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Just Say No: VC terms that can really hurt (Part 2)

Guest Author · December 9th, 2009

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

Just Say No: VC terms that can really hurt

Guest Author · December 2nd, 2009

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

If you believe the blogosphere chatter, the entrepreneur-VC relationship seems strained like at no time in the past. The discussion seems to veer towards the “good versus evil” myth of creepy financiers intent on screwing polymath entrepreneurs out of their hard-earned wealth. Good-versus-evil is not a very constructive way of framing complex debates (remember “the war on terror” and the “axis of evil”?). Most sour VC-entrepreneurs relationships are simply partnerships gone bad, and divorce is never a pretty experience.

I see a lot of misguided commentary out there focused on the wrong issues, such as “how can you ask for liquidation preferences and call yourself entrepreneur friendly?” I am happy to answer that one if you are interested.

What I wanted to do here instead is focus on a few of the 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 of the pathways to hell:

Now we own you: Full ratchet anti-dilution

Anti-dilution says “your company has no tangible value and as result I accept 20% ownership today but if we don’t create value I want some protection on potential share price reduction”. This protection is embodied in a clause called anti-dilution protection which results in additional “bonus” shares being issued where there is a down-round, i.e. a subsequent financing at a lower price per share. You can attack this clause conceptually but if VCs did not have any form of anti-dilution they would set the initial price lower. In other words, you as entrepreneur are getting less diluted today but with some ownership risk if company value goes down (at least that’s the theory, would be interesting to see how prices adjust without anti-dilution).

Anti-dilution is usually mild. Broad-based weighted average anti-dilution says that a number of anti-dilution shares are issued (or the conversion price of the preference shares is adjusted) based on a formula nicely explained by Brad Feld back in 2005.

Here is how you can get really screwed: there is one version of anti-dilution whereby the number of shares issued to the investor is FULLY readjusted if subsequent financings are downrounds. Say you raise $1M at $10 per share and hence issue 100,000 shares to your VC, in exchange for 10% of your company. The next round is at $5 per share; the original VC now gets an additional 100,000 shares issued; in the original cap table, he now owns 20% of your business, before the new money comes in.

This gets nasty when serious money has been raised. Imagine the following happens: the pre-money valuation on your next round is less than the cash you raised previously. Say your company is in difficulty and raises $10M at $10M pre-money, having raised $10M previously. Because the anti-dilution calculation is iterative, guess what, the share price mathematically converges to… zero. Legally it will be set at the par value, say €0.0001.

Your ownership just evaporated.

If your VC understands how the world works, you will sit around the table and hammer out some deal. But your negotiating position is weak. If on top of that a new CEO has been hired, the rational optimisation is to keep as much equity free for the new sheriff in town and not for the original entrepreneur. You are now relying on people’s ethics, sense of fairness, or belief that long-term you don’t build venture firms by screwing entrepreneurs. In, say, 75% of cases, good luck — few people really believe in win-win in these situations.

Note that there is usually a shared responsibility in full-ratchet: the entrepreneur is obsessed with maximising the headline number and accepts anti-dilution as a tradeoff (“OK, I will agree to this silly price but you better not screw up”). Often a Pyrrhic victory.

“Thank You and Good Luck”: Reverse vesting without good leaver clause

First, let me state that reverse vesting matters to me. I would not do a deal without some form of reverse vesting. Here’s why: I invest in three founders, two of which work hard and one of which decides to leave to open a restaurant. I (and his co-founders) are screwed. The guy or girl who left gets a free ride on the back of everyone else. He needs to be replaced, for which additional stock options are required. This is why reverse vesting exists.

The usual reverse vesting that you will find in our term-sheet is: quarterly reverse vesting of founder stock over 4 years. This is watered down or adapted based on individual circumstances.

I have seen cases where reverse vesting is not qualified: you leave the company, you lose your stock. That is a very toxic clause, and you should never accept it. You are now fire-able at will and there is even an economic incentive to do so. Unfair and abusive.

So don’t find reverse vesting per se, but fight on the details. Can a percentage of your stock be considered yours? Probably. Make sure there is a good leaver / bad leaver clause. You get fired for cause, you lose some. You decide to leave, you lose some. The company decides it does not want you around anymore, you keep it. The need to be watchful of the details; sometimes you will be asked to sell your stock at “fair market value” when you leave, or at last round price etc. Negotiate hard.

Continued in Part 2 with limited exercise period options, multiple liquidation preferences, cumulative dividends, and the trap of complexity…

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

Thanking our supporters

Nivi · November 26th, 2009

We’ve put together a page to thank our supporters, whose financial contributions support Venture Hacks. They’re also listed below. We also wish to thank them, and many others, for contributing their time and advice.

If you like Venture Hacks, take a moment to check them out. And please let them know you appreciate their support when you see them.

Finally, we want to thank you, our readers and customers, without whom Venture Hacks would be meaningless.

Our supporters

The ignorant VC

Guest Author · November 20th, 2009

Thanks to Atlas Venture for supporting Venture Hacks this month. This post is an interview of Fred Destin — one of Atlas’ general partners — by David Woodward, a journalist and blogger. If you like it, check out Fred’s blog and tweets @fdestin.

A few days ago, I had an interesting chat with Fred Destin, Atlas Venture‘s ebullient technology partner. Atlas bought a stake in the property website Zoopla at the beginning of 2008, which wasn’t exactly a fun time to be involved in the property game. It was also a pretty difficult period to source capital in any sector — all in all an investment climate fit to make even the coolest of VCs twitch. Destin, who has a seat on Zoopla’s board, adds that at that stage, his firm’s investment was in “two people and some PowerPoint slides”, hardly an invulnerable guarantee of success.

It is often said of European VCs that they lack the gumption of the Sand Hill road mob — the kind of formalised chutzpah that turns garage upstarts into grade A businesses. European investors, it is said, need data, data and more data, followed by proof of concept, before they are willing to stump up any capital. And to some extent that remains true. But Destin added an interesting spin.

The problem with European investors, he told me, was that even when faced with unmistakeable proof of concept, they tend to undercapitalise, thus hampering their investment’s ability to scale to its full potential. Put it this way: not many US VCs get accused of undercapitalising a potential winner.

He also did a great job of making early-stage investments sound very much like sticking it all on red and preying to the gambling gods for clemency. Destin says he actually prefers working with unknowns. He says:

“Our job is to manage risk proactively. We don’t think about it as a casino at all. We scrutinise and think about it very hard. But it’s our job to take these shapeless risks. I am early-stage, my natural DNA is around early-stage. It’s tough to make investment decisions without much data, [but] that’s what makes it exciting. Your average market practitioner does not how to deal with that level of risk. You take data away and they panic.”

Conversely, Destin says he revels in a vacuum of information.

“I profess ignorance and I use that as a tool. I can assess market attractiveness. I can assess the management team. We then make absolutely no assumption as to what’s going to work because if you do, you lock yourself into a strategy that you haven’t [yet] proven. You tend to be internally led rather than market led. This is where the risk may seem inconsiderate because you’re willfully declaring ignorance about the market you’re addressing.”

But ignorance allows you to

“…force yourself to be smart. You use what you know in terms of company building, supporting entrepreneurs, discovering the market. We will design the product around what the market needs with an intuition, but then we’ll go and test it. We don’t want to be smarter than the market we are entering.”

And here’s Destin’s view on Europe’s investment weakness. There are, he says, three stages involved in readying a start-up for potential greatness:

“At Atlas we call it ‘prove-build-scale’. You spend very little at the prove stage. You have 6-15 people, spend as little as you can proving the hypothesis. The build stage is [about] scaling up the management team, adding talent, putting in place the technology you need to accelerate. Only when you’re ready can you understand how to scale properly, go into a big investment round and hit the accelerator.

“I think that Europe usually fails on the third category: we tend to undercapitalise the businesses that are doing well. And this is where we get a competitive disadvantage to the US. They have a tendency to overcapitalise early, but when they scale they scale well because they are able to raise repeat large rounds of money to really capture an opportunity.”

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. – Nivi

The problem with VC motivation

Guest Author · October 28th, 2009

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. – Nivi

Many VC’s, particularly in Europe, are disappointing in their (lack of) intensity. They are not 24/7, passionate advocates of the businesses they fund; neither do you meet them at random conferences scouting for new companies; nor do they necessarily come across as particularly engaged at board meetings. Why is that? Let’s talk VC compensation and motivation for a second.

My motivation as a VC

Introspection is as good a place as any to start. Here are my top motivations for being a VC (leaving out the personal stuff):

  1. Company building: Every VC is different, some like doing the deals but don’t really care for the long-term relationship that ensues. With me it’s the “deal management” (as we call it) that provides me with the greatest satisfaction. An engaged relationship with the management team and co-directors towards building a great business. That’s when I feel I am part of a greater whole, of creating jobs, of the whole great forward human movement of innovation and entrepreneurship.
  2. Intellectual stimulation: I am a fairly consistent guy, but I do get bored. As a VC you get to see 100’s of new projects every year and meet a ton of creative people, and understanding each one challenges your (dwindling number of) neurons in a different way. Every company you invest in is different, and requires fresh thinking. So being a VC keeps me entertained, frankly. This is the primary reason why I never started a company. The trade-off is that you work through others (the management teams you fund) and hence never quite get that satisfaction of achievement in the same way.
  3. Personal recognition: Let’s face it, I love being recognised for what I do. Thankfully my wife keeps that ever-burgeoning ego firmly in check.
  4. The Hunt and the Deal: I don’t think you can be an effective VC if you do not like to be a Hunter, to be always out on the move looking for the next big thing, to want to win the confidence and trust of entrepreneurs and co-investors to take your money and no-one else’s. Inking that term-sheet and closing that deal gives me a great buzz every time. After all, I grew up on a trading floor !
  5. Money: More on this below.
  6. Lifestyle: I work hard, but on my own terms, when and where I choose. The less glamorous reality is that I spend 2/3 of my time on the road and that they greet me by name at hotels in at least 3 different cities, but I remain a master of my own destiny.

That’s my list.

Let’s zoom in on money

Here is the issue with venture capital as a way of making money:

  • It’s easy to get a comfortable lifestyle (say $300,000+ a year, often multiples thereof).
  • It’s (really) hard to make it really big (say $20,000,000+).

The not-so-secret fact about venture capital is that it has not made serious money for 10 years now. That means many, if not most, venture capitalists have not seen a large carry check in a decade. For those who don’t know venture economics, the partners in a fund contribute the first 1-3% of a fund with their own cash, which means most of us write checks worth > $100,000 every year to our own funds, sometimes a lot more. So if you are a VC in a median return fund, you keep writing these checks vaguely hoping you will make your money back; some will tend to get more and more focused on the nice salary they can take out every year.

To generate real carry, you need to work hard with no obvious improvement in the probability that your fund will be a wild success. In other words, the marginal return on effort expanded is not obvious and may well be zero. You won’t know until much later… And that, my friends, is the core problem with VC motivation.

Because it takes a very long time to know whether you are a good VC, partners can keep taking comfortable salaries for a decade or more before any form of verdict is placed on their money-making abilities. In the meantime, they manage their own calendar and work at their chosen intensity, with no immediately obvious return on effort expanded. Q.E.D.

The Solution

The solution is not simple. As an LP you would only want to invest in partnerships that provide:

  • Accountability
  • Meritocracy
  • Paranoia
  • Professionalism
  • Absolute hunger
  • True Passion for the business

…and of course, deal picking skills, deal building skills, and returns!

Paul Kedrosky at Xconomy has considered this problem from the LP angle with the following recommendation: pre-agree on budgets and/or find out what your chosen partnership uses its money on. Good advice, with plenty of practical problems, but clearly sound.

In a good partnership, paranoia and professionalism mean that emulation keeps everyone on their toes. And your passion for the business keeps you working all the time. And you really want to make a ton of money. And you want to be remembered for all the great business you contributed to. All of the above!

Hence:

VC is only a lifestyle business if you do not fundamentally care about being wildly successful. Now how do you screen for that, when every manager that comes into your office sings the same song?

Thanks for reading. If you like this post, check out Fred’s blog and his tweets @fdestin.

Get drunk with VCs and help charity

Nivi · October 7th, 2009

This post is for people who want to get drunk with Boston VCs and help charity at the same time. For free.

Atlas Venture and General Catalyst are throwing a charity wine party in Boston on Thursday, October 22, 2009 at 6pm. You can buy tickets at TUGG’s site and learn more in this Xconomy article. VCs from about 10 Boston funds will be attending: Spark, Battery, CRV, etc.

Free tickets

They’ve given us 5 free tickets to give away (they’re normally $150) and we’re running a contest to give them away: Where do you think the money should go this year? Last year, the party raised $40K for Build, a Silicon Valley non-profit that helps students start small businesses.

Send your idea to dsamuels@tugg.org or tweet it with the #tugg tag. We’ll give free tickets to the 5 best ideas. Even if you don’t know where the money should go, send a note to say hello and introduce yourself.

Atlas Venture: A new supporter

Atlas Venture is now supporting Venture Hacks. That’s another way of saying they’re sponsoring us. But I like the idea behind “support” better. It’s more like the Hewlett Foundation sponsoring PBS, and less like P&G buying an ad on Days of our Lives.

Frankly, Atlas has supported us financially for quite a long time; I was an EIR at Atlas while I was getting Venture Hacks started. Many other firms and people have also supported us financially and otherwise — we need to figure out a way to thank them soon.

Sponsor: Charles River Ventures

Nivi · December 2nd, 2008

Thanks to Charles River Ventures for sponsoring Venture Hacks.

After our first post on CRV’s sponsorship, people suggested we make the sponsorship more “real”. We are down with that.

So here’s an e-mail that George Zachary from CRV sent me—I’m sharing it with his permission. It gives a good sense that CRV is “open for business”:

From: George Zachary
To: Nivi
Date: Thu, Nov 6, 2008

Nivi,

Sorry for the delay amigo.  Just been s-w-a-m-p-e-d with 3 new investments for CRV in the last 2-3 weeks. We are closing docs on one of them today/tomorrow.  I issued a term sheet on another last Friday that’s now signed and in major diligence/docs mode.  And just about to shake hands on a 3rd probably tomorrow.   All are consumer internet.

Probably the busiest 2-3 week period I have ever had since 1995 in venture.

Also, prepping for my annual LP meeting in Boston which runs from this coming Monday through Wednesday.  So, swamperoo’d.

Apologize on the delay.

The text looks good with one exception.  “Initial investment can be as small as $100K…”  instead of the $25K.

Thank you for doing this!

What is new with you?

Thank you and sorry for my humongous delay,
George

Yes, George actually sent me this email. I added the emphasis and hyperlink.

Our Sponsor: Charles River Ventures

Nivi · November 7th, 2008

We’re going to try something new here: sponsorships. We hope this experiment will be effective for you and our sponsors. Send us your feedback.

We would like to welcome our first sponsor, Charles River Ventures. And I would like to thank George Zachary from CRV for working with me to get this done. You’ll find the sponsorship near the top right of our website. It looks like this:

You’ll also see occasional messages from our sponsors in our blog and Twitter feeds.

If sponsorships are useful to our readers, they’ll be useful to our sponsors. And if they’re not useful to you, they won’t be useful to our sponsors. Let us know what you think as this experiment progresses.

Here’s a message from CRV that describes what they do and how they do it:

“CRV’s approach to investing is simple: we seek out visionary entrepreneurs, and give them the support they need to build great companies from the ground up. It’s our job to enable startups. Not second-guess them.

“Our initial investment can be as small as $100,000, or as large as $5 million. The bulk of our investments have been to companies with fewer than 10 employees—many have as few as 2 or 3. We don’t require a complete management team, since we can often help in bringing the right talent to the mix.

“Unlike many venture firms, we don’t lurk on the sidelines waiting for a strong lead investor to step up. When we believe in a project, we want to be the lead investor.

“The best way to get our attention is not with a 100-page business plan. A concise executive summary, an expense budget for the first two years, the revenue model, and a PowerPoint presentation are the materials we’re interested in seeing. It helps if one of our portfolio companies, or a member of our contact network recommends you.

“Since 1970, we have helped startups turn their ideas into real, viable businesses. Companies like Cascade, CIENA, ChipCom, NetGenesis, Parametric Technology, Sonus, Speechworks, Stratus Computer, Sybase, Vignette and dozens more have realized stunning success with our backing and support.

“But our greatest successes, we believe, are the ones that lie ahead.”