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Cramdowns, Ratchets And Other Four-Letter Words
Dilution and the post-bubble term sheet

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andrew rosen: what’s your angle?

Thank you very much.  It is interesting listening to the other perspective.

          Here are two stories of investors that we've confronted recently in the marketplace.  One company took strategic money too early and in the second round got a $400 million valuation on about $2 million in revenues.  It put them in a position where they could only do a down round.  When they started dealing with investment banks (in the days when investment banks existed in this area), no bank was going to talk to them.  By dealing with an investor like that and pushing the valuation, they might have gotten a lot of money cheap, but they put themselves into a box.

          The other investor story involves another company we saw, and, again, it goes back to investor selection. They did a strategic round of financing, I believe in a G round, and gave control of a preferred class of stock to a strategic investor.  When they started going out and looking for merger or acquisition opportunities, they'd taken all the control out of the hands of management and the other investors, and basically gave it to that single investor.  Deals just can't get done if a strategic investor has a different goal for the company than the management team or the other investors.

          Those are just two interesting examples that show how investor selection, in terms of a term sheet, can be extremely significant in very subtle ways.  What we have done at Blackboard, and I've worked with the founders since the inception of the company, is that we have traditionally looked for people who actually share our vision.  What does that mean?  It means that they understand the space and they don't need to be convinced about the marketplace.  Maybe you teach them a little about the size and how you look at it, but in today's market they really need to understand what you're trying to accomplish.  If they don't, and especially if they take a board seat, it's going to be very, very contentious moving forward and trying to develop and deploy strategy.

          So, first, they need to understand and share your vision.  Second, they need to understand the economics, and that goes to the market rate term sheet.  They need to understand the comparable group, and, therefore, the valuation.  They need to understand who the analysts are at the investment banks that they can go to and ask, "What do you know about this company in this space?"  or "Have you run into this?" or "What do you know about this particular space and who is in it?  What have they done?  What is the competition?"  Often, very informed investors know the analysts at the banks and know the bankers.  They will find out everything about your marketplace and your viability in two phone calls.  You really want to be dealing with people who understand the economics of what you offer and why you're sitting in front of them.

          Third, you want to know their track record with entrepreneurs.  You want to make sure that they're going to be team players with you and that their personality is going to work with your personality.  Will they be behind you with resources to commit?  It's not just financial resources, obviously, but you want to make sure that they'll be there for the subsequent rounds of financing.  What is their portfolio?  Can you leverage into it?  How many other companies do they have?  When you need their attention, can you get it?  We rely on our investors a great deal.  We have some very sophisticated, highly intelligent investors, and they bring different things to the table.

          When you are talking about investor selection, it's basically a matter of who do you want to be working with on the board of directors?  Who understands your company?  Who is going to be able to sell you into the investment community?  From our perspective, I hope that we have done it very well.  We've had a unanimous board ever since our existence, which has been just phenomenal.  Everybody is moving in the same direction and understands the marketplace and the economics.

          What I found interesting about the first term sheet from the company perspective -- I used to do it as a lawyer -- and what people really don't tell you is that the first term sheet actually sets the tone because it is going to be used and reused and reused.  Very often, when you're in your second and third rounds, they say, "Let's see your last term sheet."  That is what gets marked up.  They'll look at the liquidation preference; they'll look at the qualified IPO price (QIPO) ; they'll look at a number of different things and say, "Oh, antidilution.  Here you have weighted average.  We want full ratchet over here."  We found that it is what they use as a starting point, very often, and that is why the first term sheet becomes very, very critical.  It goes back to a point made earlier, which is to make sure that you are being represented by somebody who has done this before and knows the market rate terms.  For lack of a better expression, you might get crammed down in your first round, which is not very smart.


          I represented Blackboard on all the term sheets in the first venture round and beyond.  You have to pick your fights, so to speak.  What that means is that I look at the world in two different ways.  On one side, you take the terms in the term sheet and you divide them up.  You look at issues that confront you from the founders’ perspective, those that confront the company, those that confront the other investors and those that confront the employees.  You look at issues about control -- founder control of the company, for example.  After all, it’s your baby, and the question is, how are you going to keep it that way?  It's not always that easy, especially in a marketplace like this.

          On the other side, you look at the big points, you look at the little points and you look at the ego points.  You have to realize that at a certain stage, to get a term sheet, it's not about ego.  The ego points have to come off the table immediately because you're not going to get anywhere with them.  Then, the question is the big points and the little points.  What might be a big point to the company is a little point to the other investors and a little point to the founder.  At a certain stage you're going to get a term in there like liquidation preference.  You know it's going to be in there.  The question is, what are the parameters?  From a founder's perspective, you are not really that concerned, but someone is going to get rank and seniority.  To the other investors it's a very, very big issue.  You have to put things in perspective.

          Some other examples.  To a founder, to the person representing the company on the term sheet, you are looking at co-sale rights; you're looking at participation and personal preemptive rights; you're looking at board seats and who is going to be on the compensation committee.  They're going to set your compensation going forward, an important aspect to the company.  Who is going to be on the audit committee?  What does the liquidation preference look like, and what is the participation cap?  If it's unlimited, there is nothing at the end of the rainbow for the common shareholders, so where is the incentive?  Those are issues that might not have a lot of importance to you as somebody who is trying to get money in the door, but they might have importance to people who previously funded your company.

          Then there are other things that employees are very concerned about and will be asking you about.  They want to know: What is the size of the stock option plan?  Is it included in this round?  What's the max?  Who is on the board?  We came to work with you, so are the founders going to be able to retain control?  There are certain things that affect different people, so you have to chisel them away.  There are big points, little points and ego points with respect to each one of those groups.

          From my perspective, obviously, valuation is a huge thing, but, in today's marketplace, getting the deal done is the most important thing.  When it came to big points, I used to have a list of 10 or 15 things.  Now it's like three: valuation, structure and rank.  Are there warrants in it?  Because every time the participation cap liquidation preference increases, there is seniority or there are warrants, and both the structure of the deal and the rank of the actual security being issued have valuation overtones.  At the end of the day, when you actually calculate the cap table three years out and you are looking at your pro forma and what that investor is going to hold, assuming X, Y and Z, the valuation is a lot different than the number that they put in the term sheet.  They say, "Oh, we're going to give you a $10 million valuation based on the following...."  After you do the math, it's really a $3 million post-cash valuation.  Again it's looking at those factors.


          Those are on the big side -- structure, rank, liquidation preference and participation cap.  Participation cap is most of the securities that get issued in today's venture deal is a participating preferred security, meaning that, in addition to our liquidation preference, what we've invested plus a dividend right, we get to participate on an as-converted basis with the common shareholders.  If there is ever a cash event or liquidity event, if it's an unlimited participation cap, you just diluted the common ownership significantly.  So, when you get through the first round -- if you're smart enough to realize in the first round -- "Can I set a cap?"  (If you have that sort of weight, anyway, you should be so lucky…)  In the second round, you might want to be negotiating a participation cap, after you've gotten 2 times your investment, then you sit aside and let the common shareholders take over. 

          Another large point is board of director composition, and it's actually a very, very big point.  Say you have three founders in the company; is only one going to sit on the board with three investors?  If so, you have effectively just given control away.  If you have $5 million in the bank and can't write a check larger than $50,000 dollars without having to go back to the shareholders, it becomes very, very cumbersome.  That might be perceived as a little point, but some of them have large ramifications if you know they’re coming down the pike. It goes to a control issue.

          More little points.  Qualified IPO price.  Unless you're in mezzanine financing, you are going to set something as a market rate.  But for somebody to say “I need 200 times my investment before we're going to waive something,” that is craziness -- 150%, 200% -- there is a price at which the investor can actually not be in control and you can force conversion if you're going to be going under an IPO.  People might say, "You should be so lucky to get to an event that is a qualified IPO."  In reality, it's a little point that you do have to pay attention to.  Antidilution calculations.  Weighted average antidilution was a standard.  Now people are moving towards full ratchet antidilution, which means that when you do a down round, how do you true up the investors to compensate them for the lower valuation?  In full ratchet antidilution, you are going to give them the full benefit of the lower price and give them more of the company.  In weighted average, you are going to look at how much you just raised, do a calculation and true them up -- I wouldn't say nominally -- but you true them up to keep them whole, but not in a full ratchet sense.  Again, a little point.  Important to pay attention to, but, obviously, not to draw your sword over.

          Then there are the ego points.  Dividends.  “I'm going to pay you 8% a year in stock?”  Um, 8%, 5%, 12%, what is the number?  It doesn't matter -- close the deal.  Mandatory redemption.  Every term sheet has a mandatory redemption period in it, meaning that if you have not gone through liquidity (you haven't been bought, merged, gone public, whatever it might be) it used to be that the standard was seven years mandatory redemption.  We would all sit back down at the table and figure out, “How am I getting my money out of this? What is my exit strategy?”  A small point, but I've seen people make it a big point.  “You're going to force me back to the table in seven years?”  If they are forcing you back in 24 months, that is a bigger issue.  It probably rises to the tone of a little issue, because you can renegotiate that if you're in a position of strength. But, again, it's an ego point.  Registration rights.  Always, in a standard deal, there is a market rate.  They’re called registration rights (reg” rights in the short form).  There is a lot of different lingo for this.  Without getting complicated, it's an ego point.  The investors are going to get reg rights, and it doesn't matter.  You give them up.  Hopefully, if you're smart enough, you're dealing with a representative who is representing you, a lawyer who knows what the market rate is and keeps it intact. It's an ego point.

          To recap, you look at the issues, who they confront and then you divide them up into big, little and ego.  You drop the ego very quickly and you get the deal done.


the audience: q & a

Mr. Sherman:  Thanks to Kevin, Rusty and Andrew.  Lots of great advice there.  Lots of insights on specific terms and conditions, and, most importantly, we left plenty of time for Q&A to get interactive.

          One of the themes today is the cramdown.  The term actually came out of bankruptcy law, and it's used as a term to quiet dissenting creditors who don't like the restructuring plan or the pay-out plan.  It's designed to cram those terms down their throat.  Now, in the last 18 months, it has been used to cram down entrepreneurs who are desperate for the next round of capital.

          Before we get into Q&A, I have brought you something. This is an excerpt from the book that is kind of fun: How the venture capitalists interpret your presentation in today's markets.  Just follow along. The first phrase is what you say, the second is what VCs know that you really mean.

When you say:   They're thinking:
The product is 90% complete.   You've got a name for it.
We've got leading edge technology. They can't make it work.
There is limited downside. Things can't get much worse.
There is a possibility of a shortfall. They're at least 50% below plan.
Proven technology.  It probably worked at least once before.
We are repositioning the company in the business model. They are totally lost.
It has upside potential. It's probably stopped breathing

          I just want you to know that your words -- and how you choose them -- may be interpreted differently.

          We'd like to get interactive now.  We don't have our normal mikes in the audience, so the three formats are to stand up and ask the question, in which case I'll repeat it; hand me one of these cards; or send me a smoke signal.  We want to make sure that we leave here clearing up any misunderstandings that you may have.  Maybe some of you were tired, but there were very few hands that went up when Rusty asked, "Do you know what a cap table is?"  If you are going to do business with investors, you are going to have to know these terms inside and out.  Understand them, and understand the impact they'll have on your company.

          I've already got three questions here, so why don't I start with those.  “What are the venture capitalist's or angel investor’s feelings on a startup that gave too much equity to non-full-time consultants early?  Do they care?  Is it a deal killer, or do they not care where their percentage comes from?  Does the entrepreneur try to renegotiate with these consultants prior to coming to the venture investors?"  Then they add, “Will a venture capitalist or angel run from a deal that has a legal equity dispute?"  I'm pretty sure I know the answer to that one.  Gentlemen?


Mr. Burns:  Believe it or not, we care largely about the incentive structure for the founders, the management and the people who are pulling the oars.  They're going to actually build the business.  If they're performing, it doesn't matter to us.  You have to remember that, as an entrepreneur, your best antidote to all of these provisions is to perform.  If, in working together, we're actually building a great business and we're hitting product milestones, we're signing up household name accounts and we have revenue starting to flow, the tone of what goes on at board meetings is a lot different.  In our most successful companies, no one whips the term sheet out and says "According to Provision 32(b) we're going to outvote you on something."  They actually don't take many votes, you just kind of just keep going.  So, we don't like to see the performing management team that has the great vision and passion to build this thing get their incentives diluted or out of whack.  We can't dilute you down to the point where you say, "Hey, here are the keys.  Knock yourself out.  Have a ball, Kevin.  Hope you are good at programming and selling."

          We don't actually want to do anything ourselves, so one of the dirty secrets is that we have to maintain motivation.  Now, if these stupid consultants have taken off a big piece of the equity pie, we view that as a very big problem, particularly any stake-holder that is not in the company doing something valuable.  We might just not invest because they screwed up your equity situation, or we're going to have to go in and retool it with great difficulty.  You have to think of the amount of capital you need to go the distance.  You may be raising a $1 million round, but, if it's a software product, to go the distance it might need a $15 million sizing over three rounds.  If it's a big fiber optics deal, it could be $50 million.  Who knows?  So, there will be other rounds, you may get diluted and here are these stupid consultants who are no longer doing anything, sitting out there with 4%, 5%, 6%, even 10%.  We do view that as a problem.  We may not want to go to the effort to renegotiate the consultants.  If there are legal disputes going on of any kind, if we can't quantify them or get our hands around them, well, you don't ever want to give the VC a plausible reason to walk.  We have thousands of plans and all we have is our capital and our money.  We are actually looking for a reason to stop talking to you, so the fatal flaw, the fights, the lawsuits, all that goes on the punchlist.  If it's too heavy, they might just say, “Oh, forget it.  Too messy.”

Mr. Griffith:  I would add that when you are paying a consultant with equity, don't think it's the cheapest way to do it.  You could be misleading yourself into thinking, “I can pay him $10,000 in cash, or I can give him 10,000 shares, say 2% of the company.”  Equity is not going to be cheap.  Generally speaking, I agree with Kevin.  We don't really like to see a lot of consultants as shareholders.  It's going to hurt you more than it will hurt us because we are going to get our share, whatever it is, based on fully-diluted common.  When you've got a lot of stakeholders who have absolutely no connection with the company anymore . . . well . . . I've seen it where one company had a name for three consultants who had an enormous amount of shares because they thought it was so cheap.  You just give them this piece of paper that says they own X number of shares, and they're done.  They ended up calling them ”the boys” because they ended up being such big problems.  They were not helping the company anymore, but, at certain times, they would crop up and create issues.  From our perspective, they're going to get diluted along with any other ownership, but, more importantly, the biggest issue that we would have is that they may be diluting the founders more than we would want.  Then we have to try to figure out something to do to keep the founders and key executives incentivized.  If we can't do that, then you really create a problem for yourself that may not show up until a year or so later.  I would caution you against using equity to pay vendors unless it's a true value proposition for you.

Mr. Rosen:  Friends have asked that same question, and I've always thought that if an advisor or consultant is asking for a percentage of the company, they're asking for too much.  “For 10% I'll do the following.”  You don't want to be talking in those terms.  It's the wrong conversation because, at the end of the day, you are setting a valuation.  If they are going to be putting in 100 hours, their consulting rate is $200 an hour and you are giving them 10% of the company, you've just set a valuation for your company.  It may be a good valuation, but most people don't recognize that.  They say, "Oh, for 10% of the company, are you guys going to hook me up with this market and this and this and this?"  At the end of the day, it's a valuation set and it can be used against you.  Venture capitalists will look at it as a dilution to your ownership.

Mr. Burns:  You can also paint yourself into a corner on your stock option plan, which is the big juice to get world-class employees to leave their safe jobs and come work for you in your risky environment.  The juice in that plan is the strike price, and it’s the desire on all of our parts to keep the strike price relatively low for as long as possible.  If you give some consultant 10% of the company and say you're going to value yourselves at $100 million, then your friendly accountant says, "Congratulations, your strike price is now up here because you have a common stock transaction at a high water mark."  You've done yourself a great disservice.


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