Over the past several months I’ve tried to continue some type of a give back program to the entrepreneurial community here in Canada. I’ve helped review proposals, looked at term sheets, and provided feedback to a number of funded companies with respect to managing their VC “partners.” Based on this plus my years of actually doing the VC job, I’ve thought about creating some kind of self test entrepreneurs can use to figure out if the investment path really is for them.
Here’s an example of what I mean.
If you believe, truly believe, you have a business that will sell for 100 million dollars, then would you object to this funding:
2x participating preference with a forced conversion at $40 million sale or IPO with $40M being the net proceeds.
In plain English: The investor gets a preferred share in your company which sits on top of the common shares for the purposes of liquidation and dividends. If you sell your company for $39M, the investors get 2 times their investment back (if they put in a million, they get back 2) and then they get to share in the remaining amount as it distributed. So take $2M off the $39M (leaves $37M) and then the investor’s shares get part of the remaining $37M on a pro-rata formula. If, on the other hand, you sell the company for $45M, the investors are automatically converted into commons and share in the proceeds. Finally, if you sell the company for $2M and an investor put in $1M under a 2x participating pref, you’d get zero.
If you spent or would spend legal dollars trying to fight this, then do you really REALLY believe you are going out the door at a certain price. I know Suzi, Rob, and other smart legal brains will flip out when (if) they read this but there is a larger macro point I’m trying to make. I know there are other issues like valuation, etc.
If somebody puts, say $1M, into my company and it is a 4X Liquidation Pref with a forced/automatic conversation at $40M, I’d have this response:
The reason is simple, I believe. I’m not flipping this puppy so whatever the VC needs to be comfortable, go for it. I think we will get bought for north of $100 million, I’m happy with a little slice of $100 million, and I’m going to be as friction free as possible with respect to terms and conditions. If I “blow it” and only sell the company for $20M, the investors didn’t win the bet they made when I said $100 million and deserve whatever. I’m good with that because I am a) swinging for the fences and b) perfectly fine to eat it if I’m wrong because I’m not wrong.
Note: I’m being (slightly) melodramatic to make this crystal clear point: Do you really really believe? If you do, sweet, let the VC have all the downside protection they want. Focus on that conversion point. $40M? $20M? Debate that number, yes, because that’s where fair comes in. No, I’d never do it without some conversion point where the pref shares just get treated like commons. But, yes, I’d do a 4X with forced conversion because I’m going to be well north of that conversion so the 4x doesn’t matter. I believe.
I also know there are different rules for angel/seed investments perhaps but my general ‘do you believe’ point should still hold.
My point: Do you really want that VC coin? Do you really have the outstanding next whatever to the extent you believe. If so, grab the cash and let the investors have what they want with respect to ‘downside’.
Again/To be clear, this is a macro point here so don’t get caught up in the exact numbers, I just made them up.