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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.”

Burns 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.

Their 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.

And 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.

Dilution 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 priorities.

As 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.”

Echoing 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.”

There’s 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.

And 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.

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