Fair and Not Fair in Deal Terms

Posted on February 15, 2010 by Dave Broadwin

I have been thinking of the NVCA meeting of the forms group that I attended in LA last week. One of the themes of this group has been to make the NVCA forms even handed. The forms are not intended to be either investor friendly or entrepreneur friendly. They are intended to represent a fair compromise of the issues that are inherent in any VC investment. They are also intended to be consistent with current market practices. So, if the market has evolved in a direction that seems unbalanced, well, the form reflects market practices. In the areas where practice is variable, the forms either provide alternative provisions or make reference to differences in footnotes.

One good example of how the NVCA forms try to balance fairness and current practice is in the area of founder representations. Founder representations are rare (extremely rare) in west coast deals but appear with some frequency in east coast deals. In general, the trend is away from founder reps. So, the forms (in their next iteration) will provide a footnote explaining this (and going through the limitations commonly seen in connection with founder reps, when they appear).

Having said this, to the extent that there are obvious areas of unfairness that have found their way into regular market practices, then the forms just reflect the prejudices of the market. One example of this is the ubiquitous presence of weighted average antidilution provisions. I believe that (with the exception of deals that have full ratchet provisions – far worse for entrepreneurs) all VC investments have weighted average antidilution provisions. Despite what I am about to say, don’t try to get these provisions out of VC docs; you will fail and will waste time, resources, and will leave an impression that you are difficult to deal with.

How can anyone justify antidilution? As far as I can tell the reasoning is that it is up to management to increase shareholder value. If management fails to do this, the argument goes; they should take a hit for that failure. As far as it goes, that argument has some merit.

If we agree with this argument, how do we deal with the effect of antidulition provisions on common stockholders other than management (angel investors for example). By the way, management is often holding options, and they are often "topped up" with more options. In effect, the people who suffer the ill effects of antidilution are not the people who are responsible for the performance of the company.

If you get past the issue I just described, how do you deal with declines in shareholder value that are not due to poor management? For example, what if there is a world-wide recession that affects all businesses, without regard to the quality of management? What justification is there to put greater risk of macro-economic events on management (or the common holders) than on investors?

Let me be clear, if you try to get antidilution provisions out of VC investment docs, you will (a) fail and (b) cause people to think that you are weird. So don’t try.

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NVCA Forms Project

Posted on February 12, 2010 by Dave Broadwin

For the first time in several years, I was able to actually attend (as opposed to sign up for and then not be able to go) the annual meeting of lawyers and VC in-house counsel that was organized by Sarah Reed  (of Charles River) long ago to develop what are now the NVCA document forms. In my view, this is one of (perhaps the) most successful forms projects ever undertaken. We are about to publish EEC Perspectives for Q4 (the link is to Q3, but Q4 will be available in the next day or so) and year end. It will show very high continued adoption rates.  For those of you who are not familiar with these forms, they are an annotated set of series A deal documents.  They are a great resource for any entreprenuer trying to understand what is in the docs and what is "market".

Based on comments at the meeting, there will be some modest revisions to the documents. Perhaps the most noteworthy is that we will be going back to the future: The next round of forms will (when done) include an additional form of charter with a pay-to-play provision. If my memory serves me well, we included pay-to-play when we did the original version of the charter seven or eight years ago (can it really be that long ago?).

Another noteworthy discussion revolved around whether or not registration rights should be deleted from the forms. They won’t be – at least not this time. Let’s hope that by the time this group meets again next year, there will have been a few (more than a few) IPOs and everyone will start feeling like reg rights are important after all, even if rarely used.

One final note, Ted Wang from Fenwick, discussed model seed series financing documents (based on the NVCA docs) that he prepared and will be making publicly available. This is another great project and great service to the entrepreneurial community.

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More on Adoption Rates

Posted on November 17, 2009 by Dave Broadwin

To follow up on comments on my post of a couple days ago and based solely upon our published numbers (which does not include all the transaction that we track),  77% of Series A investments tracked by us used the NVCA forms and 22% did not.   If I add unpublished data the adoption rate is slightly higher.  With respect to Series B and later stage investmens based solely upon our published numbers, 58% of transactions used the NVCA forms and 42% did not.  Again, if I add unpublished data the adoption rate becomes slightly higher.

The increase from 58% of Series B and later stage transactions to 77% of Series A transactions suggests that, at least in New England, the NVCA forms are gaining increasing acceptance. 

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NVCA forms Adoption Rate

Posted on November 10, 2009 by Dave Broadwin

I had lunch with Sarah Reed ,of Charles River Ventures, who was the moving force behind the NVCA forms project, and our discussion got onto the subject of adoption rates for the NVCA forms.  This harkens back to some old posts I have on the subject of forms.  This inspired me to go back and look at some research our firm had done (a portion of which is published in EEC Perspectives) and calculate the actual adoption rate in New England deals.  Based  on a somewhat random unscientific sample of more than 140 VC investments over the last two years, the actual adoption rate for investments that we looked at is 64.54% used the NVCA forms and 35.46% did not.  The transactions selected for analysis were drawn primarily from a search of the Dow Jones VentureSource data base. The sample included only a small number of transactions handled by our firm and, I believe, includes a broad selection of Boston based (and other) law firms and venture funds.  Based upon what I know of the practices here in Boston, I suspect that this "survey" if you can call it that, understates the level of adoption.   

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All Hail Morty

Posted on June 17, 2009 by Dave Broadwin

Last week I noted that Fred Wilson had the last word on what is "standard" and quoted a paragraph from his blog. The gist of the quote was that you need to be able to articulate a reason for the "standard" provision you want. (By the way, often things get to be standard because they address some important and recurring issue.)

Recently I ran into this little conundrum: an investor client agreed in a term sheet that he would get (in a liquidation event) the greater of a 4x capped participation or what he would get upon conversion into common stock. Well, we served up a draft with the NVCA standard term that embeds in the certificate of incorporation a provision that says in a liquidation event, the company will make distributions to give effect to this arrangement without the bother of having to convert.

Counsel for the issuer objects along the following lines "am inclined to remove it as it's not a standard provision that I have seen in certificates. I think it also tends to unduly burden the holders of common in an acquisition scenario." This works its way up to me as a "deal point." So my question to opposing counsel was something along the following lines, "Do you really think that the business people think that the investor has signed on to buy the right to guess whether conversion or non-conversion will provide the greater return or to actually be assured of getting the greater return?"

That issue went away. All hail Morty.
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More thoughts on understanding what is market

Posted on June 15, 2009 by Dave Broadwin

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:

We look at the gross number of deals that were done in New England by category in the period. So we look at Series A deals and then later stage deals. One thing to think about is the simple number of deals done in the period compared to the prior year period and the preceding period. One measure of robustness would be whether or not the number of deals is increasing.

But, simple numbers are not enough. For example, what if there are a lot of deals, but they are all down rounds. It turns out that we can determine this. If I am not mistaken, we are the only source that researches this fact and publishes objective data on it. What if there are a lot of Series B and later stage deals but relatively few Series A deals. At the risk of stating the obvious, increasing numbers of deals and rising valuations for later stage deals indicate strength in the market.

By the way, we also look at it by industry sector and by size of investment.

Some of these larger trends suggest what other data might be. By way of example, in a robust market (increasing numbers of deals and increasing valuations) you would expect certain terms, such as the number of deals with participating preferred stock, would decline. (A robust market, I think, implies greater bargaining power for entrepreneurs, hence more favorable deal terms.) For this reason, we also track and report on deal terms, such as how many deals have participation, how many have dividends etc.

One thing is that you need a very broad sample to be comfortable that you understand the market. We don’t look at every deal, or perhaps I should say we don’t report on every deal we look at. However, we have been doing this for 18 months and are now starting to feel that we have enough data and historical information to come to meaningful conclusions about where we are at the end of any given quarter.

Another thing is gut instinct and anecdotal evidence. To feel comfortable that you have your finger on the pulse, all these inputs should be pointing in the same direction. Right now, my sense is that the market is confused. Anecdotal evidence suggests that there are still a lot of down rounds and low valuations but the same instinct says that there are a lot of new Series A deals – which suggests increased activity. I am looking forward to the end of June to take a good look at the numbers. Separately, if you want to be on the email list for EEC Perspectives, send me an email and we will add you to our distribution.
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Following up on standards and forms

Posted on June 8, 2009 by Dave Broadwin

My post on the NVCA forms and levels of adoption did get one comment, which I did not get to releasing until yesterday because it got buried under an avalanche of work related email. The gist of the comment is that adoption levels for the NVCA forms are way lower on the west coast than the east coast – Yokum Taku (of Wilson Sonsinni) suggests in the 5% to 10% range. Our firm does not track west coast deals for the obvious reason that our home base is Boston. So, I don’t have a basis for disagreement with Yokum Taku. Having said that, I believe there are huge efficiencies in using widely accepted agreed upon forms in a field in which so much is basically repetitive and in which efficient use of resources is so important. I find myself surprised that competitive pressures and the ever increasing need to provide cost efficient services has not driven west coast firms in this direction as much as it appears to be doing in New England.

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