Ratchets And Other Four-Letter Words
the post-bubble term sheet
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andrew rosen: what’s your angle?
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
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
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:
product is 90% complete.
got a name for it.
got leading edge technology.
can't make it work.
is limited downside.
can't get much worse.
is a possibility of a shortfall.
at least 50% below plan.
worked at least once before.
are repositioning the company in the business model.
are totally lost.
has upside potential.
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
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
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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