As part of my 30 minute, no harm, no foul, meetings, I’ve been getting lots of requests to review term sheets and offer opinions on what’s been presented to a start up by another VC. In most cases, they are deals I can’t do for one reason or another (locations, size, industry) so there is no real agenda on my part beyond helping a start up.
One of the more interesting things that pops up in the terms sheets I’ve seen is the notion of a participating preferred share structure. Basically, for those that don’t know, this is a share, upon a liquidation event (IPO/Sale/Merger), has rights to money before the other shareholders.
In the participating preferred shares I’ve seen, the structure goes something like this. When the company is sold, the preferred shares get their money back and then get a pro-rata share of the remaining amount of coin to be divided up. In one case, the structure was money back, then a return rate on that money of 15%, then a pro-rata share of the remaining coin.
Yowsa.
I think these types of structures, to put a technical term on it, suck. Double and Triple dips (or more) create a condition where you and your investors are not on the same side of the table when it comes to many things; additional financings and liquidity events to name two. A simple example:
Let’s say you take in 5 million dollars on a 5 million pre-money valuation. The post money value of the company is ten million. If everybody had common shares and somebody comes along to by the company for 20 million, easy math, 10 million for you, 10 for the VC. Now, let’s add one of these weird preferred share structures to the mix.
Suppose the VC has a preferred share that calls for money back and a pro-rata share of the remaining money. As you can see, that simple 10 million 50/50 split is no longer the case. The VC first gets 5 million back and then the remaining 15 million gets split up. If there is a 2x liquidation preference or additional preferred terms, you can see this ‘easy’ 50/50 split doesn’t work out.
In outside negotiations, this can hurt you because sometimes a good deal for one side is no longer a good deal for the other given all the preferred features. And if you pile on multiple rounds of financing with multiple preferred shares, you (sitting with common shares) start to stare at a very big mountain which must be climbed before you get some coin. My biggest fear with all this preferred stuff is that you end up taking your enthusiastic entrepreneur and turning her into a simple employee who just feels like they are collecting a paycheck.
The common excuse is that pref shares get around value. An entrepreneur decides he wants a 50 million dollar value for his ten day old start up. The VC likes the idea but thinks the value is insane. So, you end up with a 50 million dollar pre-money value for the company with the VC getting a preferred share structure that calls for all kinds of rate of return guarantees, pro-rata this, etc, etc, which in the end, don’t help the entrepreneur.
In my opinion, entrepreneurs should get as close to common shares as possible. To do this, value becomes the big issue and as a VC I’ve got an obvious agenda; that being the notion of doing an investment at a good entrance value. So while it may seem like I am saying ‘dilution is the solution’, I’m actually pointing out that sometimes simple terms with a lower value can net more cash into your pocket at the end of the day.
A simple preferred share that is designed to give me downside protection but not get greedy on the upside usually can work for both sides. Typically, I will ask for a non-participating preferred share. What that means is that I can get my money back and the remainder is divided among the other shareholders or I can convert my preferred shares to common and then we all divide up the loot. Either option but not both. In addition, I recommend that in all cases there is a forced conversion of the preferred shares. If you are going to get stuck with a participating preferred, you should at least have a value in the term sheet where the preferred shares are forced to convert to common. If you hit one way out of the park, it only seems fair that the participation right goes away. This amount can usually be negotiated if you can’t get away from the participation clause or you are stuck on a particular value for whatever reason.
In the end, my simple advice is just that, keep it simple. Take a little less in value, get a little more in simplicity of share structure. In the end, it may make a big difference to your winnings.
Great post! It's all about balance - high valuations mean complex "unfair" terms... dilution is the solution because the terms are more reasonable and there is alignment of the two parties.
Your solution creates value - the other, well who knows, the entreprenuer smiles in the beginning, and then when he fails to execute the VC smiles.
The win - win is both parties smiling at the same time.
Posted by: Peter Cranstone | May 10, 2006 at 06:32
It's not the #1 reason experienced entrepreneurs say "VC" in the same tone of voice as those initials would be spoken by your average Vietnam vet...but it's in the Top 10. (Actually, I think you could abstract the whole Top 10 under "contracts that are deceptively attractive and yet disproportionately harm the interests of the entrepreneur in the name of enhancing security for the VC".)
When negotiating term sheets and valuation, entrepreneur and VC will necessarily always be on opposite sides of the table. This is normal and indeed correct. But term sheets that _keep_ them on opposite sides even after the negotiations are over are per se evil.
Posted by: Matt | May 11, 2006 at 01:27