Three Basic Rules: Dilution, Dilution, Dilution

Written by Joseph W. BartlettVC 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 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.

[1] Williams, “Community Development Venture Capital: Best Practices & Case Studies,” (Jan.2004)

Beware the Non-Disclosure Agreement

Joseph W. Bartlett, Co-Founder of VCExperts

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.

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How Venture Capitalists Talk

Joseph W. Bartlett, Co-Founder,

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.”


Who Controls – Me Or Them?

Joseph W. Bartlett, Co-Founder of VC Experts

To understand that cohort of issues which has to do with the control of a startup, some background is in order. Thus, in a mature business corporation, it has been understood, at least since Berle and Means’s seminal work, that non-management purchasers of stock in public companies are passive investors. If they don’t like the way the company is being run, their remedy (absent some actionable legal wrong) is to sell their shares. Venture capital operates on an entirely different set of principles. When raising money from his own investors—the limited partners in his venture pool—the professional manager of a venture-capital partnership holds himself out as someone with the expertise to “add value” to the investments under his control. The notion is that the typical founder is an incomplete businessman, with gaps in experience in matters such as financial management and marketing. An active board of directors, staffed by representatives of the investors, is expected to help fill these gaps. Significantly, even in successful venture-backed companies, a large percentage of the founders are fired, moved sideways or otherwise relieved of their duties as chief executive officer prior to the company’s achieving its maturity. It is rare to find the likes of a Ken Olson at Digital Equipment or a Bill Gates at Microsoft, executives with the necessary breadth and scope to take the company through every phase of its path toward maturity. Consequently, a term sheet will deal with a series of related control issues immediately after the question of valuation is tentatively settled.

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Economics 101

Joseph W. Bartlett,, Counsel, Reitler Kailas & Rosenblatt LLC

The question arises in my mind whether a summary index could be organized to track and elevate it to its proper place and level of influence that portion of the U.S. economy composed of the contributions to GDP and other economic indicators from the activities of emerging growth companies (called “EGCs” or “gazelles”) and their principals, the index helping all hands, including the Fed and Treasury economists, to adjust their view of economic growth in the U.S. to take into account small business creation and operations as a vital element of the economy, an element which often is overlooked when forecasting overall GDP and constituent elements such as job creation. As a business/academic colleague of mine likes to say, you can only measure what can be measured. The question is whether one can measure the impact of the start-up economy once one is shown the ropes, so to speak, and to adjust the snapshots and forecasts of U.S. growth accordingly.

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