|Cramdowns, Ratchets And Other Four-Letter Words
Dealing With Dilution In The New Investment Environment
(Reston, VA -- May 23, 2001)
According to Kevin Burns of venture capital firm Lazard
Technology Partners, when an investor offers an
entrepreneur a term sheet it’s a signal.
He calls it a “transitioning
vehicle to tell you that we're moving from the business due
diligence to actually doing a legal transaction.”
was speaking at this morning’s Netpreneur Coffee & DoughNets
meeting, joined by three other experts to explain some of the
potential landmines within that legal transaction.
Also on the panel were attorney and author Andrew Sherman of McDermott,
Will & Emery; Rusty Griffith, Director of Portfolio
Management at early-stage investor Steve
Walker & Associates; and Andrew Rosen, EVP of Corporate
Development and General Counsel for Blackboard,
Inc., a growing provider of e-Education infrastructure that has
collected several rounds of funding to date, including participation
by several institutional and strategic corporate investors.
particular focus was on dilution
of ownership issues such as “cramdowns” and “ratchets.”
While dilution provisions have always been an essential
component of investment deals, they are particularly acute today,
ever since the so-called “bubble burst.”
Today, both investors and entrepreneurs admit that during the
past two years of dot.com euphoria unrealistic expectations and
valuations became the norm. Now
that reality has checked back in, down
rounds (rounds done at lower valuation than previous ones) have
caught many entrepreneurs not in a vise, but in a ratchet
(an arrangement that allows an investor to
automatically receive free additional stock when converting their
preferred shares if the company’s stock is ever sold at a price
lower than what they paid) as investors try to protect their
position in portfolio companies that have come back down to earth.
Other factors have contributed as well, such as the tendency
of strategic corporate investors to offer higher valuations that
seem great at the time, but can end up trapping entrepreneurs out of
future rounds from institutional venture capital investors.
then there are cramdowns.
Technically, it’s a right originally provided under Chapter
11 of the Bankruptcy Code, though the term’s use has been expanded
to describe forced terms for equity shareholders as well.
According to Griffith, “A cramdown is when you've lost all
leverage. You're out of
money, you can't make payroll, you can't get any other money
interested in you.” What
do you do? You go to your inside investors, but you don't get very
favorable terms, and it means that founders and original investors
see dilution of ownership percentage or other rights¾though
it may be better than going out of business.
provisions are written into all term sheets.
As with other provisions, some are negotiable and some are
not. That’s why the
most important lesson for any entrepreneur is to get an experienced
lawyer who knows what he or she is doing and knows the market rates
and conditions. Don’t
bring in your Uncle Fred and don’t get into the minutia yourself.
Let the lawyers do their job.
In fact, according to Burns, how you handle these points is
actually a test that the VC is using to evaluate you.
They’re learning about your willingness to accept
professional assistance, getting a sense of how you’ll negotiate
with suppliers and assessing how well you keep focused on the real
an entrepreneur who negotiated several rounds for Blackboard, Rosen
makes it clear that getting the first term sheet right is extremely
important because it will be used as the basis for later rounds,
especially relative to dilution issues.
“The first term sheet sets the tone,” he said, “because
it is going to be used and reused and reused.
When you're in your second and third rounds investors say,
‘Let's see your last term sheet.’ That’s what gets marked up.
They'll take a look at the liquidation preference, the IPO
price and a number of different things.”
Burns, Rosen says, “Make sure you are being represented by
somebody who has done this before.
For lack of a better expression, you might get crammed down
in your first round, which is not very smart.”
no doubt that getting a term sheet is tougher these days than it was
a year ago, and today’s terms are a bit tougher as well. Investors are still funding good ideas, however, so an
understanding of concepts like cramdowns and ratchets are essential
for any entrepreneur hoping for funding.
As Sherman put it, “The party is not over but the bouncer
got bigger, and he’s more selective about who gets in the door.”
Sherman began the program with a quick review of the
investment process, including handouts
with advice on how to get offered a term sheet in the first
place and a sample term sheet for discussion.
In addition, the
panelists offered a wealth of tips, pointers and advice on a
variety of related topics, all collected in the edited transcript of
the event that will be available shortly.
Entrepreneurs looking for early-stage funding will find
assistance in handling that first term sheet negotiation properly.
if you’re an entrepreneur who’s already caught in a down round
as the markets readjust, you
may still have upside options.
According to Griffith, if you’ve solidified and
continued to build good relationships with your current investors,
there are ways to minimize the potential pain, such as restructuring
earlier deals. As he noted, “Nobody wants to drive a company
into the ground out of spite. It
makes no sense.”
Copyright © 2002 Morino Institute. All rights reserved.