Venture Capitalists and Entrepreneurs: The Same – Only Different

Guest post by Paul A. Jones of Michael Best & Friedrich LLP

Venture Capitalists (VCs) and entrepreneurs are a poster child couple for the notion of the love-hate relationship. Any VCs who have been around the block more than a time or two is certain to have their stories of inept, dishonest, and/or overwrought entrepreneurs. Ditto any entrepreneurs who have spent any serious time courting or managing relationships with VCs. And yet, the VC/Entrepreneur nexus is the greatest innovation engine the world has ever seen. Go figure.

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Venture Capital Fundamentals: Three Basic Rules-Dilution, Dilution, Dilution

Written by: Joseph W. Bartlett, VC Experts Founder

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 securitiesoptions 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 a post-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 VCs still make out.


 

The Business Plan And Private Placement Memo

Since a private placement memorandum, usually abbreviated as the PPM, is the norm in most deals, the founder should familiarize himself with the standards for memorandum preparation, keeping in mind that, like any legal document, there are various audiences. The audience composed of potential plaintiffs (and, theoretically at least, the SEC enforcement staff) will read the document against the requirements contained in the cases imposing liability. The audience composed of investors will read the document for its substantive content: “What are the terms of the deal?” To professional investors interested enough to become potential buyers, the private placement memorandum is a handy collection of only some of the information they are interested in, plus a lot of surplus verbiage (the empty language about suitability standards, for example). To the issuer, it is a sales document, putting the best face possible on the company and its prospects. To the managers, the memorandum is a summary of the business plan. Indeed, it may incorporate the business plan as an exhibit or be “wrapped around” the plan itself—a memorialization of how the business is to be conducted.

The first page of the PPM, the cover page, contains some of the information one might see on the front of a statutory prospectus: name of the issuer, summary description of the securities to be sold, whether the issue is primary (proceeds to the issuer) and/or secondary (proceeds to selling shareholders), the price per share, the gross and net proceeds (minus selling commissions and expenses), and a risk factor or two (that is, the offering is “highly speculative” and the securities will not be liquid). Some would argue a date is important, because, legally, the document speaks as of a certain date. However, if the memo becomes substantively stale between the offer and the closing, it is critical that the issuer update and circulate it; omission of material information as of the closing is not excusable on the theory that the memo displays an earlier date. Moreover, a dated memorandum will appear just that—dated—if a few months elapse and the issue is still unsold. A related issue is whether to specify a minimum amount of proceeds that must be subscribed if the offering is to go forward. If the financing is subject to a “minimum,” a reference belongs on the cover page. It makes common sense that there be a critical mass in most placements; however, a stated requirement that X dollars be raised or all subscriptions returned inhibits an early-closing strategy—the ability to “close,” if only in escrow—with the most eager of the issuer‘s potential investors. Such “closings ” may not be substantively meaningful; the deal may be that the “closing” will be revisited if more money is not raised. However, a first closing can have a salubrious shock effect on the overall financing; it can bring to a halt ongoing (sometimes interminable) negotiations on the terms of the deal and create a bandwagon effect.

The cover page should be notated, a handwritten number inscribed to help record the destination of each private placement memorandum. It is also customary to reflect self-serving, exculpatory language (of varying effectiveness in protecting the issuer), that is:

1. The offer is only an offer in jurisdictions where it can be legally made and then only to persons meeting suitability standards imposed by state and federal law. (The offer is, in fact, an “offer” whenever and to whomsoever a court designates.)

2. The memorandum is not to be reproduced (about the same effectiveness as stamping Department of Defense papers “Eyes Only,” a legend understood in bureaucratese to mean, “may be important … make several copies”).

3. No person is authorized to give out any information other than that contained in the memo. (Since the frequent practice is for selling agents to expand liberally on the memo’s contents, it would be extraordinary if extraneous statements by an authorized agent of the issuer were not allowed in evidence against the issuer, unless perhaps they are expressly inconsistent with the language of the memo.)

4. The private placement memorandum contains summaries of important documents (a statement of the obvious), and the summaries are “qualified by reference” to the full documentation. (A materially inaccurate summary is unlikely to be excused simply because investors were cautioned to read the entire instrument.)

5. Each investor is urged to consult his own attorney and accountant. (No one knows what this means; if the legally expertised portions of the private placement memorandum are otherwise actionably false, it would take an unusually forgiving judge to decide the plaintiff should have obeyed the command and hired personal counsel.)

6. The offering has not been registered under the ’33 Act and the SEC has not approved it.

The foregoing is not meant as an exercise in fine legal writing and the avoidance of excess verbiage. Certain legends are mandatory as a matter of good lawyering—a summary of the “risk factors”; a statement that investors may ask questions and review answers and obtain additional information (an imperative of Reg. D); and, of course, the language required by various state securities administrators. A recitation tipping investors that they will be required in the subscription documents to make representations about their wealth and experience is generally desirable, particularly in light of cases finding against plaintiffs who falsified their representation. However, in my opinion, a cover page loaded with superfluous exculpations may cheapen a venture financing, signaling to readers that the deal is borderline, in a league with “double write-off” offerings in the real estate and tax-shelter areas.

A well-written private placement memorandum will follow the cover page with a summary of the offering. This section corresponds to a term sheet, except that the language is usually spelled out, not abbreviated. The important points are covered briefly: a description of the terms of the offering, the company’s business, risk factors, additional terms (i.e., anti-dilution protection, registration rights, control features), expenses of the transaction and summary financial information. The purpose of the summary is to make the offering easy to read and understand. As stated, suppliers of capital are inundated with business plans and private placement memoranda; the sales-conscious issuer must get all the salient facts in as conspicuous a position as possible if he hopes to have them noticed.

At this juncture, it is customary to reproduce investor suitability standards, identifying and flagging the principal requirements for a Reg. D offering, that is, the definition of “accredited investor.”

Issuers should approach offerings that have stated maximums and minimums with caution. The SEC has made its position clear. If the issuer elects to increase or decrease the size of the offering above the stated maximum/minimum, each of the investors who have signed subscription agreements must consent to the change in writing. It is not open to the issuer to send out a notice to the effect that “We are raising or lowering the minimum and, if we do not hear from you, we assume you consent.” The issuer must obtain the affirmative consent of each investor, which may be a bit difficult if the investor is, at that point, somewhere in Katmandu.

Investors should be aware that issuers sometimes do not want the investors to know certain information. For example, some issuers elect to code the numbers on the private placement memorandum so that no investor knows he is receiving, say, number 140; he is, instead, receiving “14-G.”

Finally, the current trend is to prepare both a full placement memo as well as a brief summary, such as the so-called “elevator pitch”, a concise summary that can be read while riding in an elevator. Venture capitalists are chronically short on time and a 40-page document is likely to be left unread if this is the only pitch material available.

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 stage investments 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 a post-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 VCs still make out.


For more information about raising Private Equity & Venture Capital, please visit VC Experts

What Will VC’s Want For A Security: Common Stock? Preferred Stock? Debt? Warrants?

Written by: Joseph W. Bartlett/VC Experts Founder

As one programs any financing, as in corporate finance generally, the objective is to make 2 + 2 = 5; that is to obtain added value for the issuer. In the course of a financing, the insiders are attempting to raise the maximum amount of money for the minimum amount of equity (“equity” meaning claims on the residual values of the firm after its creditors have been satisfied). A corporation will issue at least one class of common stock because it must; many firms stop there; they pursue the simplest capital structure possible in accordance with the KISS principle (“Keep it Simple, Stupid”). However, in so doing, the corporation may close down its chances to pursue the added-value equation (2 + 2 = 5) because that equation involves matching a custom-tailored security to the taste of a given investor. The top line of the term sheet will ordinarily specify the security the VCs opt to own; the following discussion takes up the most common possibilities.

Different investors have differing appetites for various combinations of risk and reward. If a given investor has a special liking for upside potential leavened with some downside protection, the investor may “pay up” for a convertible debt instrument. An investor indifferent to current returns prefers common stock. The tax law drives some preferences, since corporate investors must pay tax at full rates on interest but almost no tax on dividends. On the other hand, the issuer of the security can deduct interest payments for tax purposes–interest is paid in pre-tax dollars–but not dividends. The sum of varying preferences, according to the plan, should be such that the issuer will get more for less–more money for less equity–by playing to the varying tastes of the investing population, and, in the process, putting together specially crafted instruments, custom made as it were. A potential investor interested in “locking in” a return will want a fixed rate on debt securities instead of a variable rate; the ultimate “lock-in” occurs in a zero coupon bond, which pays, albeit not until maturity, not only interest at a fixed rate but interest on interest at a fixed rate.

As the practice of tailoring or “hybridizing” securities has become more familiar and frequent, the traditional categories can become homogenized. Preferred stock may come to look very much like common stock and debt resembles equity. In fact, the draftsmen of the Revised Model Business Corporation Act no longer distinguish between common and preferred stock. Moreover, it may be advantageous (again with a view to making 2 + 2 = 5) to work with units or bundles of securities, meaning that an investor will be offered a group of securities, one share of preferred, one debenture, one share of common, and a warrant, all in one package.

Indeed, creativity by sponsors has spawned a variety of novel “securities,” equity and debt, which have played a role in venture capital, the underlying notion being to maximize values by crafting instruments to fit the tastes of each buyer and to capture current fashions in the market. The use of “junk” or “fluffy debt has been the focus of popular attention of late; however, junk bonds debt securities which are less than investment grade and, therefore, unrated are only one species of the complex phyla of hybrid securities invented by imaginative planners. Thus, a given issuer‘s financial structure can perhaps be best envisioned by thinking in terms of layers of securities. The top layer is the most senior: usually secured debt, “true” debt in the sense that the holder is opting for security of investment and “buying” that security by accepting a conservative rate of return, a fixed interest rate, or a variable rate tied to an objective index. The bottom layer is the most junior: common stock (and if the common stock is divided into different series, the most junior series); on occasion, this level is referred to as the “high-speed equity.” The risk of a total wipeout is the greatest, but, because of the effects of leverage, so is the reward. In between are hybrids, layers of securities with differing positions, meaning differing claims on Newco‘s current cash flows and the proceeds of a sale or liquidation of the entire enterprise.

The variables open to the planners include the following:

  • a security can be denominated either debt or equity with different tax consequences to both the issuer and the holders;
  • a security may be senior, or subordinated, or both, as in senior to one level and subordinate to another (the term “subordinated” opens, in and of itself, a variety of possibilities);
  • a security may be convertible into another at a fixed or variable rate of exchange (and convertible over again, as in debt convertible into preferred stock, in turn convertible into common);
  • an equity security may contemplate some form of fixed recoupment of principal, perhaps expressed in terms of a redemption right;

Redemption can be at the option of the issuer, the holder, or both; and the issuer‘s obligations to make periodic payments with respect to a debt security can range from the simple to the exotic–monthly interest payments at a fixed rate to so-called PIK payments (payment in kind, meaning in stock versus cash) tied to the performance of a particular business segment (as in “alphabet stock”). The utility of this structure is that it gives Newco time to fulfill the promises in its pitch book.

All that said, in today’s universe, the market standard is common stock to the founder founders, plus the friends and family. The next round, with the exception noted, is convertible preferred stock. The jump balls are participating versus non-participating, cumulative dividends, etc. But the security is convertible preferred, even in the angel round, which used to be common. The exception is a convertible note in the bridge round, next round pricing. See the Buzz article, The Next Round Pricing Strategy.

For more information on Venture Capital and Private Equity, please visit VC Experts.

The Entrepreneur’s Shares: A Balanced Approach To Founder’s Equity

Guest post by Daniel I. DeWolf, Evan M. Bienstock, Samuel Effron, and Ilan Goldbard – Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C.

When accepting money from outside investors, entrepreneurs are generally asked to give up some degree of control over their start-up, exchanging equity in their company for cash. In an effort to minimize the control they relinquish, upon formation of their company entrepreneurs can grant themselves equity that comes with special rights. These rights, such as special voting privileges or guaranteed board seats, allow founders to maintain control of their company in spite of a dwindling ownership percentage. They may also include special rights that make it possible for a founder to cash out some of his equity prior to an IPO or other exit event.

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