The VC Barbarians Are Coming
The economic crisis could mean a resurgence of convoluted term sheets that leave founders with nothing
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I hate complicated terms in venture investments. Value is created by backing exceptional companies that return your fund, not by wordsmithing aggressive legal agreements. In the last decade, we’ve seen cleaner and simpler terms become the norm, which has been great for everyone involved and has overall created more alignment between entrepreneurs and venture capitalists.
But founders beware: Veteran venture capitalists like myself remember vividly the days of wiping out entire cap tables and leaving founders with nothing.
We’re entering a new ice age, and I’m hearing that paring knives are being sharpened and old weapons might get taken out of storage. I’m hoping I’m wrong and VCs will keep their term sheets clean, but in case they don’t, here’s a detailed look at the arsenal that these barbarian investors can draw from.
Share terms
There are ordinary shares, which simply pay out pro-rata (in proportion to each investor’s holdings compared to the total number of shares), and there are preference shares, which offer a preference of some kind paid out to investors on exit or liquidation. This was designed so that founders couldn’t take, say, $2 million for 20% stake and then immediately sell the business for $5 million, leaving their investors with half their money back and pocketing $4 million in the process. We may start to see investors demanding even more favorable preference shares.
For a while, the market norm has been that liquidation preferences are simple (1x multiple and nonparticipating), whereby the investors get their money out first until such time as the pro-rata amount they own is greater than the value of the cash they put in.
This preference is just downside protection in case the company’s valuation drops, but it can be used to enhance returns as well. This can be done two different ways: with participating preferred stock, where investors get their money back and then share in the rest of the proceeds pro-rata with all other equity shareholders (so-called double-dipping), and/or with multiples being applied to the preference…
