Three Basic Rules: Dilution, Dilution, Dilution

Take a sample of 100 venture-backed companies successful enough to undertake an initial public offering. In a high percentage of the transactions, the prospectus discloses that the earliest stage investors (founders and angels) wind up with close to trivial equity percentages and thus, puny returns on their investment in the company. One would think that these investors are entitled to the lushest rewards because of the high degree of risk accompanying their early stage investments, cash and/or sweat. The problem, however, is dilution. Most early stage companies go through multiple rounds of private financing, and one or more of those rounds is often a “down round,” which entails a disappointing price per share and, therefore, significant dilution to those shareholders who are not in a position to play in the later rounds.

The problem of dilution is serious because it has a dampening impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. Estimates put the relationship of angel capital to early stageinvestments by professional VCs at five dollars of angel capital going into promising start ups for every one dollar of VC investment. But if angels are increasingly discouraged by the threat of dilution, particularly since the meltdown, we don’t have much of an industry; there is no one to start the engines. [1]

There are a variety of fixes for the dilution issue open to founders and angels.

  • Make sure you enjoy pre-emptive rights, the ability to participate in any and all future rounds of financing and to protect your percentage interest. Pre-emptive rights can be, of course, lost if you don’t have the money as founders and angels often do not to play in subsequent rounds.
  • Try to get a negative covenant; this gives you a veto over the subsequent round and particularly the pricing of the terms.

You don’t want to kill the goose of course, meaning veto a dilutive round and then once the Company fails for lack of cash; however, a veto right at least will you the opportunity to make sure the round is fairly prices; that the board casts a wide enough net so that the round is not an inside trade; meaning that the investors in control of the Company, go over in the corner and do a deal with themselves. Those rounds can be highly toxic to the existing shareholders (cram downs, as they are called). Finally, if you don’t have cash try to upgrade your percentage interest with derivative securities, options and warrants (a warrant is another word for option, they are the same security, a call on the Company’s stock at a fixed price but options are if the call was labeled if an employee is the beneficiary is the holder and the warrants are for everyone else). If you are the founding entrepreneur therefore, make sure you are a participant in the employee option program. Often the founder will start off with a sufficient significant percentage of the Company’s equity that she doesn’t feel necessary to declare herself eligible for employee options. This is a major mistake. In fact, I am likely to suggest founder client consider a piece of financial engineering I claim to have invented; the issuance of warrants in favor of the founders and angels at significant step-ups from the current valuation, which I call ‘up-the-ladder warrants.’ To see how the structure works, consider the following example:

Let’s say the angels are investing $1,000,000 in 100,000 shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post money valuation of $4 million ($1 million going into the Company). We suggest angels also obtain 100 percent warrant coverage, meaning they can acquire three warrants, totaling calls on another 100,000 shares of the Company’s stock; however not to scare off subsequent venture capitalists or, more importantly, cause the VCs to require the warrants be eliminated as a price for future investments. The exercise prices of the warrants will be based on pre-money valuations which are relatively heroic win/win valuations, if you like. For the sake of argument, the exercise prices could be set at $30, $40 and $50 a share (33,333 shares in each case).

Let’s use a hypothetical example to see how this regime could work. Since the angels have invested $1 million at apost-money valuation of $4 million, they therefore own 25 percent of the Company–100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares. Subsequent down rounds raise $2,000,000 and dilute the angels’ share of the Company’s equity from 25 percent to, say, 5 percent–their 100,000 shares now represent 5 percent of 2,000,000 shares (cost basis still $10 per share) and the down round investors own 1,900,000 shares at a cost of $1.05 per share. Assume only one down round. Finally, assume the Company climbs out of the cellar and is sold for $100 million in cash, or $50 per share.

Absent ‘up-the-ladder warrants,’ the proceeds to the angels would be $5 million–not a bad return (5x) on their investment but, nonetheless, arguably inconsistent with the fact that the angels took the earliest risk. The ‘up-the-ladder warrants‘ add to the angels’ ultimate outcome (and we assume cashless exercise or an SAR technique, and ignore the effect of taxes) as follows: 33,333 warrants at $20/share are in the money by $666,660 and 33,333 warrants at $10 a share are in the money by $333,330. While the number of shares to be sold rises to 2,066,666, let’s say, for sake of simplicity, the buy-out price per share remains at $50, meaning the angels get another $999,999–call it $1 million. The angels’ total gross returns have increased 20 percent while the VCs’ returns have stayed at $95,000,000. Even if the $1,000,000 to the angels comes out of the VC’s share, that’s trivial slippage … a gross payback of 47.5 times their investment, vs. 47 times. If the company sells for just $30 a share, the angels get nothing and the VC’s still make out.

How Venture Capitalists Talk

Joseph W. Bartlett

This post reviews basic terminology commonly used in the venture world. First, the entities into which capital sources are aggregated for purposes of making investments are usually referred to as “funds,” “venture companies,” or “venture partnerships.” They resemble mutual funds in a sense but are not, with rare exceptions (AR&D was one), registered under the Investment Company Act of 1940 because they are not publicly held and do not offer to redeem their shares frequently or at all. The paradigmatic venture fund is an outgrowth of the Greylock model, a partnership with a limited group of investors, or limited partners, and an even more limited group of managers who act as general partners, the managers enjoying a so-called carried interest, entitling them to a share in the profits of the partnership in ratios disproportionate to their capital contributions. Venture funds include federally assisted Small Business Investment Companies (which can be either corporations or partnerships) and, on occasion, a publicly held corporation along the AR&D model, styled since 1980 as “business development corporations.” This book, following common usage, will refer to any managed pool of capital as a “fund” or “partnership.”

Once a fund makes an investment in an operating entity, the fund or group of funds doing the investing are the “investors.” A company newly organized to exploit an idea is usually called a “start up,” founded by an individual sometimes referred to as the “entrepreneur” or the “founder.” Any newly organized company, particularly in the context of a leveraged buyout (LBO), is routinely labeled “Newco.” The stock issued by a founder to himself (and his key associates) is usually sold for nominal consideration and those shares are labeled “founders stock.” (The use of the male gender is used throughout for ease of reference only.) The founder, as he pushes his concept, attracts professional management, usually known as the “key employees.” If his concept holds particular promise he may seek from others (versus providing himself) the capital required to prove that the concept works—that is, the capital invested prior to the production of a working model or prototype. This is called “seed investment” and the tranche is called the “seed round.” Each financing in the venture process is referred to as a “round” and given a name or number: “seed” round, “first venture” round, “second” round, “mezzanine” round, and so forth.

Once the prototype has been proven in the lab, the next task ordinarily is to place it in the hands of a customer for testing—called the “beta test” (the test coming after the lab, or “alpha,” test). At a beta test site(s), the machine or process will be installed free and customers will use and debug it over a period of several weeks or months. While the product is being beta tested, capital is often raised to develop and implement a sales and marketing strategy, the financing required at this stage being, as indicated above, “the first venture round.”

The next (and occasionally the last) round is a financing calculated to bring the company to cash break-even. Whenever a robust market exists for initial public offerings this round is often financed by investors willing to pay a relatively high price for the security on the theory that their investment will soon be followed by a sale of the entire company or an initial public offering. Hence, this round is often called the “mezzanine round.” A caution at this juncture: The term “mezzanine” has at least two meanings in venture-capital phraseology. It also appears as a label for junior debt in leveraged buyouts. In either event, it means something right next to or immediately anterior to something else. As used in venture finance, the financing is next to the occasion on which the founder and investors become liquid—an initial public offering (IPO) or sale of the entire company. As indicated earlier, the measures taken to get liquid are categorized as the “exit strategies.”

One of the critical elements in venture investing is the rate at which a firm incurs expenses, since most financings occur at a time when the business has insufficient income to cover expenses. The monthly expense burden indicates how long the company can exist until the next financing, and that figure is colorfully known as the “burn rate.”

Cloudcade’s Harsh Series-A Term Sheet

Following up from last Thursday’s blog post about certain deal terms that entrepreneurs and employees at startups should become familiar with, our analysts found an interesting scenario with the October 2014 Series-A financing for Cloudcade, Inc. Founded in late 2013, Cloudcade is a free-to-play mobile games developer with a tablet-first approach towards deployment. Since inception, Cloudcade has assembled an all-star team with extensive experience in the gaming industry and an undying passion for creating the next generation of mobile entertainment. While its games will be optimized to be played on tablet devices, the company aims to bring gaming to the next level by releasing cross-platform on mobile, web and TV to allow users to play synchronously across any platform around the world.

Over the years, we’ve analyzed thousands of term sheets from venture capital financings in our Intelligence database. Most of the time, you tend to see investor friendly deal terms in later stage financings or in Healthcare/Biotech/Medical Device investments. With Cloudcade, however, this was their first round of institutional money in the booming “gaming” industry. IDG Ventures invested $1.5mm into the company in October 2014, with the following terms:

  • Round: Series A
  • Liq. Pref.: Not Applicable
  • Liq. Multiple: >1 – 2x
  • Stock Type: Participating Preferred
  • Capped Participation: No
  • Anti-Dilution: Full Ratchet
  • Redemption: Yes
  • Cumulative Dividends: No
  • Dividend Rate: 8%
  • Pay to Play: No
  • Reorganization: No
Notice the “Full Ratchet” Anti-Dilution provision? “Full Ratchet” (sometimes called “Ratchet”) Anti-dilution provisions reduce the effective per share purchase price of the investor’s shares purchased in a round to the actual, lower price set in a later offering or event (for example, a subsequent financing round or issuance of shares as consideration for a transaction) thereby raising the number of shares of Common Stock into which the investor’s Preferred Stock will convert. Full Ratchet is more favorable for the investors who receive it and can result in significant dilution for founders and other holders of Common Stock in the event of a Down Round. “Vanilla”, or company friendly, terms have been the norm for Silicon Valley early stage financings as of late. With IDG publicly  professing their appetite to invest in gaming companies, what could be the reason(s) for the harsh terms so early in the capital infusion process?


Doing Deals With A Non-U.S. Investor Or Buyer

Guest Post by Nancy Yamaguchi, Partner, Withers LLP

Every company, big and small, must operate globally these days because there are business opportunities and investors all over the world. In the previous years, venture capital investment seemed most active in the U.S., and the venture capitalists on Sand Hill Road in Silicon Valley were dominant players in providing early stage funding to successful companies such as Google and Cisco. As for an exit strategy, the typical path for almost every startup in the U.S. was an initial public offering (IPO) on Nasdaq or a sale to a large public company in the U.S. Today, we are seeing a lot of activity in Asia in terms of venture capital investment and acquisition of startups, and there are more and more venture capital investors in Asia, especially in Hong Kong, Singapore and Japan, as well as private investors in Europe, especially in the U.K., Norway, Finland and Denmark. Granted, these locations where we are encountering investors and buyers may be as a result of my firm’s presence or client base there, but nevertheless, the fact is that there is a new trend. This trend is that many of the U.S. technology startups and entrepreneurs are closing more deals with investors, buyers, customers and partners outside of the U.S. Any startup company in the U.S. currently seeking financing or looking to be acquired should not preclude themselves from financing sources outside of the U.S. or being acquired by a non-U.S. buyer, and as long as they are prepared to think “outside of the box” and adapt to other business cultures and legal systems, they would be well-advised to think globally and act globally.

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Beware the Non-Disclosure Agreement (“NDA”)

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Any number of private equity transactions begin with the execution of a confidentiality or non-disclosure agreement (“NDA”). Assume a venture capitalist is investing in the private equity of an early stage firm, or two venture-backed companies are discussing a merger. The usual protocol insists that, before due diligence commences, each of the parties (in the case of a merger, particularly if stock is the consideration) or the issuer (in the case of a venture investment) seek to protect their confidential information by requesting the other party to execute an NDA.

Any number of private equity transactions begin with the execution of a confidentiality or non-disclosure agreement (“NDA”). Assume a venture capitalist is investing in the private equity of an early stage firm, or two venture-backed companies are discussing a merger. The usual protocol insists that, before due diligence commences, each of the parties (in the case of a merger, particularly if stock is the consideration) or the issuer (in the case of a venture investment) seek to protect their confidential information by requesting the other party to execute an NDA.

Amongst many practitioners, the NDA is viewed as a formality or “boilerplate” language. However, there is no such thing in the law as “boilerplate” if, by that label, one means language which has insufficient significance to be interesting to the parties. In my experience, any misplaced or ill-advised word in an agreement can, in accordance with Murphy’s Law, be given a meaning and interpretation which confounds at least one of the parties to the transaction.

Moving to the NDA (assume we are discussing a merger in which both parties are executing an NDA prior to commencement of due diligence), there are a variety of issues which should be considered … even if a “standard” model agreement is the template from which the parties are working. First, in most deals one party to the transaction (usually the target), is undertaking a much greater risk in the event of an abort than the other. The target, by entering into negotiations to sell itself, is sending a signal to its employees and its customers (and perhaps its vendors and creditors) that it is going to be under new management … management which is perhaps unknown and maybe even offensive to the individuals and firms concerned. A lot of key employees start looking for the exit when they learn their company is being sold. Nothing can be worse for the target’s shareholders than suffering that loss of critical talent and then not winding up with the pot of gold at the end of the rainbow.

With that in mind, some of us like to view the NDA process as segmented into at least two phases. In the first phase, when the parties are simply flirting with each other, the target or the issuer will disclose only enough confidential information to whet the appetite of the counterparty to the transaction. The best way to keep information confidential is to not disclose it in the first instance, particularly if the NDA suggests (as it usually must) that the counterparty is privileged not only to review the confidential information itself but to share it with its agents (say, the financial adviser), its lawyers and its accountants on a so-called “need-to-know basis.” As the circle of informed parties widens, the risk of a leak increases geometrically. Accordingly, and consistent with the target’s or issuer’s posture of keeping its powder dry, there may be two NDAs or at least a segmented NDA covering two tranches of information. The party atrisk will lift the curtain only so far initially, and then wait until the definitive agreement has been signed before exposing the entire tranche of information the other party needs. This entails a risk, of course, of the definitive agreement having a due diligence “out,” which is not good news (generally) for the party most at risk. Accordingly, one solution is to make disclosures in escrow. If the information is particularly sensitive it is disclosed to an independent expert and only to that independent expert, who in turn can satisfy the counterparty that, say, the trade secrets are what they are represented to be.

Secondly, a question the target has to think through very carefully is what kind of access, NDA or no NDA, the other party can be afforded to, say, its key technical people and/or its customers. Sometimes quite elaborate protocols have to be built so that neither the executives nor the customers are spooked. Perhaps, only one individual from the other side is allowed to make those inquiries … and then only in the company, or with foreknowledge, of a specified contact person at the target, so that the executives and customers can be conditioned in advance and not surprised by the inquiry.

Although the concern is not as great as it was some years ago when some maverick judges were (see the Texaco, Getty, Pennzoil litigation) wont to construe any writing as implying some sort of obligation to conclude a transaction, the NDA should make it clear that there is no obligation of any sort (express or implied, good faith or bad faith) to proceed to a final, definitive agreement. The NDA is not the place for an obligation to bargain in good faith; in order to avoid an eccentric interpretation, that language should be stated in the most comprehensive and direct fashion.

The next remark is prompted by an NDA which I recently reviewed. The parties in an otherwise well drafted NDA imported a provision that the contract could be assigned by either party without the other’s consent. That is totally inconsistent, at least in most circumstances, with the spirit of an NDA. It is hard enough to police a confidentiality agreement when you know with whom you are dealing; if the other guy turns out to be a stranger to the initial transaction, the issuer/target’s policing power can become totally ephemeral.

In this document, there is also typical language that neither party will solicit nor (indeed) “contact” any of the customers, vendors or employees of the other. This is designed to prevent the recipient of the confidential information from swiping valuable business relationships once the metrics of the same have been disclosed. However, the mistake was to use the verb “contact” without conditioning the clause. Obviously, any party may come into “contact” with an employee, vendor or customer of any other party in the ordinary course of its business. This obligation, therefore, has to be limited to “contacts” which are somehow related to the financing or the acquisition; otherwise the clause can be inadvertently violated.

Finally, the agreement I am looking at talks about the obligation, if the transaction does not go forward, to restore and/or destroy, any “writings,” including informal memoranda, which contain confidential information. Confining the obligation to disgorge “writings” (including notes and memoranda) is “Old Economy.” In the New Economy, it is necessary to enhance the term “writings” by including e-mails and other memorials of confidential information which exist only in cyberspace.

One last substantive point before leaving NDAs; the VCs will not sign them, at least until a term sheet has been signed. They are paranoid, and rightly, that an ultimately disappointed entrepreneur will claim his or her trade secrets have been misappropriated when another company in the VC’s portfolio starts or continues to compete with the disappointed firm. The VCs have a lot of irons in the fire, maybe in companies closely resembling the entrepreneur’s. Thus, I advise my issuer clients … keep your core secrets to yourself; forget about an NDA and protect yourself by telling the VCs only enough to get the hook sunk in the soft part of their mouths.

Some of these remarks may appear to be quibbles: but there are a number of cases in which NDA violations, on occasion inadvertent, have been the subject of heated litigation. The fact is that, in today’s economy, the assets of many firms are almost entirely intellectual property, and particularly intellectual property protected as a trade secret. If the trade secret becomes public knowledge it, of course, loses its value. Thus, the stakes are very high in drafting NDAs and putting into effect protocols and procedures which allow each party to supervise very carefully and nip in the bud potential violations. On the other side of the coin, if the deal doesn’t happen, one must be careful not to have been “contaminated” by information, meaning accepting disclosure of information you already own … and plan to use in your business.


Attention Startup Employees – Because of These, Your Options May Be Worth NADA

Congratulations! You landed a job at a fast-growing, covered in the media weekly (if not daily), company that has caught the attention of the world’s leading Venture Capital firms. As part of your compensation package, you were issued “equity” in the company, coming in the form of stock options. Sitting pretty, right? For the newcomer to the game, think again. While those options on paper have value, employees at startups need to be mindful of protective clauses investors inserted into the deal docs (AKA: Term Sheet), that could potentially wipe any value away from those options.

Venture Capital investors pride themselves on investing in world-class companies, burgeoning with world-class employees. Greed aside, they also pride themselves on the returns they provide the Limited Partners who ponied up the cash that enabled them to invest in the first place. Here’s a list of key terms that startup employees should monitor as their company raises capital. To see what affect they may have on their stock options in the future, monitor those terms here:

Additionally, investors who don’t have access to information rights may also want to monitor future financing terms. Did you know companies such as Uber, SpaceX, Aliphcom, Bit9, and many others received investor-friendly terms as part of their financings? With companies staying private longer, will more investors consider favorable terms in future financings?

Read more on Stock Options, Term Sheets, and Venture Capital finance in VC Experts Encyclopedia.