Emerging Enterprise Center Blog - Commentary and Analysis For Entrepreneurs and Startups

The outcomes of negotiations around preferences never seem to have a compelling logic.  Under a particular set of circumstances is there a compelling reason why the A and B should be equal (pari passu, as lawyers like to say) in the preference stack or one (usually the B) should be ahead of the A?  It seems to me to be more determined by how eager to invest the new money is (or how desperate to get a next round the old money is).  This “you get what you negotiate” situation probably accounts for why there are a wide range of provisions out there. 

Having said that, there do seem to be some broad buckets that the outcomes fall into.

An Up-Round Scenario

Let’s look at a situation in which the B comes in at a significant increase in valuation compared to the A.  In this situation, the valuation of the company starts off at a point higher than that aggregate of the existing preferences.  If the company were to be sold in the following nanosecond, the B would get its money back and the A would get its money plus, perhaps, some return.  The same result would obtain if the valuation increased over time. 

If, however, the valuation declines over time, and the company is later sold for a valuation below that at which the B invested, then all investors would be at risk of not getting their investment capital back.  If the B is equal to (or – God forbid – below) the A in the preference stack, the B would, in effect, be funding the A’s preference.  For example, if the company were sold at a down valuation shortly after the investment, the A might likely be paid in full and the B might likely receive a reduced return – in effect the B’s money would have gone to pay the A.  New investors (the B in our example) are very unlikely to be willing to do this, unless they are truly eager to get into the deal. 

For this reason, the most typical arrangements in up rounds are for the new money to either have a priority over the old money or to be equal to the old money in the so-called preference stack.

A Down-Round Scenario

Now, let’s consider a situation in which the B comes in at a significant decrease in valuation from the A round – a down round.  For the reason described above, it is hard to imagine that in this scenario, the B would agree to be anywhere other than at the top of the preference stack.  So, let’s assume that is a given. 

How will the B feel about the A keeping any preference? 

The debate will center around how much, if any, of its preference the A should keep.  To focus the issue, let’s assume that there was a really large A round (more likely there have been several early rounds and the new round is the D) and the old preferences add up to a large number, say $50 million.  If the B invested, say $10 million and the A keeps all of its preference, then the company would have to be sold for more than $60 million for the B to start to see a return on its investment (not taking into account anything for the common).  No new investor will agree to that structure in a down round situation.

So, the question is: What happens to the A? 

When the A does not participate

In a down round where the A does not participate in a meaningful way in the new investment, the A holders have very little leverage.  Their bargaining position consists of either holding the deal up altogether, at the risk of watching their entire investment disappear or making a huge concession to the B. 

When all the A participate in an inside round

When all the A participate (without an outside investor), then the question becomes how much can reasonably be stacked on top of the common (typically meaning management’s options) before there is just no incentive for management to stay with the company.  If it is necessary to reduce the aggregate preference that is stacked on top of the common, they can go ahead and do so by amending the A.  In the alternative in a case where there is significant common ownership by persons no longer with the company, the investors may leave the preferences in place but create a management incentive plan that carves out some portion of exit proceeds to be distributed to management.  (This, of course, has its own complexity.  If management has an incentive plan that sits on top of the preference stack, it can affect management’s motivations.  Which suggests another blog topic:  How to structure management incentive plans to properly align management’s motivations, a topic for another day.)

The Cram down and the Pull-Through: when some, but not all, of the A participate

When some of the A participate and some do not, the negotiation can get interesting.  The ones that participate (particularly if they lead and comprise substantially all of the B round) will be in a pretty strong position to hold onto their position in the preference stack.  But, free riding by the non- participating A investors will be anathema to the participating investors. 

Often the result of this situation is the pure cram down.  The non-participating A investors end up converted into common stock (sometimes a pay-to-play is used to convert them into a preferred “lite”). 

Sometimes, however, the new investors are willing to leave the non-participating investors with some preference over the common (and presumably over the profit potential to (as opposed to the return of invested amounts) the participating investors).  Having observed this dynamic on a variety of occasions, I can’t say that I have seen any pattern to when it arises.  One situation that seems to have some logic to it is when some of the A round investors were the sorts of angel and early stage investors whom nobody expected to see invest in later rounds.  Another situation that I have seen arise is when some of the early round investors were brought in by the larger VC investors or are persons with whom the larger VC investors have ongoing relationships.

In these situations, you sometimes see a so-called “pull through”.  It works like this:  for every $XX of B that an existing investor buys, he gets to convert some number of shares of A into shares of B.  In this arrangement, the B is ahead of the A in the preference stack. 

Final Thought

The negotiation of all this is usually done among the investors and away from the sight of the company and management.  Actually, it may be even more arbitrary than that suggests.  It is often discussed among a small “inner” group of investors, who try and guess what they think it will take to get the deal done.  When they finally come out with the offer, it is often a self-fulfilling prophecy.  They are often so invested in the solution they propose that it is impossible to get them off it, with the result that it becomes their offer or nothing.

However, how the preference stack works can affect exits.  At certain price ranges some investors at the top of the stack will get a return (or perhaps their bait back) while others will get nothing.  As a result, there may be very different opinions around when and at what price investors will support an exit. 

I know that we are all bored with the perennial comparisons between the Valley and New England in which New England inevitably appears as the landof the hide-bound and the home of the risk adverse.  The fact that we are all bored with the discussion does not however address the merits of the claim.  It just blinds us to the looming consequence: New England, already only half the size of the Valley by many measures, will lose further ground as exciting start-ups from the Valley (and New York, but we will get to that in a minute) continue to make their mark and investor money drifts (or perhaps races) towards perceived greener pastures.

I finally got around to my quarterly comparison of deal terms published by our firm, Fenwick (a Valley based firm that reports on transactions in the Valley) and Cooley (a firm with many offices that reports on transactions handled by it).

And here of New York:  No one that I am aware of reports on New York transactions.  But, starting with Q1 o f 2012, we will, because we are doing increasing amounts of emerging company work there.

So here is part 1 of my thesis:  I expect that terms will be most favorable to entrepreneurs in the Valley, least favorable in New England and somewhere in between for the rest.  Of course, I think that the “somewhere in between” number will include Cooley’s New England transactions (which will have the effect of making them generally seem less favorable to entrepreneurs).  We should all note that Cooley feels compelled (at least in some instances) to report numbers for Northern California separately from the others.

So, without further fanfare, below is the table that compares certain of the deal terms reported on by the three firms for Q4 of 2011.

Fourth Quarter 2011 Transaction Terms

Of course I knew what the chart would say before I made the prediction, so no surprise that it supports my thesis.

Here, however, is part 2 of my thesis:  When we start reporting on New York separately (which we will be doing starting with a Q1, 2012 report – to come out soon), it will show that terms in New York are far closer to those in the Valley than to those in New England.  Now I don’t’ know the answer to that question, but we are doing the research now and will have an answer soon.

Keep in mind that New York has gone from nowhere just a few years ago to equaling (or passing by some measures) New England.  Could it be that NYC is just a friendlier place for entrepreneurs than New England?

My blogger friends (and the firm’s blogger consultants), indeed, it seems the entire blogosphere seems to agree that blogs are not really an optimal publication platform for dissemination of pure content.  I take that to mean that putting law review articles (or any substantive articles on legal (or other) topics) is really not what blogs are “about.”  

Instead, blogs are supposed to be pithy comments on other people’s posts (or perhaps some other thing going on in the real or virtual world).  Hence the prevalence of blog posts that begin with some reference like, “Harry has a great post about his date with Sally….”  Harry’s post, it turns out, is likely to be some observatlon about something Sally wrote on her blog.  Sally’s blog, in turn, refers to Tom and Dick….

So, the consultants appear to say, blog posts should be pithy comments about pithy comments.

And, the occasional pithy comment is probably a good idea, but when I look at the statistical data concerning this blog and I consider which posts seem to have generated interest and which have not, the numbers (meager as they are) support a completely different notion. 

Readers want content more than conversation – at least as much as conversation.

I am, for example, under the impression that Fred Wilson was very successful with MBA Mondays.  (Now, his entire blog is a huge success.)

Switching gears, Prithvi has told me on many occasions that the content posts I have done in the past are more geared for consumption by lawyers than by entrepreneurs. 

So, I am going to try and take a trick from Fred’s book and apply Prithvi’s advice and write a series of posts (I will try for weekly) that will be both substantive and usable by entrepreneurs.  The posts will be checklists for things that are legal in nature.  The idea is to put the entrepreneur in a position to think about whether he or she has covered everything he or she needs to cover in a document or deal. 

Of course, the usual caveats about how this is not legal advice and does not create a lawyer client relationship etc. apply. 

I thought I would tackle seed preferred term sheets first.  Although these can vary from one pagers to 5 pagers (or more), for the purpose of creating a checklist, I am going with the longish form.  After all, it is the purpose of a checklist to be over inclusive.  Also, I have linked each of the terms (and some other items) to the glossary defining these terms on the EEC microsite and, where it seemed relevant, to my blog. 

Please send me thoughts on the checklist.  If the checklists seem useful (or popular) I will post them on their own site on an easy to use open source basis.

Here goes:

First, a disclaimer: The client referred to below has read and signed off on this post.

Now to the matter at hand: We were retained by an investor leading a $1mm seed preferred type financing for a start-up digital media company. The investor will end up with around 20% of the company after close. The company is pretty hot and the entrepreneur is already a one time winner in the space. The entrepreneur is a huge Fred Wilson fan and can’t imagine how costs could exceed $5K for this deal.

In an effort to control costs, once the investment got passed the “term sheet” (and I use that phrase loosely) stage, the entrepreneur insisted that he would only make and take comments in the form of tweets. Our client agreed to this.

The deal went into hyperdrive as soon as the tweets started to fly, with tweets like:

            “Always get 6% cumulative dividends but only paid on liquidation”

            “why?”

            “standard”

            “won’t agree to have a common vote on the drag”

             “Why?”

             “have in all our deals”

As you might imagine, with this limitation on discussion we are way under Fred Wilson’s magical $5K.

Unfortunately for my client, a well-known angel got wind of all this and tossed her hat in the ring with a convertible note. She wised the entrepreneur up to a number of things including that idea that converts are better for entrepreneurs than priced deals.

So here is my challenge:

Explain in 140 characters or less why the entrepreneur should accept any of the following:

(1) a priced deal and not a convertible deal

(2) a 6% dividend

(3) a drag without a common vote

The winner for best explanation within the 140 character limit gets free legal services from me to the extent of the positive difference, if any, between $5K and my fees at standard rates on this deal.

The bad new is that I have taken a blogging holiday since February 2.  The good news is that the holiday is the result of being pressed on client matters and business travel (including to China).  But, it is time to come back. 

As I have done each quarter for some time, this blog presents a comparison of the published statistics relating to venture deals from my firm, Foley Hoag LLP, and the west coast firm, Fenwick & West LLP.  This time I am not including Cooley LLP because their year end edition has not yet been published. 

Here are some general thoughts:

Foley Hoag, in our publication Venture Perspectives, reported on a total of 46 deals in New England.  Fenwick reported on 95 deals in the Valley.  This puts the New England market at about half the size of the Silicon Valley market  -- entirely consistent with historical norms (at least for so long as I have been observing the scene).  The new comer, of course, is New York, where, according to Crain’s New York business.com, there were 51 financings in Q4 in New York in the following industries 20 in software, 17 in media and 14 in IT (for sure there were other in other industries). 

On the one hand, this might suggest that New England is losing ground to NYC.  On the other hand, it suggests that the north east (New England plus New York) is now as big a market as the Valley and is probably growing faster given the velocity in NYC.  (I can hear the Valley folks saying you’ve gotta include Seattle and San Diego – whatever.  If that is where they take it, they have in effect conceded the point.)

Even more interesting, is that most of the New York deals are software, digital media and IT related.  Based on anecdotal evidence there were a significant number of digital media deals in New England (unfortunately, our survey lumps media in with software so I don’t have precise number).  According to Fenwick, the most active sectors in the Valley were software followed by cleantech and hardware then came internet and media followed last by biotech.

If I had to pick something hot today, it would be internet and digital media – and the epicenter is not in the Valley!  The reasons for this are almost certainly that the advertising industry is headquartered in New York, there are lots of digital and data infrastructure companies in New England, and there is lots of money in New England and New York to fund these businesses.  It is efficient to be near the relevant infrastructure (the advertising world).  Apologies to Nivi and all the other “you have to move to the Valley” proponents, but if you are working on a digital media company – don’t relo to the Valley quite yet.

So, with that as a background, below is my usual table comparing actual deal terms.

Comparison of Terms for Q4 2010 Venture Deals from Foley Hoag and Fenwick & West

(some percentages are approximate)

It pains me every time I write this, but there is a persistent and consistent difference in terms between New England and Valley deals.  Look at cumulative dividends and redemption.  The numbers are consistent quarter after quarter.  At least as to these terms (and painful as it is to admit, I suspect as to others), entrepreneurs get a better deal in the Valley than they do in New England.

The US secondary market for private company stock has exploded nearly 3,200% in the last several years!  Longer lead times to an IPO, more companies becoming profitable faster and the weakness of the public equity markets are all touted as reasons why (See the FT’s recent article on “The New Stock on the Block” - The article reports that the number of venture backed IPOs from a decade ago have shrunk nearly 93.7% ,whoa!). 

The article makes for excellent reading, and I will not rehash its contents.  Rather, I’m going to focus on the efforts by lawyers like myself to curb the ability of holders of stock of emerging companies to resell their founder’s stock or vested options to third parties in a private transaction before the company’s stock is available on the public market.  Why do we do this?   To control your shareholder base, after all, as an emerging company the last thing you want (as the founding/executive team) is to be dealing with a belligerent activist shareholder.  There are some other side benefits to this as well.  Keep reading for more...

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After Q1, I was wondering if the venture economy was back or if folks just thought so.  At the end of Q1 things seemed to be on a steady upward trend; now they seem to be sputtering.

Well, the Q2 results have now been reported on by many sources, including the three law firms that publish data, Foley Hoag (my firm), Fenwick & West (a Silicon Valley based firm), and Cooley.  Unfortunately, I think Dave Pierson from my firm put it well in his analysis of New England based activity, “the environment for venture investing … has generally improved compared to the dismal conditions prevailing last year, but also that pace of improvement has stalled.”

Fenwick described third party analysis of the venture industry as follows, “2010 reported a significant increase in venture investment, mild improvement in venture funded company liquidity, and continued difficulty in capital-raising by venture funds.”

Cooley had this to say, “the second quarter of 2010 produced mixed signals for the venture financing environment.”

In my last post on quarterly results, I described what each firm covers in its reports so I won’t go into that again except to say that my firm’s publication, Foley Hoag Venture Perspectives, is devoted to venture financings for companies headquartered in New England.  Fenwick’s publication is devoted to companies headquartered in Silicon Valley.  Cooley’s is devoted to information taken from transactions in which Cooley served as counsel and is not focused on any particular geography.

Activity Levels

According to Foley Hoag’s research, as a general matter, activity levels for both Series A and Series B and later rounds in New England were up significantly when compared to Q2 of last year.  The data shows a more mixed performance when compared to Q1 of this year.  Perhaps the most striking piece of data is that there were no (as in none) cleantech deals in New England in Q2.  Variability is too great from quarter to quarter to draw much of a conclusion from this fact.  Having said that, it is consistent with anecdotal evidence indicating that VCs are being very cautious about cleantech deals.  Also the flattening between Q1 and Q2 is consistent with anecdotal evidence of a general slowing in the economy.

Fenwick had this to say about activity in the Valley, “Up rounds exceeded down rounds in 2Q10 55% to 27%, with 18% of rounds flat.  This was an improvement over 1Q10, when up rounds exceeded down rounds 49% to 32%, with 19% of rounds flat.  This was the fourth quarter in a row in which up rounds exceeded down rounds. … In general, the cleantech, software and internet/digital media industries had the best valuation-related results in 2Q10, while the life science and hardware industries trailed.”

But, Cooley seems to have slightly different experience.  Cooley had this to say about their findings, “Overall, our data points to mixed signals in the venture financing environment. In Q2, we saw a reversal in a recent trend of increasing up rounds. Though the majority of deals were still up rounds, the percentage decreased to 52% from 61% in the prior quarter. Median pre-money valuations were also mixed. The data showed valuation increases for Series A and C deals, while pre-money valuations declined for Series B and D+ rounds.”

Looked at from 30,000 feet, reports from all three firms seem to have picked up on some mixed results for Q2.  While it is not clear what this augers for Q3 and beyond, it does seem to reflect the general queasiness of the general U.S. economy.

Terms

The flattening trend, if that is a fair description, is also reflected in the terms for transactions.  I have tried to consolidate the deal terms reported on by the three firms in the table below.  This table shows the percentage of deals having a particular term and compares the findings of each firm (to the extent that the firm covers the particular term) with respect to particular terms that appeared in deals closed during the first quarter of 2010.

Cumulative Dividends

Consistent with a long standing trend and as was the case last quarter, the most striking comparison in this table is the fact that more than half of all New England deals carry cumulative dividends but less than 10% of Silicon Valley deals have them.  As I noted last time, “That is huge difference.  And, it is hard to explain. Many VC funds have offices in both markets.  Based on that fact alone, I would have guessed that there would be a tendency to have some homogeneity within a fund and that this alone would cause differences to be much narrower than an order of magnitude.  So, I checked out historical numbers going back a couple of years and this seems to be a persistent and consistent difference between New England and Silicon Valley.  It certainly suggests that Silicon Valley is more founder friendly than New England, I am sorry to say.”

Preferences with Participation

Also consistent with last quarter, the similarities are striking when it comes to participation.  Foley Hoag’s numbers for Series B and later stage deals and Cooley’s numbers for Series C transactions seem to be higher than the norm, but this may well be due to peculiarities in the sample.  As I noted last time, “This really begs the question why there is a seeming convergence around participation but not dividends.”  I would love to get some commentary from readers on this inconsistency in convergence.  BTW, I have again run across a New England based VC (and counsel) who insist that founder reps (covering all the company reps in a superseed deal but with recourse limited to the founder’s equity) are the norm.  I don’t think this is ever asked for on the West Coast, and I think it has been many years since some version of this was the “norm” on the East Coast, but I would also love to get some commentary on founder reps in the context of superseed deals, as well.

Redemption

With respect to redemption provisions, Foley Hoag continues to find that redemptions provisions exist in more than half of all deals or twice as much as Fenwick reports.  Last quarter I thought I had identified a trend away from redemption, but the numbers seem to be holding steady.  I will be curious to see how the numbers trend over the next few quarters.

Pay to Play

The incidence of pay to play provision is low across the board, and I don’t think the small differences are meaningful.

Antidilution

No surprises here:  Weighted average antidilution rules.  Full ratchet deals are rare everywhere, and, I believe, that they reflect unique circumstances.

Conclusion

While it would be nice to be able to report a steady upward trend across the country and across various factors, it ain’t happening.  But the news if not great is not all bad.  As one of my partners, Dave Pierson, put it in his article in Foley Hoag Venture Perspectives, “Thomson Reuters and the National Venture Capital Association have reported that exit activity for venture-backed companies was up during Q2 2010…..There were … 92 M&A exits, down from Q1 2010 but up significantly from Q2 2009.  The M&A exits with reported values generally yielded more favorable returns than in Q1 2010.  Venture-backed M&A exits with reported values greater than 4X the venture investment represented 65% of the Q2 2010 total versus only 45% of the Q1 2010 total. Venture-backed M&A exits with reported values less than 1X the venture investment represented 15% of the Q2 2010 total versus 31% of the Q1 2010 total.”  In addition, there were 17 venture-backed IPO’s in Q2.  This is the most in any quarter since 2007.

The angel investment debate rages on. I don’t know if rages is quite the word, but it continues. Many people have written about it including Brad Feld, who cites a number of others. I have written about it. 

Mostly the debate revolves around who is and who is not a “good” angel investor. If the disputants are to be believed, a VC who just plopped $250K into your business to get an option on leading the next round is a “bad” seed investor but a VC who thinks like an angel investor and will give you some bandwidth is a “good” seed investor.

I am going to take the position that the later is just a “less bad” angel investor and that if you are looking for angel money, you should go to someone who does angel investing and has no pretenses to leading (or maybe even participating in) the next round. (I can hear the chorus now: But you want an investor who can support you as you grow etc….) My point of view is that if your business merits VC investment, you will get it on better terms if you started with an angel and then went to a VC than if you started with VC angel money. (Now, I may come to a different conclusion with respect to businesses that require really large amounts of capital, such as biotech and some cleantech companies.)

As I see it, the issue is that VCs who made angel investments are motivated to keep the first round valuation low whereas true angel investors are motivated to keep the first round valuation high.

The reasoning is simple. A VC who will be investing big dollars in the A round will get more for his or her money if the price is low than if the price is high. The dilution resulting from a low price will fall disproportionately on the founders, the holders of common stock and angel investors.

The exact opposite is true for an angel investor who is unlikely to participate in (or at least unlikely to participate in a big way) the first big round. A low price means more dilution to them than a high price.

Once you have a VC inside the tent, they will influence the next round price by their mere presence and because of the contractual rights you will have given them. Your VC investor will in all probability be involved (either as a BOD member or an advisor) in your efforts to find financing. In addition, their financing docs are likely to require that you get their consent to the issuance of new securities or any amendment to the certificate of incorporation (not to mention rights of first refusal and other things that might be in the docs). So, you are going to need their consent to any deal. All this of course assumes that your VC will participate in the new round. If they don’t you may have even bigger issues.

It is hard to imagine that in this context the VC’s presence won’t have a depressing effect on the price you can get from a “new” investor.

So, when you take on a VC angel investment, you are taking a significant risk that your next round valuation will not be as high as it would be if you went with a regular angel investor.

Everyone thinks things in the venture world are looking up. Numbers of deals are up, valuations are up, terms are friendly. VCs and entrepreneurs are lining Winter Street and Sand Hill Road holding hands and signing kumbaya. Well, not quite. Foley Hoag LLP, Fenwick &West LLP, and Cooley LLP have now all published their reviews of venture financing transactions for Q1 of 2010, and, while there are some interesting differences, the tone is generally upbeat. Having said that, perspective is everything and sweeping statements about the health of the venture economy are l likely to be wrong if you don’t take all the available facts into consideration.

Reports from these firms cover a lot of the same types of material however they each look at some different things and they each source the data in different ways.

Foley Hoag, my firm, is headquartered in Boston. Our publication, Foley Hoag Venture Perspectives, is devoted to an analysis of financings for companies headquartered in New England. We try to cover all New England deals (that is we don’t limit our reporting to deals in which our firm is involved). We cover activity levels, valuations, and terms. In each case we break it up between Series A investments on the one hand and Series B and later stage investments on the other hand. We also report on activity and size of deals by industry.

Fenwick describes its report as “Trends in terms of venture financings in Silicon Valley.” This firm reports on venture financings for companies headquartered in Silicon Valley, and reports on financing rounds, price changes, and something they refer to as the Fenwick & West Venture Capital Barometer (you will have to look that one up for yourself). They also report on a variety of deal terms.

Cooley has this to say about its report, “This quarterly report provides data reflecting Cooley’s experience in venture capital financing terms and trends. Information is taken from transactions in which Cooley served as counsel to either the issuing company or investors.” This firm reports on numbers of deals, valuations and certain terms. Cooley has nine offices, so their data comes from many regions but, as noted, is limited to deals in which they were involved.

Because we cover similar data (but not the same data) in different ways and present it in different ways, it just isn’t possible to compare the data from all firms on an apple to apples basis. So, I have focused this post on (1) activity levels (that is numbers of deals) and (2) deal terms. 

Activity Levels

All three firms are reporting increased activity in Q1 of 2010 over Q1 of 2009 and over Q4 of 2009.

Foley Hoag found that activity levels for Series A investments in New England measured by the number of deals was up both compared to Q4 of 2009 and Q1 of 2009. The picture was mixed for Series B and later stage investments. The number of these deals was down from last quarter but up from a year ago. It seems to me that variability is too great from quarter to quarter, so the year on year comparison seems to me to be more telling of the general direction of the venture economy.

Fenwick had this to say about the results they found, “1Q10 results were similar to 4Q09, with up rounds exceeding down rounds in 1Q10 49% to 32%, with 19% of rounds flat.” They also noted that according to their findings, internet/digital media had the best results while cleantech had the worst results.

Cooley had this to say about the deals they were involved in, “Though we saw a slight decline in deal numbers, we saw a significant increase in invested dollars compared to the same quarter a year ago. Additionally, up rounds reached a level we have not seen since the middle of 2008.”

In a big picture way, all three of us observed a modest but steady upward trend in the tech economy. 

Terms

The upward trend also appeared in the terms that companies are getting from their venture investors. I have tried to consolidate the deal terms reported on by the three of us in the table below. This table shows the percentage of deals having a particular term and compares the findings of each firm (to the extent that the firm covers the particular term) with respect to particular terms that appeared in deals closed during the first quarter of 2010.

Cumulative Dividends

The most striking comparison in this table is the fact that more than half of all New England deals carry cumulative dividends but less than 10% of Silicon Valley deals have them. That is huge difference. And, it is hard to explain. Many VC funds have offices in both markets. Based on that fact alone, I would have guessed that there would be a tendency to have some homogeneity within a fund and that this alone would cause differences to be much narrower than an order of magnitude. So, I checked out historical numbers going back a couple of years and this seems to be a persistent and consistent difference between New England and Silicon Valley. It certainly suggests that Silicon Valley is more founder friendly than New England, I am sorry to say.

Preferences with Participation

If the differences are striking when it comes to dividends, the similarities are striking when it comes to participation. Cooley’s numbers for Series A and Series C transactions seem to be higher than the norm, but this may well be due to peculiarities in the sample. This really begs the question why there is a seeming convergence around participation but not dividends. I don’t even have a good speculation around this one.

Redemption

With respect to redemption provisions, Foley Hoag is finding numbers that are twice as high as Fenwick (Cooley does not report on this term). This one, however, I think has an explanation. In New England the incidence of redemption provisions is trending downward rapidly. As I have said elsewhere, I suspect that this is in response to changes in accounting practices. The numbers probably reflect a more rapid response to these changes in Silicon Valley than New England, but I predict the will converge at a very low percentage over the next year or so.

Pay to Play

The incidence of pay to play provision is low across the board, but higher in New England than in Silicon Valley and higher than Cooley reports. My sense, entirely subjective, is that the difference is not particularly dramatic and probably reflects a slightly more conservative investment culture in New England than in Silicon Valley. I also predict that, as the venture industry works through the current very rough fund raising environment and more funds know where the stand with investment dollars, that the incidence of pay to play provisions will both decline to a lower number and converge across the country.

Antidilution

No surprises here. Weighted average antidilution is the universal standard. Full ratchet deals are rare everywhere, and, I believe, that they reflect unique circumstances.

Conclusion

While it is nice to be able to report an upward trend in our sector of the economy, it is not time for kumbaya yet. Let’s remember that it isn’t 2007 (which was a good, but not a great, year). We are staring at some chronic problems (trends like the retirement of the baby boomers and how is that going to be paid for and the staggering debt the U.S. and other countries have run up) and some acute problems (the debt crisis in Europe and the volatility of the stock markets). We are not going to dig our way out of this hole with a strong manufacturing comeback. We need a thriving entrepreneurial tech economy to lead the way. Fortunately, this sector looks like it may come back to life.

Yesterday we (Foley Hoag) released our review of Q1 venture activity and deals in New England. Here is the link to Foley Hoag Venture Perspectives. As usual, the numbers are fascinating. A big downward trend in redemption provisions. Why? Perhaps accounting reasons. A topic for another post. Also, a noticeable trend favoring entrepreneurs. Why? Perhaps just the result of an overall improvement in the economy? Series A investments seem stronger than Series B and later. Why? Perhaps because all Series A investments are optimistic whereas at least some later stage deals are not? I will write more on this subject in the next few days.

Bijan Sabet has a post on the subject of east coast versus west coast term sheets. The post raises the issue of whether there are differences and why. The more interesting part is the comments. There is a lot of back and forth on east coast having tougher terms etc. There is a comment to the effect that east coasters are more likely to have redemption rights and founder reps and, perhaps, other terms. There is even comment to the effect that a lot of the differences stem from the lawyering style.

But I want to make a few points. First, while we all have some experience with both coasts, and some have more than others, no one has a comprehensive view of what is going on on both coasts. As a result, all the assertions are impressionistic. 

Second, a lot of the major VC firms have offices on both coasts and regularly do deals on both coasts. It is hard for me to imagine that they sit in their Monday meetings and say “well this is a west coast deal so no redemption but this one is an east coast deal we have to have redemption.” Just stating the proposition makes it sound ridiculous. There has to be convergence. Perhaps there are some identifiable differences (such as the founder reps thing or the redemption thing), but these are at the margins. If there were significant variations in valuations and terms, arbitrage would be closing the gap.

Finally, and this is what I really want to get to, the founder’s rep variation has really done the east coast a vast disservice. It is undeniably true that seven or eight years ago, when we first started working on the NVCA forms there was a significant difference in practice with regard to founder reps between east and west. For certain kinds of series A deals, east coast VCs insisted on getting founder reps. Whereas, this practice was anathema west coast VCs. 

I am not going to go into the merits of the two positions (BTW – I think the west coast VCs have largely beaten their east coast brethren into submission on the point). Rather I want to point out that the way the argument set up was that one coast (west) was entrepreneur friendly and one coast (east) was not. Despite the fact that, from my limited observation post, the differences between the coasts are very minor, this view of the east coast VC community as less friendly to entrepreneurs than the west coast VC community persists. It has become an unexamined bit of tech culture.

Again, while the practice of asking for founder reps has a sort of nasty edge to it (after all it tries to saddle the entrepreneur with personal liability for a variety of things), I think it rarely (perhaps never) has a practical consequence. I am unaware of even one instance in which a VC has sued to get made whole based upon a failure of a founder rep. Of course, I am not aware of everything. I have a hard time imagining a VC fund suing a founder other than in the context of serious fraud, in which case the VC would have claims outside the purchase agreement. If you agree with what I just said, it is hard to imagine why a VC would insist on founder reps.

This is the one issue that everyone consistently points to when noting the different attitudes towards entrepreneurs between the two coasts. So, I think that the negative view of east coast VCs is largely a self-inflicted wound.

This was going to be one post, but it reached 5000 words, so I broke it into two.

If Vinod Khosla is standing there ready to write you a check for $10 million, perhaps you should take the money (and not worry about the 1x preference with full participation and 8% dividend) before he changes his mind. These days, clients are having a hard time finding any financing. So, almost always, you take what you can get.

However, let’s engage in the willing suspension of disbelief. A name brand VC has handed you a term sheet with everything slanted her way. You are feeling feisty, and you are ready to negotiate. What should you care about and what should you let go?

I am not going to discuss valuation, except to say that it is a black art (not a science). One piece of evidence to support this observation is that way too many deals are done on what looks like a formulaic basis. The five on five valuation happens way too often to be random. Obviously, negotiate the best deal you can get, but I am going to leave valuation to another post. 

I am also not going to discuss full ratchet antidilution. (It has its place is some (very few) deals, but it is not a typical Series A term.) If Vinod presents you with a term sheet that has a full ratchet provision, tell him you will save him from investing in a founder stupid enough to sign up to that.

Finally for this post, I am going to take the words of the various provisions I comment on from the NVCA form term sheet. I strongly recommend that you familiarize yourself with that form (and the related deal docs). They are a gold mine of useful information about all the legal stuff in the investment docs.

Here is my list of six terms you should negotiate over:

(1)          Dividends. Hate them dividends. According to us (see, EEC Perspectives), 70% of series A venture deals in New England in Q4 of ’09 had a dividend provision. Dividends ran from 3% to 8% per annum. Let’s assume, for purposes of this post, that the term sheet has this in the dividend provision:

The Series A Preferred will accrue dividends at the rate of 8% per annum, payable only when and if declared by the Board or upon a liquidation or redemption. For any other dividends or distributions, participation with Common Stock on an as-converted basis.

A couple of things to note here (assume per below that the term sheet also provides for a 1x participating preferred): This provision (taken with the provision for a participation) means that, when you sell your company to Google for a princely sum, your investor will get her investment back plus accrued interest at the rate of 8% per annum before you get one penny. BTW, this is also the amount that you would have to pay upon redemption (should that provision ever come into play).

I have reason to believe, based on research, that the average number of years from inception to exit is about 10 years. I also know, based on anecdotal evidence, that the average number of years from initial investment to exit for portfolio companies of top tier venture funds is about 8 years. (Years to exit depends upon so many factors that it is hard to make sense of.)

According to the rule of 72, at 8% in 9 years the amount of the investment will double. So, if the initial investment is $10 million and you exit in 9 years, your investor will get $20 million before you get one penny. In low to mid valuation exits, this can be painful. It also gives the investment a debt like feel rather than an equity feel. Finally, it creates a set of outcomes in which the investor may want to exit and you may not.

So, knowing that in the last quarter 30% of deals didn’t have dividends, I would push back. Argue that it misaligns the interests of the investors and founders. When your investor says that they always get dividends, don’t believe them.   (Our firm keeps a database of deals that tracks who the investors are and what the terms are. As a result, we can tell you, on an investor by investor basis (for the years since we have been keeping the data), whether, and how often, they get dividends.) Try to get no dividends or low dividends. It could be real money to you, and you want everyone’s interests aligned.

(2)            Participating Preferred. Sometimes referred to (when there are no VCs around) as “pig preferred”. So here is the hypothetical participation provision in your yummy term sheet:

First pay one times the Original Purchase Price plus accrued dividends on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock pro rata on an as-converted basis.

It should be clear from point number 1 what this means, but just in case, when you sell the business (not in an IPO situation) even in a good scenario, the investor gets its bait back plus the 8% interest (which after 9 years means twice its bait) before you get anything. Then, you and the investor share pro rata on an as converted to common stock basis.

            We know, and we have published for all the world to see, that in the last quarter of 2009, 32 % of Series A deals in New England had a 1x participating preferred without a cap on the participation, 9% had a capped participation and 54% had no participation. (The remaining 5% had greater than a 1x preference and are outliers.)

            When coupled with a dividend provision, it makes the venture investment work like a note with a warrant – giving the investment a debt-like feel. (BTW, VCs also get board representation – sometimes a majority on the board. I have sometimes wondered why they have not been sued on a lender liability theory, but that is a topic for another post.)

            So, the problem with participating preferred is that in low and mid-value exits, the common holders take it on the chin. You do the math. If you raise $30 million and six years in you sell the business for $60 million, what is left for the common. Remember, the founders will not be the only holders of common. You could end up with a meager payday. Maybe that is just and fair, but it certainly misaligns the founders and the investors. Keep in mind that investors have a ten year life on their funds. If they make an investment in year four and then wait six years, they are under pressure to liquidate. You may think you are on the cusp of greatness, and a single may be looking pretty good to your VC. (Also, remember what the numbers say about years to exit.)

            Fight this one. Ask for no participation and, perhaps, settle for a capped participation. Just to be clear, in the capped participation scenario, the investor gets the greater of (a) 1x plus dividends plus participation up to an agreed number perhaps 2x the investment or (b) what they get upon a simple conversion to common (i.e. without any participation or preference).

(3)            Founder Representations. A great war has raged over this point between east coast and west coast. For many years, east coast VCs demanded and got founder reps on Series A deals. On the west coast, the view seems to have been that the practice was something close to diabolical. Fortunately for entrepreneurs, the west coast VCs are very close to beating their east coast brethren into submission on the point.

            Here is what your term sheet provision might say:

Standard representations and warranties by the Company. Representations and warranties by Founders regarding technology ownership, conflicting agreements, litigation etc.

            Try the Nancy Regan defense. Just say no. If that does not work, then focus on setting limits to your liability. Even the most rabid east coasters will accept a limit on liability to your shares in the company. This issue should not come up on B or later rounds.

(4)            Option Plan Vesting; Founder Vesting; Option Pool Provisions. I have noticed an increasing number of VCs that are looking for five year vesting on options (as opposed to four year vesting that has long been the norm). Your term sheet could say something like:

All employee options to vest as follows: 20% after one year, with remaining vesting monthly over next 48 months.

            The investors that like the five year vesting argue that you don’t get close enough to an exit in four years and they are going to have to reload and give away more options and dilute everyone etc. All good points, by the way, and, it might also be a tacit admission of the 8 years to exit issue that I pointed out earlier.

            Your problem with this approach is that it will be an impediment to hiring the best people (all of whom are expecting a four year vesting schedule). In today’s market it may not matter so much since there is a lot of talent available out there, but as things get better it may. I would resist on this ground and see if the investor does not give it up.

            Then there is founder vesting. You might think of this as adding insult to injury, but VCs investing in true early stage series A deals frequently want the founders to agree to some vesting schedule. It is not like option plan vesting just discussed where there is broad agreement on four years and a few looking for five. Here, as the saying goes, you get what you negotiate. Having said that, experience indicates that most VCs will agree readily to something between 25% and 50% fully vested and the rest over three years. BTW, this only applies to true founder shares. To the extent that you pay real dollars for stock, that you keep. The arguments to use in connection with this point have to do with how much time and sweat you have into the business. The more you have in the business; the better your argument for more immediate vesting.

I have been dreading getting to the option pool discussion because I get an inordinate number of questions about how big the pool should be and should it dilute everyone or just the founders. Unfortunately, the answers are not great for the founders (not necessarily bad in a business sense, but you are going to eat the dilution). Your term sheet will have a provision along these lines (BTW, the pool will also appear in the cap table):

Immediately prior to the Series A Preferred Stock investment, [______] shares will be added to the option pool creating an unallocated option pool of [_______] shares.

            Unfortunately, because the data is only sometimes publicly available, the sample size for our data on option pool size in New England deals is small. Having said that, option pools for Series A deals cluster around 15% to 20% of the fully diluted capitalization of the company.

            Your investor is going to make her investment with the assumption that every option in the pool will be granted. So, if she wants 50% of the company, she means 50% after you have granted all the options in the pool. If the pool is 20%, that leaves 30% for the founders. You are not going to out fox her and get her to agree to a post money pool. (That is she won’t go for 50/50 pre-pool and 40/40/20 post pool. What she might do is 40 for you /60 for her pre-pool (or whatever the numbers are) so that she gets to the 50% place after the pool.)

            Keep in mind that all players will agree that they need a pool to attract quality employees. With that in mind if you can make a decent argument for a pool that is on the smaller side, the shares you save may end up in your pocket. 

            When thinking about the size of the pool, think about whom you need to hire. If you happen to have the key players in place (and they have founder’s stock) you may only need a pool sufficient for the rank and file. This might be a good argument for a smaller pool. BTW, experience indicates that option pools are rarely large enough. They have to be reset to some extent with almost every round of financing. VCs know this better than you do. Nevertheless, under the right conditions, you might save a percent or two on the pool size.

(5)            Board of Directors. Board composition is often highly negotiated. (I am not sure why because it frequently comes out with two for the investors, two for the founders/common holders and a tie breaker who is, at least notionally, independent.) In any case, you want to make sure you have an arrangement that works for you. Here is the NVCA approach:

At the initial Closing, theBoard shall consist of [______] members comprised of (i) [Name] as [the representative designated by [____], as the lead Investor, (ii) [Name] as the representative designated by the remaining Investors, (iii) [Name] as the representative designated by the Founders, (iv) the person then serving as the Chief Executive Officer of the Company, and (v) [___] person(s) who are not employed by the Company and who are mutually acceptable [to the Founders and Investors][to the other directors]

This provision contemplates a very full board; experience indicates that a lot of start-ups don’t have five board members when they close the A round. Look at it this way: Every substantial fund investor gets a seat on the board. Many (most) VCs like to travel in pairs. That means two seats for the VCs. Sometimes you get some smaller investors in the A round. They typically don’t get board seats. However, they sometimes ask for (and sometimes get) observer rights. If they do, you need a specific agreement with the observers so you can easily exclude them from anything that might implicate attorney client privilege. Sometimes the observers are strategic investors and you may want to exclude them from competitively sensitive information as well. It should go without saying, but you want to be sure that you are on the board. An important ask to add in for the founder is to provide that he is still on the board, even if he is no longer CEO.

(6)            Drag Along. My last candidate for a provision that merits some discussion is the drag. (I admit I could have put some other provisions here instead of the drag, like preferred stockholder veto rights, but I wanted to stick with the artificial constraint of my six point list, so I put them later.) You will never get it out (well, never say never, how about almost never). The drag ensures that you must sell when the VCs want to sell (without regard to the structure of the deal). Imagine that your term sheet has words like this in it:

Holders of Preferred Stock and the Founders and all future holders of greater than 1% of Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options) shall be required to enter into an agreement with the Investors that provides that such stockholders will vote their shares in favor of a Deemed Liquidation Event or transaction in which 50% or more of the voting power of the Company is transferred and which is approved by the Board of Directors and the holders of ____% of the outstanding shares of Preferred Stock, on an as-converted basis.

            In the off chance that you are getting a minority investment, you should resist this on the grounds that the tail should not wag the dog. However, in our imaginary deal, your investor is getting 50% of the fully diluted and you have 30% of the fully diluted. We sometimes see founders negotiate for, and sometimes get, vetoes on the drag.   We sometimes also see provisions where a majority of the preferred together with a majority of the founders are needed to approve the deal to drag everyone else. The investor’s argument is that she does not want you to be able to block a good exit. 

            Having said all that, I predict that you will lose the larger argument (i.e. there is likely going to be a drag), but you can, and should, place conditions on your participation in the drag. The footnote to the NVCA form term sheet puts it this way:

This provision is typically subject to a number of negotiated conditions, including: the representations and warranties required are limited to authority and title to shares, liability for breaches of representations by the Company is limited to a pro rata share of any escrow amount withheld, any liability is several and capped at the stockholder’s purchase price and that the stockholder receive the same form and amount per share of consideration as other holders of the same class or series of stock.

You should get these qualifications on the grounds of simple fairness. For example, the notion that you would be contractually obligated to accept liability beyond the purchase price in a deal you have to be dragged to seems patently unfair. I think most (all?) investors would agree.

My next post will go into six things not to negotiate (much).

Healy Jones has some good thoughts on the current push for form documents for seed transactions on his recent post. There has been a raging, and sometimes cantankerous, discussion on series seed form documents in the blogosphere.  In addition to the Healy Jones post, check out Brad Feld and Jason Mendelson.  Here is my point of view. 

Healy asserts that standard forms are not likely to drive the time to close. I agree; the interactions between the investor and the company drive that time to a much greater extent than legal documentation. 

Healy also thinks that forms do not reduce legal costs. Here’s what I think: With respect to legal costs, they have gone up over the last seven or eight years (since the NVCA forms project began) but not as dramatically as, say, legal costs for M&A transactions. I also think if you get two attorneys who are experienced (and willing to work with the NVCA forms) the amount of discussion is way less than you might think. 

With respect to making seed rounds easier, I think Healy is  right that what drives the ease of closing are the investor and the company not the interactions of the lawyers. 

The bigger issue with standardized seed docs is that seed/angel investors are way too disagregated. They themselves don't have consensus around what their concerns are. Before the NVCA forms everyone agreed that investors should get reg rights, drags, co-sale rights, etc. It is just that there were lots and lots of ways to draft each of these rights with the result that lawyers got bogged down in arguments around whose words were better and what was the exact intended scope of each provision (nobody, of course, disagreeing with the core concepts). 

Seed/Angel investors don't have an analogous set of well defined concerns. Some like common stock, some like convertible notes, some like preferred stock, some like secured notes, etc.

To the extent that seed means seed money from VCs, then you might get some level of consensus and be able to build forms. As I have noted before in a prior post, Ted Wang from Fenwick has posted a set of "Series Seed" docs that, I understand (but I am not sure), are basically a trimmed back set of the NVCA docs. These might gain some traction in the venture community, but an investor who is not from this ecosystem and who has an attorney who is not from this ecosystem is not likely to buy into them. Most of the seed/angel investment that gets done is outside the venture ecosystem. That is why the seed forms are not likely to get broad acceptance.

There are a lot of little nuances that can come up in connection with term sheet negotiations. One of my clients recently brought one of the more irrational ones to my attention with a question about what is and what is not fully diluted. 

It began with the cap table where the option pool first appears. When determining their investment and the pre and post money valuation, the investors assume the issuance in full of the entire option pool. Just to be clear, if the investors want 50% of the company, they mean after all options in the pool have been granted. (So, if you imagine that there will be 10 million shares outstanding after a financing and the VC expects to own 50%, then they will own 5 million shares and the other 5 million will be split among all other interests (the common and the option pool – among others).

Well, that is fine. After all, the valuation is the valuation. But what happens when it comes to calculating the weighted average antidilution? [There is a complex formula that I don’t want to go into in detail. Suffice it to say that the bigger the denominator the smaller the adjustment to the antidilution ratio.]   For the purpose of the antidilution calculation the denominator includes all issued and outstanding shares (including those that could be issued upon the exercise of granted options. Note the use of the word “granted” as opposed to the entire pool. Something approaching 99% of all deals that have weighted average antidilution work with only granted options and therefore have their thumb on the scale in favor of the investor.

Now this is in many ways just a small (minute) point since the difference in the two calculations is likely to be minimal. So, in the grander scheme of things it isn’t worth much of an argument. Despite the seeming unfairness of this inconsistency, save your powder for bigger points.

Having recently had a pretty bad skiing accident that required surgery and will require a long recovery (while chasing my son down the lift line at Ninety Nine 90 in the Canyons), I have not been able to write many posts, but now that I am past the initial stages of recovery, I have had some time to think about the tech world again.

Here is one of the somewhat intractable issues that have troubled me. I know, from internal research at our firm, that the average life of a venture financed client (from the time the company becomes a client until exit) is about 10 years. I also know from discussion with a VC friend that the average time to exit for companies in his portfolio is 8 years (at least that is what he is telling people). Remember, these are average numbers, so many investments take longer to get to exit. Also remember that our firm’s numbers reflect investments from a broad variety of VCs from the top tier to the little know funds. My friend is with a top tier firm, so their results may be somewhat better than those for the industry as a whole.

OK, so why waste time thinking about this number? Well, most funds have a ten year life. Ideally during that term, the fund is fully invested and fully liquidated. Most (all?) funds provide for extensions to liquidate laggard investments. Even still, limited partners in VC funds would like to get their return in ten years – that’s the plan.

If you know that your average time to exit is 10 years, then you know that investments made in years 3, 4, and 5 (let alone anything after that) are, on average, going to run way over. This accounts, in part, for the phenomena that many VC fundss will linger long after they are unable to raise new rounds.

But, it also may have an impact on investment style. Except in the earliest years of a fund, VCs will almost always be in the position of being under pressure to look for an exit. I am sure there are many ways in which VCs try to mitigate this pressure (doing follow on investments in new funds might be one, but that is a hassle for other reasons).

I suppose it is impossible to know how much pressure this situation exerts upon VCs to favor tightly defined business plans with a clear path to an exit over grander visions? I have commented elsewhere that VCs seem to me to favor narrowly focused tightly defined business plans that address clear pain points and have obvious exits. VCs also seem to me to have become very focused on domain expertise within their investment portfolios. This makes sense, why invest in something you don’t know about? But it also leads to a certain orthodoxy in the nature of investments.

In some sense the life of a normal fund is not suited to the life of a normal company. As a result, VCs are structurally driven to favor narrowly focused investments over grand visions.

  Eric Belsley from our office had this to add on the subject of accruing but non-cumulative dividends.  More concise and to the point than my post of Wednesday.

This is a relatively unusual provision. However, it would mean that although dividends accrue daily (and thus are computed when payable on a number of days in the year to date basis), the amount of such dividends is reset to $0 at the beginning of each year.

An interesting issue is the effect of this provision on payments made in liquidation and redemption. If the liquidation and redemption sections expressly refer only to "accrued and unpaid dividends" in addition to the principal amount, the company would have an argument that the non-cumulative nature of the dividend reduces the payout attributable to the accruing dividend in these events. This argument is much weaker if the liquidation and redemption sections expressly refer to the amount defined in the accruing dividend section, without referring to it as a "dividend."

For those of you who know Sim Simeonov, you won’t be surprised or disappointed. He has developed and posed on his site, fastignite.com , a set of start-up tools together with commentary. The tools are good; the commentary is better. The initial set of tools covers (1) calculating true pre-money valuation, (2) getting a better Series A deal, (3) a vesting calculator for options and restricted stock, and (4) option exercise and sale.

With respect to the true pre and post money valuation, Sim points out that Fred Wilson has an insightful post on this topic. I think I agree with what Sim and Fred say on the subject, but I also think it sounds more ominous than it is. Keep in mind that the investor is assuming you will have to spend equity to attract talent. This is analogous to having to spend money for capital expenditures. It has to be a budgeted cost and has to be "in the mix" when you negotiate your deal. Your investor will not overlook this "cost." It will be built into the investor’s valuation assumptions. You just need to look at it the same way. A company that needs to spend money to acquire and IP license is not going to get the same valuation as one that does not (all other factors being equal).

Sometimes I wonder why legal terms exist that have little or no practicable applicability – my clients wonder the same thing. Sometimes, these provisions really are ridiculous, but most of the time they cover off some eventuality that, although remote, actually could happen. The mere presence of the legal provision prevents the bad thing from happening, with the result that after some number of years, everyone starts to comment that whatever it is never happens and the lawyers have gone overboard. One example recently came to my attention: redemption provisions in venture investments. As everyone who plies these waters knows, a typical VC investment provides that, at the election of the investor, the company will redeem the investors stock after five years in three equal annual installments etc….  The purpose of these provisions, as I understand them, is to give the investor a way out of a landlocked investment in a life style company. In all my years of practice, I have never actually seen this provision at work. I think that is because long before anyone would actually pull the trigger on a redemption everyone sees it coming and something gets worked out. But, that begs the question of what would happen without the provision. So, here is a worthless provision (worthless in the sense that it never gets used) that actually serves its purpose – so well, in fact, that as a practical matter, the problem is extinct.

As I have noted on many occasions, one of the most common structures for angel investments is a note that converts into shares of a future round at a discount to the price in that round. While this has the advantage, among other advantages, of putting off the moment when a valuation of the company must be agreed to, one client has recently pointed out the flip side to this benefit is that it caps the investor’s upside during the period from the angel investment to the moment of conversion into the future round at an amount equal to the relevant discount. While few angels ever worry about this issue, the point is well taken, especially if you believe that the future investor will require your angel investor to give up some (all?) of her discount in connection with the new round. One possible way to work around the issue of a capped upside is to issue low priced warrants to the angel investor. For some reason, venture investors have less of a tendency to bother with warrants than they do with discounted conversions. Needless to say, using warrants raises a lot of issues including how to price them both in terms of actual dollars and as a percentage of the equity of the company. They also introduce another piece of documentation and therefore complexity and expense, which may be OK or not OK depending in part on how much angel money you are raising.

I recently had occasion to look back through the data we have gathered on the presence (or absence) of cumulative accruing dividends in New England transactions and noticed what appears to me to be an interesting pattern. According to our research, 55% of Series A transactions had cumulative accruing dividends ranging from 6% to 10% per annum (and, obviously, 45% did not have such dividends). But, only 33% of Series B and later round transactions had these dividends (and the rates ranged from 6% to 8%). So, 67% of later round financings did not carry dividends. The sample is small (covering under 100 transactions) but it is somewhat random and covers 2008 and the first quarter of 2009. So, maybe the results are just random. It seems odd that Series A deals are more likely to carry dividends than later stage deals. I am not sure what the reason could be, if the results of our survey reflect a trend. One possibility is that Series A deals are riskier than later deals and investors are trying to gross up their yield.

It being the middle of June the numbers for Q2 are about to come out, with the inevitable result that many new blog posts will be added to the blogosphere providing all kinds of analysis. Our firm contributes to this quarterly cacophony with our EEC Perspectives publication which analyzes what is going on in New England. When we started this publication, we gave some thought to what we could/should publish and from what base sources. So, we look at the quarterly data that we derive from mining VentureSource and various searches of Delaware filings. We analyze the data ourselves and make judgments about its quality and significance and try to turn it into useable information. The way we think about the data is as follows:

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Even in a field in which transactions are in many respects highly repetitive, as in the case of venture investments, and even when the parties agree upon a standard form for a starting point, there is still a lot to consider in any give deal. These considerations range from the most material (say valuation) to the annoyingly trivial (say nuances in the reg rights language). At some point in the proceedings when confronted with open issues, entrepreneurs ask what’s market?

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Bullying is not often seen in negotiation. I think this is because in many negotiations, the parties need to be able to work together after the negotiation is complete, and bullying just leaves a very bad taste in the mouth of the person who was bullied. Having said that, some negotiators take that tack and it can be hard to deal with if you really want the deal for some reason. The bully is, in effect, counting on your unwillingness to break up the deal to push you into all kinds of concessions.

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The venture industry has spawned a fairly standard set of legal forms. Sarah Reed, formerly general counsel to Charles River Ventures, was the primary moving force behind the forms project. I was one of the early participants along with representatives from many of the major venture funds and law firms that regularly practice in the venture space. This includes east coast and west coast firms.. The project is perhaps six or seven years old. The project has produces a comprehensive set of investment documents and the group meets annually to upkeep and improve the documents. These docs are publicly available on the NVCA web site. Perhaps the greatest testimony to the success of the forms project is that the forms have gained wide acceptance in the industry.

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In the context of angel investment, one question that I get on a regular basis is whether investments should be structured as preferred stock or convertible notes. As with every question that you ask a lawyer, the answer is "it depends." Here are some thoughts on the merits and demerits of each:

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With new rounds getting harder and harder to do and with valuations going down, certain preferred stock terms are taking on more significance than they normally do.  Weighted average antidilution is one of those terms.  It is so standard that very little thought is ever given to it. The effect of the antidilution provision is to disproportionately shift some of financial dilution to the common stockholders.

It is pointless to argue about the intellectual underpinnings of this practice, because the practice is universal among venture investors. Having said that, you need to understand how the weighted average antidulition formula works. You also need to understand the various flavors it comes in because some are better than others from the point of view of the common holders.

Finally, you need to understand what "full ratchet" antidilution is and how it works. This will be the subject of another post because the effect of this type of provision can be devastating to founders and I don’t want it to be lost in what is a long and turgid post on the subject of more normal antidilution provisions. Full ratchet is not commonly used, but it has its place, and it tends to become more used in difficult investment climates, such as the one we are in.

In general, weighted average antidilution has the effect of increasing the number of shares of common stock into which preferred stock can be converted if any shares of common stock or preferred stock (or other securities convertible into common stock) are sold by the company at a per share price below the conversion price of the preferred stock.

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In a recent board meeting for a client, one VC director described the current investment climate as follows:  "flat is the new up 50%."  Assuming he is right, and I think he probably is, several things follow.  Some of them are obvious.  Valuations are down; it is harder to get money than it was just a few months ago etc.

However, here is another prediction (perhaps it is obvious as well).  Certain deal terms that we have not seen since 2001 will start cropping up like mushrooms after rain.  Look out for full-ratchet antidilution provisions and multiple X preferences.  Also, you may want to review a section of your preferred stock that you may not have paid much attention to -- your antidilution provisions -- because they will be triggered by a down round.

Many entrepreneurs focus on pre-money valuation to the detriment of other economic terms that can be equally significant in a venture financing.  As you may have heard venture investors or others say before, "I'll let you pick the valuation as long as I get to pick all the other terms." This is because beyond the pre-money valuation, there are an infinite number of ways through other economic terms for the investors to extract their returns.

The pre-money valuation is used to determine the price per share that your investors will pay, but the idea that it is actually the valuation of the company instead of simply the customary method of determining a price per share in a financing is somewhat of a misnomer. A pre-money valuation of $5 million for a typical Series A deal on a $5 million venture investment really just means that the venture investor will be getting a 50% equity stake for the upside portion of its investment (after all the preferred terms have kicked in). For the company to really be worth $5 million pre-money in that scenario, the investor would be getting the exact same type of security (common stock) as what is already outstanding. The fact that your venture investors give you a pre-money valuation of $5 million certainly does not mean that you could sell the company for $5 million instead. In fact, as the 409A valuation models will show you, the common stock in such a situation is often valued at approximately 10-20% of the preferred. So the "real" pre-money value of the company in this scenario (at least in an "appraised value" sense) may be more like $500k to $1m.  Add to that the fact that the unallocated option pool will generally be 10-20% and come out of the pre-money valuation and you can see that the "real" valuation could be as low as even $300k in our scenario (applying a 10% common to preferred valuation and a 20% option pool).

Other key economic terms entrepreneurs should be looking at in addition to the pre-money value include:

• Does the preferred have a participation feature? If so, is it capped?
• What is the liquidation preference? Is it more than 1x? 
• What is the option pool and is it taken out of the pre-money valuation?
• What is the dividend rate and do they accrue and add to the liquidation preference?

Here are two scenarios that illustrate some of these terms. Scenario B has the higher pre-money valuation, but its pretty clear it is the less attractive offer to a startup.

Scenario A:
$5 million Series A investment
$5 million pre-money valuation
10% unallocated option pool (dilutive to pre-money)
1x liquidation preference
Non-participating preferred
No accruing dividends

Scenario B:
$5 million Series A investment
$6 million pre-money valuation
20% unallocated option pool (dilutive to pre-money)
1x liquidation preference
Participating preferred
10% accruing dividend added to liquidation preference

Right off the bat, the difference in the option pools means that the investors in Scenario B will actually pay a lower price per share and receive a larger piece of equity. In Scenario A, $1m of the combined $10m valuation is set aside for the unallocated option pool, leaving $4 million of the pre-money value for the outstanding equity of the company. In Scenario B, even though the higher pre-money valuation means a combined valuation of $11 million, $2.4 million is for the unallocated option pool, leaving $3.6 million for the outstanding equity of the company. So right off the bat, despite the higher pre-money valuation, the existing equity is 10% worse position. In our scenarios, even if all terms but the pre-money valuation and option percentage were the same, it would take a pre-money valuation of $6.667 million for the point at which Scenario B with a 20% option pool is economically equivalent to Scenario A with a 10% option pool.

I'll cover some of the other key economic terms and differences between Scenarios A and B above in future posts.