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
Topics Dividends · Lawyers · Liquidation Preference · Negotiation · Options · Sponsor
IIRC, the limited exercise period on options has to do with tax law, not just company or investor greed for equity conservation. I think the rules around incentive stock option (ISO) treatment require this limited exercise period once services to the company are no longer being provided. That said, if the options are nonqualified stock options (NSOs), as they often are later in the company’s life, there’s no reason to keep the limited exercise period. In fact, it’s probably possible to make ISOs automatically convert to NSOs past the 3-month post-termination period.
Unnecessarily complex? You betcha! But it’s thanks to our tax code, not company management or investors.
Have been involved in a number of discussions around the concept that “only those who are there at exit reap the rewards”, the notion being that it’s hard enough to make money without peppering options around to folks no longer involved in the businesss.
So there has been in my experience sustained chatter about shortening the exercise period as a tool to achieve that. Often down to 3 months.
I am not US centric so this was from convo’s in France and the UK.
Hey Fred – another great post. As a corporate lawyer specializing in the representation of entrepreneurs, I, of course, agree with your advice that “[if] you want to protect yourself adequately, get a good lawyer.” I would add, however, as I discuss in tip #2 of my recent post on angel financing (see http://bit.ly/7jhl6v), that it is imperative that entrepreneurs understand the key deal business terms in a financing. As Chris Dixon (co-founder of Hunch) aptly pointed out in a recent blog post: “you can’t outsource the understanding of key financing and other legal documents to lawyers” (see http://bit.ly/8eRVx8).
Moreover, I agree with your point about the “danger [of] complexity,” and it is a potential problem in any deal. Indeed, I have represented a number of entrepreneurs selling their ventures to private equity firms, and the level of complexity (e.g., as a result of the layers of debt and other financial engineering) is often mind-boggling. In fact, I have on occasion recommended to a client that he sell his company to a strategic to keep it simple.
Finally, your comment that “there is no such thing as standard terms” is spot on. Every deal is different — different players, different negotiating leverage, different risks, different timing — and it is thus critical that the entrepreneur sit down with his transaction team and strategize.
I agree 100% that founders MUST get their heads around the documents they are signing. It is easy enough to have a one-on-one with counsel and ask “which terms are possibly hurtful to my position and what could the consequences be?”. There are normally a limited set of provisions one needs to understand, including in particular board control, exit control, transfer restrictions, reverse vesting, and anti-dilution.
I just sent your point on limited exercise period on to the rest of our management team. We have this argument often (usually initiated by me) whenever someone leaves the company (voluntarily or not).
My view is that the equity they earned while working long hours for a startup is theirs to keep. The idea of forcing someone to pull cash out of their pocket within 90 days in order to exercise options is ludicrous.
Its especially absurd during layoffs. Thanks for your hard work – but you don’t have a job anymore. And please write me a check for your options within 90 days or you get nothing if the company you helped to build is successful.
ginsu makes a good point above regarding tax law – it is true that ISOs need to be exercised within 90 days to receive favorable tax treatment. What should be done in this case is to offer the employee the option to convert ISO to NSO and have longer to exercise. No favorable tax treatment – but they don’t have to pull cash out now to buy options.
We agree fully. Thanks for adding colour with regards to US tax treatment which I was not aware of. Sounds quite manageable.
As someone on a recent blog (sorry can’t find the reference) said “Advisers need to be on tap and not on top”.
I have been in numerous acquisition discussions where things have fallen apart because owners are more concerned about exploring every legal nook and cranny advised by highly paid lawyers rather than getting a deal done on commercial terms. Sometimes you have put it down to trust and keep the legal/accounting costs under control – a $500k deal does not need $100k costs.
Not sure I agree on the options – 3 months/redundancy is too harsh but I think management need to take a view case by case. Someone putting serious effort into the business should keep them though. It makes for a headache on exit/sale with messy options though.