Ratchets And Other Four-Letter Words
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
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
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.
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
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
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.
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.
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?"
"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
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.
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.
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
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
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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