Options Posts

Thanks to Atlas Venture for supporting Venture Hacks this month. This post is by Fred Destin, one of Atlas’ general partners. If you like it, check out Fred’s blog and tweets @fdestin. And if you want an intro to Atlas, send me an email. I’ll put you in touch if there’s a fit. Thanks. – Nivi

In Part 1, I discussed a few of the term sheet clauses that entrepreneurs should absolutely avoid; the wrong tradeoffs which later expose them to really “losing” their company. There are rational explanations for all of these, but, as we know, hell is paved with good intentions. Here are some more pathways to hell…

“Thank You and Good Luck” for options: Limited exercise period

I am going to get some of my colleagues mad at me here. I see many stock options plans where, when employees leave the company, they have a short time window (usually 3 months) to exercise the options they have vested. This means they have to pay the strike price that the options were issued at and acquire the shares (strike price could be $3 for shares valued at $4 at the last round).

That forces startup employees to fork out cash and often crystallizes tax liabilities. It feels harsh to me. I think options should be exercisable over long periods of time, so people who have contributed to the wealth creation process can exercise when the value is realized (i.e. the company is sold) and it becomes a cash-less exercise for them.

Things I cannot get too excited about

Multiple liquidation preferences: This means investors get a multiple of their money back before you see anything. I don’t like these conceptually, they feel very un-venture to me, but they are only part of the deal. If you push super hard for a $100M valuation but have to accept multiple liquidation preferences as a trade-off, it’s your call. If the company goes public (at which point preferred shares convert into ordinary shares and the liquidation preferences disappear), you win. If the liquidation preferences are negotiated away in a subsequent round of financing, you win. Personally, I have a strong preference for simple terms at the right price from the outset.

Cumulative dividends: Sometimes an 8% dividend is slapped on, and it accrues over time when it isn’t paid. Again, this is not appropriate for most venture deals, but it may be part of an acceptable trade-off.

The trap of complexity

More than anything else, I find the real danger is complexity. When you need 3 full days of modeling to come to grips with a cap table, or when no-one can agree anymore on how clauses should be applied, you are in trouble. You will spend more time discussing internally how clauses should be applied than focusing on that critical acquisition you should be closing. I have seen cases where you needed robust macros to model outcomes. How about adding an exit-value-dependent management carve-out to a participating liquidation preference reverting linearly above 3X return on top of a French legal requirement that the first 10% gets distributed to all shareholders equally ? I have modeled this and it’s simply not worth it.

Value is not created by arcane legal language but by nailing business execution and growth. Keep it simple and keep yourself focused on the right elements.

Get good advice (duh!)

I was at Seedcamp on the VC panel with Fred Wilson and a few others recently and there was a lot of talk about terms and how not to get screwed (evil evil VCs…). I will repeat the advice I gave then: you want to protect yourself adequately, get a good lawyer. You will not out-compete us on terms negotiation. I use Tina Baker at Brown Rudnick in the UK and Karen Noel / Olivier Edwards at Morgan Lewis in Paris; they are great, go talk to them.

Having said that, it is completely your responsibility to understand what you are signing, and it is up to you to push back. Read the documents, ask questions about everything you do not understand. Ask your lawyer: where does this document create risk for me, both on my income stream and my ownership. How does this go wrong and how do I protect against it? This is advice you are seeking, not an outsourcing service.

And remember, there is no such thing as standard terms. May the force be with you.

If you like this post, check out Fred’s blog and his tweets @fdestin. If you want an intro to Atlas, send me an email. I’ll put you in touch if there’s a fit. Finally, contact me if you’re interested in supporting Venture Hacks. Thanks. – Nivi