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

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Mr. Sherman:  The only thing I'd add to reinforce all three of those perspectives is that the last part of the question was, “If you have a legal dispute over equity, is that a turn-off?”  It is most definitely a turn-off, as you've heard.  I would suggest that you sit down, hopefully not with Uncle Fred, as Kevin talked about, but with counsel that really understands cap tables and disputes over cap tables.  Get those things resolved before you sit down at the presentation.  Be able to look Rusty and Kevin in the eye saying, "Yes, there might have been issues before, but we got them resolved.  We now feel good about who is in the company, who thinks they should be in the company, at what percentages and the value they provided to the company for that stock."

          Well, our cup runneth over.  There are now more questions in front of me than we've got time for, so I'm going to have to edit.  One is, “What about investment bankers, why are you putting them down?”

          I think that was related to my comment about my grandmother.  I would not put down my grandmother, nor would I ever put down an investment banker.  It was merely to say that if you think of everybody stepping forward in line, angels conducting themselves more like venture capitalists, venture capitalists conducting themselves more like investment bankers from the perspective of due diligence, then investment bankers have no one left to mimic.  They step over, if you will, and say, "We are going to be on the sidelines for a little while with respect to the public markets."  So few deals are getting done in public markets that a number of investment bankers I know are really waiting on the sidelines or refocusing on other kinds of transactions, whether it be private equity transactions or M&A.  That is all I meant by that comment.

          Let me raise this issue to the panel about private equity investment bankers and finders or intermediaries.  What happens when someone other than the principal brings the deal to Rusty or Kevin and is expecting a large finder's fee or cut of the equity?

Mr. Griffith:  Generally speaking, we don't want that.  There is plenty of opportunity for you to come directly to us.  There is no need for you to pay up to 7% of the deal, because we're not going to pay it.  That means that if we were to fund you and you paid this person a broker's fee, we are, in effect, paying it, and we are not going to do that.  There is no reason for us to do that today.  So, generally speaking, we are not going to deal with a brokered situation 

Mr. Burns:  I would agree, particularly if it's early-stage, first institutional round or second round.  If you happen to be late-stage mezzanine, maybe, and that is out of our investment window.  When I see a fancy book with all that legal stuff in it, I think, "Oh, God, there is something weird going on here.  It's going to be high value and out of our investment window.”  Usually, that is the kiss of death and would get thrown in the round file.

Mr. Sherman:  Everyone, by show of hands, know where the round file is located?  I think everybody has got that one.  We can go back over cap tables, but round file is clear.

          Since we have so many questions and I don't want to discourage the hand-raising method, I'd like to volunteer that after the session we’ll go through any questions on these cards that we don’t get to and look for common patterns.  Perhaps, we can answer some of them on the Netpreneur Web site.  I'm hoping I can draw from the expertise of the panel as well.  It's obvious that we've touched on a lot of points which people are unclear about, and the questions range from very basic, such as “Where can I learn more about capitalization tables?” to some that are very specific.  I'm trying to edit these and look for questions that I think would be of broad applicability and interest as we go.  So, check the Netpreneur site for more answers.

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Mr. Rosen:  Andrew, if I can return to the question about consultants for a minute, law firms, especially from the West Coast, have an interesting model.  They might defer some fees, say 25%, and say, “At the next round of financing, whatever that price is, you let us convert that 25% of deferred fees into the round.”  That is a way of keeping a consultant honest, because (a) it sets it at the round, and (b) it also lets them waive 100% of their fees at whatever the next round of valuation is.  It’s saying, “If you help us get there, and you increase the value, that is your job.”  You make them prove it.  I just wanted to put that on the table, because it's hard to argue against.

Mr. Sherman:  A great point.  Here’s a good question.  "How do you keep liquidation, cramdowns, down rounds and other bad things from making employee options essentially worthless?"  This is a very hot issue.  A number of companies have redone their option plans recently, as we’ve seen reported in the press.  Everyone is clear on the option plan when the strike price is at $40, but the stock is trading at about $12, so employees aren't coming to work every day thinking, “I'm going to get rich.”  There is a disincentive.  I'd like to get the panel to comment on this issue.

Mr. Gross:  Andrew, to further the question, since I wrote it, with all the liquidation preferences, cramdowns and such, the real factor is that you can have $20 million, $30 million, $40 million in preferences, depending upon how many rounds, before the options are worth anything.  The question is, how are companies beginning to deal with that since, in the history of all the rounds and with cramdowns and liquidation preferences of two and three times the investment, you take $5 million, meanwhile liquidation preference says you've got a $15 million overhang before those options produce anything.

Mr. Sherman:  I was asked, as moderator, to repeat each question for the microphone.  I don't know if I could repeat all of that, but that was Phil Gross from AtYourBusiness.com.  I would guess that one of the more insightful questions would come from a veteran entrepreneur like Phil.  The essence of the question is: With so many different financing events and different valuations happening even before some of the options vest, how do you deal with what is essentially a moving target?

Mr. Burns:  I'll take a cut at that.  First, I'll go back to something that Andrew Sherman said: a lot of employees' expectations and venture capitalists' expectations are still living in the bubble of 1999 and 2000 when you were on a quick cycle to go public or be bought at some great value.  A year ago, if you had asked many people, "How long will that take?  What is your time horizon for creating value?" you'd have heard a lot of, “We’ll get rich in 18 months, 24 months, whatever.”  Before my venture capital career, I started a business in this area, a software company, in 1982.  We started from scratch and we went public in 1987.  Last year, during the bubble, I'd tell entrepreneurs that and they’d say, "Oh, gee, that's terrible.  Were you retarded or something?"  It's better just to accept the bubble as a total aberration.  There were things done and said that border on lunacy.

          Rather than trying to do delta management of expectations to the bubble, just jump back onto the way it always was, working on the fundamentals.  When we invest in a company, it might take four or five years or so.  When you look at some of these products to be built . . . I've even heard tell that some of these technical products can be late (laughing).  Sometimes it's release two that might get the bugs out and hit the target market.  We looked across our portfolio recently and 75% of our portfolio had morphed.  If you read the original business plan, they're still in the same space and the product is kind of the same, but there was an epiphany or serendipity that took over.  You have to have room for that.  I think that employees and venture capitalists and everybody else need to understand that we're going to run a mini-marathon here; we're not just going to get rich.

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          That puts some of your question into perspective.  However, I'm aware of several rounds in the bubble where $40 million, $50 million, $60 million of liquidation preference had stacked up.  Arguably, the company is doing a down round.  Management is not stupid; employees aren't stupid.  Maybe if we did a good job in two or three years, we might sell the company for $70 million or $100 million.  The venture caps are actually stepping up and writing off, waiving a chunk of the liquidation preference.  In the case I'm thinking of, it’s 50% -- knock the $50 million down to $25 million to allow for new money to come in, then give the new money a reasonable liquidation preference and kind of start over.  If you like the management and the employee culture, then the venture capitalist should be able to give a little to get a little.

          Many times, in concert, you might do what we used to call a re-price.  Now it's called a swap out of old stock options.  In the case I'm thinking of, there is also a swap out going where you trade in your old options.  Six months and a day later you get back new options.  A really enlightened, heads-up partnering kind of approach would, if need be, restructure the whole set of incentives, liquidation preference, strike price, option program and the like in exchange for a second effort, third effort, a fresh slate to break through and make the good idea prevail.

Mr. Griffith:  Yes, I agree with Kevin.  All over the last couple of years, the private equity markets, just like the public equity markets, experienced what Alan Greenspan referred to as “irrational exuberance.”  The feeding frenzy drove valuations way beyond what a rational person would believe possible.  When you are looking at companies that have no revenue, valuations of $50-$60 million and some of them having no sign of profitability anywhere in the near future, that doesn't make sense.  Business has to be profitable.  There is still a lot of pain to be felt from that exuberant bubble that we went through.  The way to fix it is going to be through some negotiation.  What is in the best interest of the company?  If the company is still solid, if your investors are still bullish on the company, then that is a time to negotiate with them and say:  “Look, we've got key employees who are getting a little concerned.  Their options are under water.  We can't possibly convince them or other shareholders of the value of the company to them because of all these liquidation preferences stacked up on top of us.  Let's try to work something out.”  You might have some sort of recapitalization of the company.  That would probably be your best alternative.  If you've maintained good relations with your investors, which I'm assuming you all do, then you should be able to start to work something out. It's in everyone's best interest that the company succeeds.  No one wants to drive a company into the ground out of spite.  It makes no sense.  But, at the same time, if you haven't solidified and continued to build the relationship with your investors, then you're going to have a little trouble going forward trying to do things like that.

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Mr. Rosen:  My only comment is a very rational way of addressing the issue.  If you are asking the question in terms of what do you tell the employees when there is a liquidation preference stacked up, it's a very difficult conversation, but you look at them and say, "Would you rather me not take the money?"  That means your job is gone.  Then you start building value from where the value is last set and you increase the value.  You get there together, and it's part of the impetus.  I don't mean to be so harsh about it, but it comes down to: Do you not take the money because the liquidation preference is going to be too high?

Mr. Sherman:  I think Phil Gross has won the best question award and gets the book.  We're going to take one last question to wrap up, and it is a good one to end on because it deals with relationship issues.  How much monthly face time with management should a venture capital be providing in support?  What should I expect to find on this issue in the term sheet?

Mr. Burns:  On frequency of the monthly board meeting, where it seems like the prep time always comes up and you're spending all your time prepping for some board meeting, for early-stage companies we actually like a monthly flash call.  It is just kind of like: Where are revenues?  Is the product on track?  New employees?  Just a very pithy discussion you could almost email out.  Literally, a one-hour call.  If you have a good plan with good milestones, then you can get into a delta mode or a variance mode instead of describing everything that is happening.  Just a quick commentary like, “We're off track here.”  Actually, venture capitalists deal with directness and bluntness.  Maybe it's just the way we're brought up or something.  You just say, "We're off plan here by 25%, and here is what we're going to do to try to fix it.  Here is what happened."  VCs will say, "Hey, okay, they're on top of it."  What we hate are things sneaking in, "by the way," and you find the stink.  Don't let venture capitalists discover variances as to how the business was agreed to be unfolding.  Do monthly flash reports, then every other one in person.  Maybe you're having six face-to-face meetings.  The most important meetings I have are the ones in between, where they'll call me.  My best companies call me and say, "We're struggling with issue X.  Can we have lunch, breakfast, a drink or something?"  They’ll ask, "What do you know about X?  Who do you know at Y?"  A lot of the real value-add is held in between the board meetings, through some quick email exchange.  Our best companies do it that way.  Our worst companies never call.  We always have to call them.  If they do call, it's something weird or something that you just know is going to be a fiasco.

Mr. Griffith:  Need to make payroll.

Mr. Burns:  My assistant comes in and says, "So-and-so is on the phone."  I cringe.  These are just little secrets of venture capitalists.  You say, "Show me your expense plan.”  Postage: $52, Pencils, Pads, Telephone . . . . I say, "Where is R&D?  Where is sales?  Where is marketing?"

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          "Oh, well, we don't do it that way."  You want to create a business plan that actually is reflective of the operational dynamic of your business model and hold yourself accountable to tracking how that goes.  Then you are probably off on a much better footing with your venture capitalists than just making them guess at what is happening.

Mr. Griffith:  Minimum would be once a month through the board meeting, but I would want to emphasize one point Kevin made.  You pick up the phone and you call.  You can't expect that a VC is going to be pinging each and every one of its interests on a weekly basis, a biweekly basis or even monthly.  You need to call.  Use the resource that is there.  If you selected the VC, and if you did your homework, then you picked a VC you wanted to partner with for your business. That is the person you can go to who, if they can't answer the questions or provide you with the information you need, they probably can find it.  They can connect you with a resource that can help you.  Don't hesitate to make use of your VCs that way.

          On the flip side, that doesn't mean call them every day asking some fairly simple questions that, if you continue to ask them, it indicates to us that you really haven't a clue about running a business.  You don't want to do that.  The flash report, as Kevin referred to it, could be very valuable in communicating with a VC, but make the flash report meaningful.  Don't have a line that says "Revenue," and then every month it says zero, zero, zero.  That doesn't do anything.  You need to understand what the drivers of success for your business are.  Early on, it's not necessarily going to be revenue.  You may not be looking for revenue for another year, year-and-a-half.  It may be filling out your staffing plan.  It may be that you are able to obtain some favorable lease terms for equipment that was critical for development of your product, or that you landed some sort of partnering contract.  These are things that are not necessarily found on the financial statements that will indicate whether or not you are moving your business forward and being successful.  Those are the sorts of things you need to identify.  Those are the sorts of things you need to communicate with your VC.

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          I'll tell you one pet peeve I have with financial statements.  I get the financial statement, open up the file, print it and I get like 105 pages.  That is one thing that can waste a lot of time. Often, I won't even look at it because it's just a waste of my time to have to figure out how to pull all that together so I can make sense of it.  Make sure that when you send information, it's good information.  It's needed information. Don't show a level of detail that is totally unnecessary.  Show a level of detail that is meaningful for the VC.  Ask, “What do you really want to see?  What level of detail?”  Don't just assume you know, and go from there.  Make each communication with your VC meaningful, because it will pay off for you later on.  It really will.

Mr. Burns:  Backtracking just for a second, Rusty made me think of this.  The really powerful thing is key business metrics.  In every business, great businesspeople don't wait until the end of the quarter for some accountant to come with a historical report.  They have the five things that matter, that you can just write on a bar napkin, day-by-day as your business is moving forward.  You don't create them for your venture capitalist, you use them for your own management team.  Is the beta release moving forward?  Has it passed validation?  Have we hired these people?  These are your own business metrics that let you know that you're making progress.  If you use them with your VCs, you can save work and effort.

          My biggest one is: Will the dogs eat the dog food?  I always go to R&D at my companies and everyone says, "This thing is fantastic.  We've put in some special vitamins.  It's going to make the dog's coat shiny.  In fact, when they eat it, it cleans their teeth."  This thing sounds fantastic, but, if you got a bowl of it and brought it over to a few Dobermans, a German shepherd and a couple of Labs, do the dogs eat the dog food?  Often underutilized in pitching your plan and at board meetings is just your customer anecdote.  Your win/loss.  “We called on Ford Motor Company and they are going to bring the product in.  Their value proposition was X and their cost justification was Y.  We don't have the order yet, but we think that this thing looks good.”  When you are starting a business, if Ford Motor Company buys your product and rolls you in, even if it's experimental use, you're on the map. You know that the stuff works.

Mr. Rosen:  As Kevin was saying, we call the five issues a “dashboard.”  In the last round of our financing, one of the first diligence questions was, “What is your dashboard?”  That is, how do we measure the success of our business to see where we're falling down and where we're not.  It's an interesting question because it was almost a self-deprecating question: How do you know when you're not succeeding?  It's our dashboard.  So they looked at our dashboard and said, "How do you get information into the dashboard?"  It tells them tons about your business, how you run it and how you interact with your people.  That was the first time we've ever been asked that question.  Then, "What are the drivers into your dashboard?  How often is it updated?  What are the processes and procedures around your dashboard?"  That was in addition to having marketing consultants out of Boston test our business plan and accountants out of Chicago from Andersen test our business model.  It was probably one of the tightest, most interesting and telling questions I've ever seen.

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          Going back to the question about accountability issues.  When we started out, our board meetings were every six weeks, then we moved them to every two months after the first year following our first venture round.  Now we meet quarterly.

          From a leverage perspective, how do we work with our investors?  I speak to different investors from a leverage perspective four times a week and I know that Michael and Matthew are doing it more than I am.  The stakes are going up.  The relationships are getting greater.  “Who do we know here?  How do we grow the business? How do we grow the revenues?”  Those are the investors.  You want to be surrounded by people who have the time for you and want to help you grow the business.  Like I said, accountability.

Mr. Sherman:  Great advice.  To close out the program, I want to introduce you to my friend, a genuine asset and leader in the entrepreneur community, Mary MacPherson, Executive Director of Netpreneur.

Ms. MacPherson:  Thank you very much for your time this morning, and for volunteering to answer some of these questions that did not get answered yet.  I'd also like to remind everyone about the resources on the Web site, including Andrew’s handout, Anatomy of a Term Sheet: Venture Capital, An Overview of Trends, Strategies and Structural Issues and the piece that Kevin did with Larry Robertson of Lighthouse Consulting,  An Entrepreneur's Guide to Raising Private Capital.  It really takes you step by step through the process. There is also a glossary that will give you more definition about some of  the terms you've heard today.

          Again, thank you very much.  We will see you in June at the next program.

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