lost arguments (1) and (2) (with not too much more logic than “no, those shares are in the denominator” – end of argument) and item (3) warrants was not applicable…
Typical disclaimers about legal advice apply to this comment.
Aside from the swipe about startup company lawyers not negotiating hard against the VCs (which I vehemently disagree with as a WSGR partner), I think you’ve done a great job educating entrepreneurs about subtle nuances in negotiations with VCs.”
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