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
Topics Anti-Dilution · Sponsor · Vesting
Good post, Fred. As a corporate lawyer for 15+ years, I agree that reasonable vesting restrictions should be imposed on the founders. As you point out, it would be inherently unfair for a co-founder to quit the venture after a few months, but still be permitted to keep all of his or her equity. I understand that this may be a difficult pill for the founders to swallow; however, from the investors’ perspective, this is a significant issue — i.e., they believe they are paying for the founders’ long-term commitment and “sweat” — and thus one that they will rarely give-up. That’s why I always recommend to founders that they set-up a reasonable vesting schedule upon incorporation (see tip #2 in my post here: http://bit.ly/nYZM4). Indeed, if a reasonable schedule has already been established prior to negotiations with the investors, it is more likely that the investors will simply keep it in place. Many thanks, Scott
Agreed. I especially like this part: “If a reasonable schedule has already been established prior to negotiations with the investors, it is more likely that the investors will simply keep it in place.”
Great advice from Fred, as usual. I see you agree with me on the ‘entrepreneurs need more VC education’ point 🙂
Thanks Marcin. Where did you write about that?
In an e-mail to Fred 🙂
Great work you guys are doing here – keep it going.
Thanks Fred for explaining your perspective.
Vesting makes obvious sense in the case of multiple founders but what in the case of a single founder?
On one hand side, not being diluted by co-founders already lessens the blow of the board replacing a founder, on the other hand vesting can hardly be justified with fairness towards co-founders when there is only one. So there must be other reasons that you did not mention. How would this play out, assuming the founder is not fired for cause and does not leave on his or her own accord?
fmu, This article should have everything you need:
http://venturehacks-dev.mystagingwebsite.com/articles/acceleration-termination
Thanks Nivi, fantastic article and argument.
Still interested to hear from Fred whether he or VCs like him would in fact consider acceleration-on-termination terms in the range suggested by the linked article, and what their reasons would be if not.
fmu:
First comment is that there are no rules. There is no standard term-sheet just like there is no standard entrepreneur.
Secondly, reverse vesting can only be an insurance policy against poor behaviour that “breaks the social contract”. In fact, terms in general should be used as “insurance policy” against disaster and not as a way to boost revenue or ownership at the expense of other parties in the transaction, most importantly, the founder.
When it comes to acceleration, an exit is an event that means, almost no matter whether it is a good or a bad one, that the project has run its course, except in instances where a large portion of the consideration is an earnout or has some action-triggered escrow provisions. So normally I would say acceleration is only fair, especially for the founder and CEO.
I think reverse vesting should only be used to ensure that a founder or founders work for a few years towards the success of the business they founded. Period. I don’t believe they should survive exit.
To give you one example, I asked Alex Chesterman at Zoopla for a 2-year vesting on 50% of his stock. Because I trust him and he is a known entity, I took a view that after 2 years of building his business, he should own his stock, and that my insurance policy should expire.
I think this is very much situation specific but I do believe in general that reverse vesting should apply to less than 100% of stock, should not survive exit and should generally not expose the founder to arbitrage.
Fred: Thanks for taking the time to respond, appreciate the insight into your thought process.
Hi Fred – valid points. But have you ever seen a VC try on full-ratchet anti-dilution protection? I’ve never come across it and always thought it’s purely hypothetical…
Hi Max,
I have seen a bunch of cases, have been involved directly in some fairly ugly negotiations caused by them, and have seen at least two founders at other companies get completely screwed. Think they are still frequent in a market like France. Narrow definitions can hurt too.
This is a great posting. Good job.
So, I’m a VC and used to be a venture lawyer. I think that this discussion is very helpful to entrepreneurs, but what is missing is something that is very, very important — a venture capital deal is a collection of terms that work together to create a deal. Getting the right deal requires an appreciation by both sides as to how the transaction allocates risk and reward.
I have seen for example, entrepreneurs who are hell bent on achieving a particular valuation, and then give up all the benefit by accepting a large option pool. Or, focusing on acceleration in a sale with out appreciating the affect of a multiple liquidation preference.
What I do with all of my entrepreneurs is to make sure that before they do a deal that they ask the VC for a cap table, and also a table that shows what everyone will own and receive AT THE TIME OF THE CONTEMPLATED EXIT. The VC has this spreadsheet — they need to understand what they are going to own in order to price the deal. If the entrepreneur understands what a deal structure is going to net under various circumstances, then he can have an intelligent conversation about terms and fairly protect their interest. Otherwise, he is in the position of cherry picking issues and missing the larger picture.
The fact is that many terms in a VC deal are offensive to an entrepreneur in a vacuum. What needs to be appreciated is that (i) many of those terms are in every venture deal but (ii) there is negotiating room on the margins. The best entrepreneurs understand what’s negotiable and what is not, and gets the best deal.
This is a great comment and a deal must be appreciated in its entirety. I do think some terms are simply toxic. I like your idea of showing outcomes at exit and would go further and say you should model downround examples.
I have to smile somewhat at the notion of “market terms” as this is an argument I also use but I don’t think it’s anything more than an excuse to get stuff through. 🙂
Nice article – you could one day cover fraud in startups too, which is the flip side. Recent case that was on Gigaom:
http://gigaom.com/2009/06/24/the-strange-tale-of-wi-fi-startup-whisher/
Is this common? It seems logical that VCs keep these affairs quiet as it affects their image, but how often does this happen? What controls other than draconian accounting rules and expensive audits can be applied? It seems odd that for a $1M funding a VC can ask for $50k or more yearly audits from the big firms…
I think it happens regularly.
I know of at least 2 or 3 cases involving tier 1 investors that have never hit the wire.
Very often we move fast and we may not always have the right controls in place. This is why getting decent auditors and getting them to do their job matters, even though none of us like to waste any time doing this (and trust me, I avoid audit committees like the plague :-)).
I count myself lucky that this has not happened yet to me, but it is possible that a less than completely self-confident CEO of mine may have played around with revenue timing to smooth his financial profile, I may never know!!
Fundamentally it is hard to protect against sophisticated fraud in early stage, and nothing replaces trust and… extensive reference checks. I always like having trusted people in common with people I back.
Fortunatly the scenarios described here are not particularly common. I’ve rarely heard of full-rachet anti-dilution even being proposed in a deal, and never seen one that survived a down round financing. I dont see how a VC would even consider FRAD unless they were planning on firing the entrepreneur and running the company themselves. Likewise, it is customary for vesting provisions to take place over time (e.g. 4 yr vest w/ 1 year cliff) and be tied to some sort of “for good cause” qualifier. I think it is rare that you would end up with the “nuclear option” described in the article, but there are definately some movable parts in terms of vesting provisions, that are worth careful consideration (cliff/no cliff, credit for time served; conditions of “good cause” dismissal or departure for “good reason”).
As a lawyer, I have to second Jonathan’s recommendation about showing cap tables focused on the time of exit. What is most important is to show the impact of different exit scenarios (different exit valuations, different timeframes, etc.) VCs are usually pretty good at figuring out what parts of the deal are most sensitive and “visible” to the entrepreneur and then finding alternative terms that get the deal done while maintaining the same economic outcome. When we represent entrepreneurs, we try to make sure they are able to see the full picture that the VCs are looking at.
I would be interested to see if Part II takes up the issue participating preferred — I always felt like”double dip” preferred was not really within the “spirit” of VC investing, but we often see this on the east coast. Sometime this is mitigated through the use of a cap, but sometimes not. I would be interested to hear Fred’s take.
I have seen full ratchet used in anger to screw original founders, with incoming management and VC’s leveraging it to the full. You could even have an argument about anti-dilution in general… Luckily it is rare and seems to be disappearing in the US (the Fenwick reports state that full-ratchet only appears in 3% of transactions) but it is common to prevalent in some local European markets where some so-called VC’s do not act in the “Bay Area” spirit of the industry that we should all espouse.
I don’t like double dip, thought it really depends on the return tradeoff you accept (price vs liqu pref). We will talk about it somewhat in part II.
Ok, I’ll bite. How can you ask for liquidation preferences and call yourself entrepreneur friendly? Actually, I’d ask the question differently. Other than “supply vs. demand” what argument can you give as justification for any investment term? Everything else is spin IMHO.
Here’s a quick answer from the other Fred (Wilson) on liquidation preferences:
“The liquidation preference matters because without it, if you invest $1mm for 10pcnt of a business and the next day the entrepreneur gets an offer to sell the business for $5mm, he or she might choose to take it and get $4.5mm while you only get $500k. Sure you could negotiate for a blocking right on a sale, but getting in between an entrepreneur and an exit they want to do is not a recipe for success in the venture business It’s much better to say, “give me the option to get my investment back or my negotiated ownership, whichever is more”. And that’s what a liquidation preference is, plain and simple.”
From http://www.avc.com/a_vc/2009/04/the-three-terms-you-must-have-in-a-venture-investmemt.html
Fred (Wilson) is wrong or being disingenuous. Liquidation preferences are not designed to protect against the control of a “down round” sale (there are many other protections for that scenario). They are designed to maximize return in a mid-range exit scenario…the $30-75MM exits for most tech companies. These happen to be the most frequent exits. Liquidation preferences are not a control issue…they are an economic term. So other than supply vs demand, why would an investor “need” one?
Completely disagree. The Freds are not being disingenuous 🙂
A simple liquidation preference goes away quickly when upside is created, but Liquidation Preference is necessary to protect the investor against arbitrage.
Say entrepreneur own 60% and VC’s 40% after investing $4M. Company gets sold for $10M, entrepreneur get $6M, ZERO value created since the round. QED. Not right.
Liquidation Preference forces value creation before exit. One of the few terms I cannot see myself living without.
I wrote too fast 🙁 Meant company gets sold for $5M, investors get $2M (50% writeoff) and entrepreneur gets $3M = not right.
Fred(s).
I can imagine the scenarios you are painting, and I agree that VCs will want protection against someone taking a $1M investment and selling the company the next week leaving you with $500k.
However, if there is a clause in the contract that guarantees that you can have your initial investment back in a liquidation event, isn’t that the same thing as saying that you want all upside and no downside?
When I purchase shares in a public company, I don’t have a guarantee that I can get my initial investment back. And VC funding is, by nature, more risky, right?
Help me understand this.
It may depend on the valuation used for the financing. For aggressive valuations, VCs require extra protection. If on the other hand the valuation is realistic, there should be no need for additional caveats.
A valuation, in theory at least, is a weighted average present value of expected outcomes. Outcomes range from: (1) great performance, (2) good performance, (3) average performance (4) poor performance to (5) disaster.
Given the risk in startups, VCs attribute some weight to scenarios (3), (4) and (5) when doing their valuation. This reduces the weighted average and therefore the valuation. If however, they can implement a structural feature to get protection in these scenarios and therefore have a positive return in those scenarios (or at least loose less), they can justify paying a higher price for the business.
In public stock, investors don’t have these protections indeed but the valuation (i.e. share price) should reflect that.
Then again, maybe VCs even ask for these protection features when the valuation is realistic… ?
Sho, you’re right, investors try to protect their downside. Their investment is somewhat like a debt instrument.
I used to work for a company that was HQ’d in the UK and they had good-leaver and bad-leaver clauses in the option plan but I haven’t heard much about it in the US, does that seem to be more of a UK or European convention?
Brian, It happens in the U.S. too. Check out this article: http://venturehacks-dev.mystagingwebsite.com/articles/acceleration-termination
No wonder more companies are avoiding VCs. Seems there is an opportunity here for a company to represent the company and get the best deal for them. If the business founders are working directly with the VCs their inexperience will hurt them and cost them $$$.