Venture Capital: Do You Really Want It?

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:

Thank you.

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.

Comments

[Farhan Lalji]

Problem with that is the macro trends and other things that are beyond the entrepreneur's control. Say there's an, oh don't know, a housing bubble or some other financial disaster which totally changes the market situation - which is totally out of the control of the entrepreneur. Why should the entrepreneur shoulder all the risk and the investors getting all the downside protection?

[Rick Segal]

Farhan,
Thanks for the comment. In my view, the downside risk is for the opportunity and the entrepreneur really is the one managing the issues and the business. I hear you but I still believe it.

[Leo Lax]

I believe in caring about the down side as an entrepreneur if I have also invested hard $$$. These $$ should have similar downside protection to the investor. I think that is only fair. On the other hand if I invested 'only' sweat equity, then your comments are 'on the money' no pun intended. As an entrepreneur I would negotiate hard on the 'valuation' which you have not mentioned, which of course talks to the fairness of sharing in the upside.

[Rick Segal]

Leo,
You make a good (great, actually) point. My personal cash goes in with the investors for that exact reason. Great point, thanks for stopping by.

[Pat]

Rick,

Respect you a lot but I think you are flat out wrong here.

1) so would you object to a 5x, 10x, 100x ?

2) maybe you wouldn't because as a founder perhaps your starting percentage is high enough that you still see bucks on the horizon - but what about employee #40. He does the math. Math tells him that unless the company sells for $1B he isn't getting much. Instead of stock motivating -- becomes demotivator. Now as CEO you have 9-5 employee and a real gulf between the haves ( founders) and the have-nots ( everyone else ).

3) I gather you are pretty well off. If this company fails, or you get screwed by investors -- you are not financially devastated. The rest of us are not so lucky.

4) you have enough connections that an investor thinking about screwing you will know that it will get around hard and fast -- the rest of us not so connected.

5) If the investor demands so much downside protection then is the investor really convinced about the idea?

If I got such a proposal, I would demand upfront money going into my pocket, all previous investors, and all current shareholders. Additionally, the investors would lose the ability to force the sale of the company, and the provision would only kick in after a certain percentage of their money was spent. If it ends up just sitting in the bank because current revenue is adequate then the company gets to return it as a loan.

Do I think any VC would take such a harsh "deal" -- no... but then again why should I take such a harsh deal from them?

[Pat]

Follow-up to previous comment.

My response to such a "deal" would be:

"So based on this offer. Joe (employee #40) with 40000 shares would get $0 dollars unless the company sold for at least $60m. Joe would get $100,000 if the company sold for $80m. Could you (mr. sharky investor) craft the message to Joe explaining why he should stay working for XYZ-next-Youtube?

Be sure to explain to Joe in a way that he can explain the long hours at the office to his wife and kids."