The VC Barbarians Are Coming
The economic crisis could mean a resurgence of convoluted term sheets that leave founders with nothing
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.
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, where instead of 1x money back first, they may get 2x or 3x.
So in addition to getting a higher percentage of the company through a lower valuation, investors may also take more than their pro-rata share of any proceeds in a sale transaction. As purse strings tighten, and investors are less confident in a positive outcome, they might seek additional protection for putting capital at risk.
As a friend of mine recently wrote to me: “It’s easy to see how one round like this can be tough for founders, but it gets really grim when you consider the standard it sets. If each subsequent round asks for the same style of preference, the stacking effect can totally bury founders (as well as earlier preferred investors).”
Down rounds and anti-dilution
Obviously, company valuations tend to fall as the fundraising climate becomes more challenging. The direct impact of a lower valuation is obvious (founders will have to give up greater shares of the company for the same amount of funding), but startups should keep in mind the additional impact of any anti-dilution provisions. Anti-dilution rights essentially give investors free shares in the event that the next financing is a down round (at a lower valuation) to partially compensate them for the reduced value of their shares. In that case, the dilution is borne by the founders, their team, and any other shareholders who are not receiving anti-dilution shares, who will see their stakes in the company reduced.
A weighted average of the new round and the old round is used to determine the number of bonus shares to be issued (or the price adjustment to be made). For a while now, broad-based weighted-average (BBWA) has been deemed a fair approach to anti-dilution based on a blended pricing between the two rounds. Smaller rounds trigger a smaller anti-dilution adjustment and larger rounds trigger a greater adjustment.
It’s possible that we see a return of the dreaded full ratchet. This is an anti-dilution provision designed to completely negate the down round’s dilutive impact on the existing investor by giving them the number of shares which they would have held had their original investment been made at the lower price of the new round. So if you’re raising funding at a pre-money valuation equal to the cash previously raised, your equity mathematically goes down to… zero.
In cases where founders and their team suffer too much dilution, additional share options may be issued to keep everyone incentivized to stick around and continue to build, but no such luck for your angels and very early investors. A variation of the anti-dilution theme comes in the form of warrants (contractual rights for angel investors to be able to purchase stock in the future at an agreed-upon price) that trigger on a down round — different flavor, similar outcome.
Pre-emption and its sidekicks: pay-to-play and super pro-rata
Pre-emption is always a key term for investors, as it gives them the right to continue to invest in the company in future rounds of funding, thereby maintaining their percentage of ownership. Normally, the only real qualifier is that an investor majority or special resolution can waive this right for all investors.
Pay-to-play provisions are designed to penalize existing investors who don’t participate in a new funding round and support a company through tough times. Pay-to-play doesn’t come up much when the market is going strong, but it will definitely be talked about in the coming months. Pay-to-play punishes investors who don’t invest again and, implicitly, rewards those that do. It’s arguably a more balanced approach than changes to the preference or anti-dilution as the ax falls on investors rather than founders.
The simple version of pay-to-play is a “use it or lose it” approach, where an investor loses their participation right the first time that they decline to use it. Additionally, you could include that other rights or protections (like anti-dilution) are forfeited as well. The more extreme version provides that if an investor doesn’t participate, their preferred shares are converted into common shares, and they lose all preferred share rights and protections forever.
Separately, investors might ask for a super pro-rata right, which is a pre-emptive right in excess of the investors’ pro-rata holdings. Super pro-rata rights bake in a really valuable call option for investors, wherein they can request more than their initial investment in ensuing rounds. In other words, they can place a tiny bet on a startup now, but then have the chance to reap disproportionately big rewards if the company takes off. I really dislike super pro-rata rights as I feel investors have to earn their seats at the table, and if not taken up they create real signaling risk.
Milestone-based tranched equity rounds
These types of rounds basically boil down to: “I will give you the money if you do what you said you’d do.” Logical on the surface, milestone-based tranched equity rounds present two challenges: 1. They’re pretty anxiety-inducing for founders. (“Should I invest in my business when I’m not sure that the second tranche will materialize?”) 2. In an environment as fast-moving as the one we are in, setting objective milestones that aren’t dependent on external factors and don’t limit the ability of the company to evolve its strategy can be really tough. I personally much prefer to take more risk with a bigger check than to introduce tranches as a forcing function, but they are often used in internal rounds (new investment rounds for the company’s existing investors only) despite their limitations.
Higher discounts and lower conversion price caps
A convertible note is short-term debt that converts into equity. For a while now, it’s been common to see a 20% discount applied to the price being paid on the funding round into which convertible notes convert. In a downturn, we may start seeing not only higher discounts but also multiple repayments on a sale (analogous to the multiple liquidation preferences described above). Higher discounts or lower conversion price caps (which are limits on the highest price paid for a converted share) mean more dilution is suffered by founders and existing shareholders on conversion. It also means an increased risk of triggering anti-dilution adjustment — even when there isn’t a down round.
For founders who own actual equity, investors will look at implementing reverse vesting. Reverse vesting is when founders agree that their founder’s stock will vest over some period of time, normally four years. I actually like reverse vesting because it acts as an insurance policy. If a founder leaves early, they don’t walk away with all their shares, which isn’t fair to the other founding members. Typically, we’ll say 25%–30% or so is vested up front and the rest vest over two to four years. Watch out, though, for clauses that force departing founders to sell vested shares at low prices.
A bad leaver refers to an action by a founder which is damaging to the business or its shareholders. Bad leaver provisions seek to create mechanisms to remove that person from the company at employee, board, and shareholder level — as well as to penalize that person for their actions.
In most cases, a bad leaver will result in the forfeiture of all of a founder’s shares, so the definition of this is extremely important. Bad leaver is typically defined to include some or all of the following: 1) true wrongdoing, such as the commission of an offense, fraud or gross misconduct; 2) voluntary resignation; and/or 3) lawful or fair dismissal. In the case of dismissal, the concern here for founders is that poor performance, or “not adequately steering the ship,” may bring about termination. It is really unusual for poor performance to bring about termination without the usual formalities being followed, but in a difficult market, there may be a different view taken on this by the board, even for founders employed for more than two years and where the main employment protections would be in place. It may be that the drafting leaves founders technically at risk of losing all of their shares, whether this was the intention or not.
The most effective way to control outcomes is to control the board or to enshrine your rights through investor consents, which give investors an explicit say in certain high-level decisions of the company, such as whether it can be sold or if it should raise more money. These investor consents often lead to investors controlling far too many small decisions that are best left to management or quick informal board decisions. This reflects a misplaced notion that investing in startups is about controlling risk. If you keep the consents to the essentials, you’ll build a more efficient business.
Giving away a board seat to the lead investor on each round is pretty standard, though they add up, particularly if you have more financing rounds than planned. Remember: The board’s #1 job is to decide who runs the company.
The industry has made real progress in cleaning up its act over the past decade when it comes to providing simple and clean terms to founders, but it remains to be seen whether the return of a buyer’s market will reverse all that. Let’s hope we can keep the barbarians at bay.