Snap IPOThe just completed IPO of Snap Inc. has received enormous buzz and plenty of press coverage, mostly about its eye-popping valuation and offering proceeds, the big winners among the founders and early investors and the millennials who bought shares. But not nearly as much attention has been given to Snap’s tri-class capital structure and the nature of the shares that were actually issued in the IPO: the shares of Class A Common Stock sold in the IPO are non-voting. By its own admission, Snap may have pulled off the first ever IPO of non-voting stock.

Snap’s capital now consists of the non-voting Class A shares held by public investors, Class B shares snapIPO2with one vote per share held by early round investors, employees and directors and Class C shares with ten votes per share held by the founders. As a result of the Class C common stock that they hold, co-founders Evan Spiegel and Robert Murphy will be able to exercise voting rights with respect to an aggregate of 215,887,848 shares, representing approximately 88.5% of the voting power immediately following the offering. Consequently, Spiegel and Murphy, and potentially either one of them alone (see below), have the ability to control the outcome of all matters submitted to stockholders for approval, including election, removal, and replacement of directors and any merger or sale of all or substantially all of the assets.

Multiple class structures are not unusual, and several high profile companies went public with them in recent years. What’s unusual here is that whereas the shares sold in those other multiple class structure IPOs had at least some voting rights (typically, one vote per share vs. 10 for the founder class), Snap’s public offering shares have no voting rights. Technically, Delaware law would permit holders of Snap’s Class A non-voting stock nevertheless to vote with one vote per share on any proposal to amend the certificate of incorporation in any way that would adversely affect the holders of the Class A. For example, if a proposed amendment provided for the Class A to rank junior to the Class B and Class C with respect to dividends or acquisition proceeds, a Class A vote would be required and the holders of a majority of Class A shares could defeat that amendment. Such a proposal would be extremely rare, however, and the Class A holders would have no say in the much more typical matters of board elections and any proposed sale of the company.

Multiple share classes are especially useful to public technology companies because they give them the freedom to innovate without the constraints of “short termism” and also serve as a deterrence to takeover bids because of activists’ inability to manipulate the voting machinery for election of directors.

Snap’s Class A common stock will be its only class registered under Section 12 of the Securities Exchange Act, and because the Class A is non-voting, Snap will not be required to file proxy statements except for a rare case where a vote of the Class A common stock is required (see above). Nevertheless, Snap indicated in its S-1 that it will provide Class A holders any information that it provides voluntarily to Class B and Class C holders.

What makes Snap’s structure even more unusual is survivability and portability.  According to Snap’s S-1, If Spiegel’s or Murphy’s employment is terminated (which, because of their control, could only happen if they turn on each other), they will continue to have the ability to exercise the same significant voting power and continue to control the outcome of all matters submitted to stockholders for approval. A founder’s Class C shares will automatically convert into Class B shares, on a one-for-one basis, nine months following such founder’s zuckerbergdeath or on the date on which the number of outstanding Class C shares held by such holder represents less than 30% of the Class C (or 32,383,178 shares) held by such holder at the time of the IPO. Facebook, on the other hand, amended its certificate of incorporation so that Mark Zuckerberg’s majority voting control is good only while he is an executive at the company.

Snap’s capital structure has drawn some criticism. In a New York Times piece, Cal Berkley law professor Steven Davidoff Solomon referred to Snap’s IPO as “the most stockholder-unfriendly governance in an initial public offering, ever.” In the Harvard Law School Forum on Corporate Governance and Financial Regulation, Rob Kalb and Rob Yates of Institutional Stockholder Services cited a 2016 ISS study that showed that controlled companies had weaker governance standards and tended to underperform “with respect to total stockholder returns, revenue growth, return on equity, and dividend payout ratios.” And the Council of Institutional Investors sent a letter to Snap’s co-founders objecting to the capital structure and urging them to adopt a single class structure. While acknowledging that similar emerging companies with dynamic leadership and promising products have successfully raised capital despite having dual class structures, Snap’s structure is unusual in that the investors would have no voting rights and dual class company performance has been mixed at best.

When Google, Facebook and Under Armour went public, they each did so with a dual-class share structure that at least afforded public stockholders one vote per share. Nevertheless, each company subsequently requested stockholder approval for the issuance of a third class of non-voting shares. In each case, the purpose of creating a new non-voting class was to maintain founder voting control while simultaneously providing insider liquidity.

Despite the overall positive outcomes achieved by Google and Facebook for their stockholders, going public as a controlled company with an unequal-voting-rights structure is no guaranty for financial success. Groupon, Zynga and GoPro each went public with a dual-class structure, received poor ISS corporate governance scores indicating the highest levels of governance risk, and the share price of all three dropped precipitously since their respective IPOs.

Adding salt to the corporate governance wound, Snap is taking advantage of emerging growth company status under the JOBS Act, meaning that it is not required to comply with the auditor attestation requirements under Sarbanes-Oxley and the reduced executive compensation disclosure requirements and may delay adoption of new public-company accounting principles.

In the final analysis, investors will need to decide which Mark the Snap founders better resemble, Facebook’s Zuckerberg or Zynga’s Pincus. And looking beyond Snap, it remains to be seen whether other emerging companies adopt the Snap IPO playbook by launching IPOs with multiple-class structures that preserve founder control and give public stockholders little or no governance voice.

2016 turned out to be a terrible year for IPOs, both in terms of number of deals and aggregate proceeds.

According to Renaissance Capital’s U.S. IPO Market 2016 Annual Review, only 105 companies went public on U.S. exchanges in 2016, raising only $19 billion in aggregate proceeds. The deal count of 105 IPOs was downrenaissance 38% from 2015 and the lowest level since 2009.  The $19 billion in aggregate proceeds was down 37% from 2015 and the lowest level since 2003.  In fact, if you remove the financial recession years of 2008 and 2009, the 105 IPOs in 2016 were also the lowest since 2003.  And the drop in deal activity was indiscriminate; both VC- and PE-backed IPOs were at their lowest levels by deal count and proceeds raised since 2009.

The temptation would be to blame the weak IPO market on political election 2016uncertainty, with Brexit and the U.S. election being the biggest culprits. But then how to explain the broader U.S. capital markets, which were hot in 2016. The Dow Jones Industrial Average hovered around 20,000 at year end, and the S&P 500 Index was up 9.5% for the year.  One would expect that the market for IPOs would be pretty strong, as bullish markets normally encourage companies to go public.  To be fair, much of the market gains took place in the latter half of the fourth quarter.  But market weakness doesn’t explain the two-year drought in IPOs for technology companies, considered the mainstay of the IPO market.

Another common theory is that over-regulation, particularly Sarbanes Oxley, has made it much more expensive to go and remain public, thus discouraging many growth companies from doing so. The 2012 JOBS Act tried to remedy this by creating an IPO on-ramp for emerging growth companies, allowing for confidential registration statement filings with the SEC, “testing-the-waters” and scaled disclosure.  The immediate results were encouraging: a dramatic increase in IPO deals and aggregate proceeds in 2014.  Yet IPOs plummeted in 2015 and even further in 2016.

Renaissance Capital’s report points the finger squarely at the public-private valuation disconnect. The tech startup space in 2015 was a mystifying series of mega rounds, sky-high valuations, unicorns and unicornbubble fears. But another trend has been IPOs being priced below the company’s most recent private funding round.  In its pre-IPO round, Square Inc. was valued at approximately $6 billion, but IPO’d at just over half that valuation and then plunged further post-IPO.  Etsy Inc. and Box Inc. both reported $5 billion plus private valuations, only to plunge in the days leading up to their IPOs.  Many, including Benchmark Capital’s Bill Gurley, have blamed the late-stage bidding frenzy on institutional public investors such as mutual funds rushing into late-stage private investing.  Another major contributing factor in the escalation of late stage valuations is the trend toward generous downside protections being given to investors in exchange for lofty valuations, such as IPO ratchets and M&A senior participating liquidation preferences.  The former is simply antidilution protection that entitles the investor to receive extra shares on conversion in the IPO if the IPO price is below either the price paid by the late-stage investor or some premium above that price.  The latter means that, in an acquisition, the investor gets first dollars out ahead of earlier series of preferred and then participates with the common pro rata on an as converted basis.

Renaissance maintains that VC-backed tech companies with lofty late round private valuations chose in 2016 to avoid inevitably lower public-market valuations and had the luxury of remaining private due to ample available cash in the private markets. Mergers and acquisitions offered alternate pathways for other tech companies, such as TransFirst, BlueCoat and Optiv, all of which had previously filed S-1s for IPOs.

Although the private-public valuation disconnect was a major impediment to IPOs in 2015 and 2016, Renaissance believes this phenomenon is close to correcting itself and is optimistic about 2017. Many growth companies have seen their valuations flat or down in new funding rounds to levels that will be more palatable to public investors.  Also, the election results will likely bring a dramatic change in fiscal, regulatory, energy and healthcare policies, all of which should be stimulative to equity markets, new company formation and, ultimately, IPOs.

Another reason for tech IPO optimism for 2017 is Snap, Inc.’s highly anticipated IPO in the first half of 2017. It filed confidentially under the snapJOBS Act, and has begun testing the waters with investors.  The Snap IPO is rumored to raise $4 billion at a valuation of over $25 billion. Another one is Spotify, which raised $1 billion in convertible debt in March 2016 which signals a likely imminent IPO. These two IPOs might raise more capital than all VC-backed tech IPOs in the last two years combined.

In Part I of this two part series on model structures for seed rounds, I explained how the dramatic decline in the cost of launching an internet-based startup over the last 15 years primarily due to the disruptive effects of open source software and cloud computing has led to a surge in seed stage investing by angels and early stage VCs.  In Part I, I addressed seed rounds structured as equity, the two most common forms of which involve the issuance of modified versions of preferred stock designated as Series AA or Series Seed.

As I explained in Part I of this Series, the more complex, time consuming and expensive to negotiate deal documentation associated with Series A and later rounds can be justified when a company is raising several millions of dollars, but makes little sense for a seed round of a few hundred thousand dollars. The resulting pressure for deal document simplification has resulted over the last several years in innovative seed investment deal documents.  This Part II of the Series will address seed round structures fashioned as convertible notes or alternative instruments that functionally resemble convertible notes.

Convertible Notes

Convertible Notes advance the objective of deal document simplification and cost effectiveness even more than Series Seed and Series AA structures because they allow parties to defer negotiation of the thorniest issues to a next significant equity round.

Technically, convertible notes provide for payment of principal and interest on a maturity date of typically one to two years, but in reality these notes are not expected to be repaid.  Instead, the principal and interest is intended to get converted into the security issued in a next equity round meeting some minimum dollar amount, albeit typically at a discount to the next round’s pricing in an effort to reward the seed investors for the additional risk they’re assuming by investing at a more vulnerable juncture for the company.   In recent years, it has also become common for the valuation at which the seed investment is converted to be capped, in which case  the conversion price would be the lower of the discounted rate or the price based on the capped valuation.  Less sophisticated angels will focus on the interest rate and try to negotiate that higher; those more experienced in startup investing will understand that the conversion terms will have a far more significant impact on the value of their investment and thus focus on discount and cap.

Another way the practical reality departs from the technical is that if a qualified funding has not occurred and the note is not converted prior to maturity, the note is rarely paid at that point. Instead, a difficult conversation takes place between the company and the seed investor in which the company seeks to extend the maturity date.  The price for any such extension is usually in the form of more generous conversion terms for the investor.

Simple Agreement for Future Equity or “SAFE”

In 2013, the legendary accelerator Y Combinator introduced an alternative to theY Combinator convertible note which it called a Simple Agreement for Future Equity or “SAFE”. Although it looks like a convertible note in that it converts the investment amount into the next round’s security and typically features discounts and caps, it is not a promissory note for the simple reason that, unlike a note, there is no basic promise to repay the invested amount.  Essentially, a SAFE is a contract that provides for the type and amount of shares that will be issued in a qualified next round, if there is such a round, along with an option to receive either common stock or a return of the invested amount if the company is acquired prior to a qualified round.

The absence of a payment on maturity date feature is a major advantage to companies and a serious drawback for seed investors relative to convertible notes in that it removes an important source of leverage that the investor would otherwise have as a convertible noteholder if the company has been unable to raise a qualified next round before maturity. If that were to happen in the context of a convertible note, the note holder could demand payment and force the company into dissolution or bankruptcy.  That leverage would allow the investor to negotiate for an increase in the conversion discount or decrease in the cap.

The lack of a maturity date means that the SAFE is really only appropriate for a technology based startup that could scale quickly and achieve rapid growth. Conversely, a non-technology based startup could theoretically prosper and enrich its shareholders without the SAFE holder receiving anything for a long time, if ever.  In other words, a company may be able to grow organically without the need to do another significant raise, and may even be able to dividend out cash to its stockholders (not shared by the SAFE holders because they’re not yet stockholders), and the SAFE holders would not receive anything until the company gets acquired, if ever.

Keep it Simple Security or KISS

The Keep it Simple Security or KISS was created by another accelerator, 500 500 startupsStartups, in 2014, in reaction to resistance to SAFEs because of their lack of investor protections. KISSes more closely resemble traditional convertible notes, i.e., promise to pay on a maturity date, etc., and contain certain other important investor protections such as an option at maturity to convert into a newly created Series Seed (see my discussion of Series Seed in Part I of this two-part series), information rights and the right to participate in future funding rounds.  But inasmuch as the impetus for convertible note alternatives was a desire for simplification, cost effectiveness and time saving, it’s unclear whether the KISS, which actually contains a few more deal points to negotiate than convertible notes, will gain significant traction among seed stage companies and investors.

Seed stage investment deals, i.e., those in a range of approximately $100,000 on the low end and around $1.3 million on the high end, are structured either as straight equity or as convertible loans. If straight equity, the company typically issues to the investor shares of preferred stock usually designated as Series Seed which includes a package of enhanced rights but usually stripped down from seed investingthose typically associated with Series A shares.  Alternatively, the investor could invest in the form of a loan that converts into the security issued in the next equity round, usually at some discount to the next round’s price.

This post will focus on convertible note deal term trends based on the 2016 Venture Capital Report recently released by the helpful folks at Wilmer Hale. The convertible note data in the Report was compiled from over 100 deals handled by the firm from 2013 through 2015 for companies and investors in the U.S.

Conversion Discount

Seed investors often negotiate for a discount from the price per share in the next equity round to reward the seed investor for investing at an earlier, riskier stage. discount89% of convertible loan deals covered by the Report in 2015 had discounts, a significant increase from the 66% that had them in 2013.  Sometimes parties negotiate for an ascending discount in which the discount increases as the period between seed and next round increases.  The Report doesn’t provide any information on time periods between seed and next round, or on the percentage of deals that had a sliding discount.  The range of discounts was between 10% and 50%, with 74% of discounted deals having a discount of 20% or less and 26% having discounts of more than 20%.

Conversion Caps

A major advantage of convertible loans is that they allow the parties to defer negotiation of probably the most difficult business issue until the next round: valuation. But that advantage also poses a risk to the seed investor, namely that at the time of conversion at the next round the company’s pre-money valuation will be much higher and thus much more expensive for the seed round investor. caps A discount offers protection against valuation inflation, but only relative to what the next round investors are paying.  An added measure of protection is a cap on the next round valuation applicable to the seed investor’s conversion rate.  For example, imagine a $1 million convertible loan with no discount, no cap, and the company subsequently raises $5 million in a Series A round at a pre-money valuation of $20 million with a per share price of $1.  The note would convert into one million shares ($1 million loan (leaving aside interest for simplicity) divided by $1/share).  But if the note had a $5 million cap, the shares would convert at the rate of, not $1 per share, but $0.50 per share, so that the seed investor would receive two million shares ($1,000,000/$0.50) rather than one million.  I’ve previously blogged here about why valuation caps are loved by angels, tolerated by VCs and hated by entrepreneurs.

Although still popular, valuation caps seem to be trending down somewhat. The Report indicates that only 55% of convertible loan deals contained caps in 2015, nearly a 20% drop from the 74% that featured them the year before.

Conversion on Maturity

The truth about seed round convertible promissory notes is that they are promises that no one intends to be kept. At least the repayment part.  They are intended to be converted into equity.  But what happens if a qualified next round doesn’t occur prior to the maturity date of the note?  Very often, the note will provide that the outstanding principal and interest will convert on a given date, either automatically or at the option of the holder, at a set price or a price determined by a formula or procedure.  According to the Report, 60% of deals in 2015 had some kind of conversion at maturity.  Of those, 89% were at the investor’s option (up from 80% in 2013) and 11% were mandatory (down from 20% in 2013).  In addition, 32% of the 2015 deals that converted upon maturity convert into common stock, substantially unchanged from 2013 but a dramatic decline from the 54% of the conversion-at-maturity deals in 2015 that convert into common.  68% of the 2015 convert-at-maturity deals convert into preferred, also substantially unchanged from 2013, but a sharp increase from the 46% of the 2014 deals that convert into preferred.

Sale of the Company

Upon a sale of the company prior to maturity and prior to a next-round conversion, the outstanding principal and interest may convert into common or preferred stock, either automatically or at the option of the debt holder. In 2015, 74% of the convertible deals covered in the Report had some kind of conversion on a sale of the company, up from 66% in 2014.  Of those, the conversion-on-sale feature was overwhelmingly at the option of the holder (91%, up from 86% in 2014; 9% were mandatory).  Of these deals, they were pretty evenly split in 2015 between those converting into common and those converting into preferred.  In 2014, on the other hand, the conversion-on-sale provisions tended to favor conversions into common (60%) rather than preferred (40%).

Conversion Premiums on Sale of the Company

Seed investors sometimes negotiate for the right to be paid a multiple of principal and interest upon a sale of the company, similar to a liquidation preference associated with preferred stock. Roughly one half of the deals in the Report had company sale premiums.  The premiums ranged from 1.5x (i.e., 1.5 times the outstanding principal and interest) on the low end to 4x on the upper end, an increase from the upper range of 3x in 2014, although the median multiple was steady throughout 2013-2015 at 2x.

Secured Notes

Convertible note investors sometimes negotiate for the note to be secured by some or all of the company’s assets. If the note is not repaid or converted at maturity, the investor could look to the pledged assets to satisfy the loan.  Investors in 2015 were not as successful as they were in 2013 in getting their notes secured.  Only 15% of the convertible notes covered by the Report in 2015 were secured (85% unsecured), down from 25% in 2013 (75% unsecured in 2013).

Conclusion

The foregoing data on conversion discounts, caps, conversion at maturity, sale-of-company conversions and premiums and security suggests that the convertible note deal term pendulum may have started to swing back in favor of investors in 2015. Deal terms in the categories of conversion discounts, conversion at maturity, sale-of-company conversions and sale-of-company premiums were more favorable to investors in 2015.  Terms were more favorable to companies in 2015 with respect to caps and note security.  Given recent developments regarding cooling valuations and a stalled technology IPO market, it will be interesting to see whether the pendulum for convertible deal terms will move more significantly in favor of investors in 2016.

 

Lane Becker, Former CEO of Get Satisfaction
Lane Becker, Former CEO of Get Satisfaction

The Founder of a $50 Million Startup Just Sold His Company — And He Didn’t Make a Dime”.  Such was the provocative headline of the Business Insider article last year reporting the sad tale of young entrepreneur Lane Becker and how he and his management team received none of the acquisition proceeds on the sale of Get Satisfaction, the company Becker founded.  Becker’s fate was not anomalous, and happens when the cumulative liquidation preference amount payable to investors exceeds the value of the company itself.  In this blog post, I’ll briefly explain the liquidation preference overhang phenomenon and discuss how to keep founders and key employees incentivized with a carveout arrangement.

Liquidation preference is a key term negotiated in venture and even seed stage investments. It’s the amount of money the preferred stockholders are contractually entitled to receive off the top on a sale of the company before the common stockholders receive anything.  The common stockholders receive only the balance after the liquidation preference is paid, and if the liquidation preference has a participating feature, the preferred stockholders also participate pro rata in that balance on an as-converted basis.

I have previously blogged here and here about how entrepreneurs often are too fixated on valuation and tend to overlook at their peril the impact that liquidation preference can have on the value of the entrepreneurs’ equity stake. A rich valuation could be completely undercut by a heavy liquidation preference stack.  For example, suppose an investor is proposing to invest $20 million at a pre-money valuation of $60 million for Series B preferred stock constituting 25% of the total equity on an as converted fully-diluted basis and includes a 2x liquidation preference.  The founder is giddy about the $60 million pre-money valuation and takes the deal.  The company had previously raised $10 million in a Series A round where the Series A had a 1x liquidation preference.  Two years after the Series B, the company is sputtering, challenged by competitors and investors and management alike believe the company may only be valued at $40 million, $10 million below the cumulative liquidation preference of $50 million (2 x $20,000,000 (Series B) + 1 x $10,000,000 (Series A)).  Founders’ and management’s common shares are essentially worthless and, consequently, they have little or no incentive to work hard and help the company succeed.

Prior to being acquired, Get Satisfaction was reported to have raised $10 million in a Series B round at a pre-money valuation of $50 million, bringing the total amount raised to $21 million. The purchase price of the acquisition was not disclosed, but it must have been less than $21 million for management to have been washed out (assuming a 1x liquidation preference).

In Lane Becker’s case, he had been terminated as CEO a few years prior to the acquisition of Get Satisfaction, which could happen when founders negotiate away control of their company. But what happens in the more typical scenario when founders are still the CEO or otherwise are employed by and managing the company at a time when the liquidation overhang looms, i.e., when the aggregate liquidation preference amounts exceed the company’s valuation?  What incentive does the common stock holding management team have to stick it out?  Cash compensation will rarely get management satisfaction (pun intended), either because startups seldom have the cash to do so or because cash compensation was never a motivating factor for key employees to begin with.  By joining a startup, talented employees typically sacrifice higher cash compensation they could earn with more established companies in favor of the upside potential that comes with equity they receive in the startup.  Hence, the drill would be to come up with a mechanism that simulates the upside potential of equity without that upside being negated by the liquidation preference overhang.

That mechanism is a bonus or carve-out plan that provides for a payout to carveouteligible employees upon a sale of the company or other liquidity events identified in the plan. A typical plan sets aside a pool of money whose amount is determined based upon a certain percentage of acquisition proceeds.  A well drafted plan would address certain issues related to calculating the proceeds upon which the payout is determined, such as assumption of debt by the purchaser, deferred payments, earnouts and contingent payments.  The relevant percentage may also be on a sliding scale, e.g., 3% on the first $100 million, 5% on the next $50 million and 7% on amounts exceeding $150 million.

Inasmuch as these plans are intended to provide value to common stockholders when the common is worthless, plans could (or should) consider the value of the common (i.e., when the purchase price exceeds the liquidation preference amount) as an offset to payouts and also set a ceiling on payouts. The plan could be structured either as a quasi-contractual commitment by the company in the form of a benefit plan or as a special class of common stock that would be issued to founders and key employees that would be pari passu with the preferred but have a separately calculated payout formula upon the sale of the company.

It’s never easy to take an entire business day out of the office, but the annual Cornell Entrepreneurship Summit is well worth it.  The 2014 edition, dubbed “Beyond the Horizon”, was no exception.  One thing that struck me about this year’s summit was that, unlike previous years, none of the entrepreneur speakers were Cornell alums, demonstrating that the summit has evolved from a Cornell entrepreneurship event to a Cornell event about entrepreneurship.  As to the speakers, here are some of the more memorable and meaningful takeaways for me.

Skybox CEO Tom Ingersoll
How did a startup succeed in creating a real-time Google-Earth?  Skybox Imaging CEO Tom Ingersoll asked the audience, “Have you looked at your house on Google Earth? Disappointed it was two years old?” Because satellites are so expensive to build and launch, most of the pictures that we see are of poor quality and years out of date. Until now. Skybox knew that real-time satellite imaging would require dozens of satellites, a prohibitively expensive endeavor with the cost of a single satellite being around $850 million.  So Skybox needed to find a way to build satellites for a fraction of that, and created a lightweight, nimble satellite in-house for about $10 million.  Ingersoll insisted that the key to Skybox’s success is in execution, and evoked the line mostly attributed to Thomas Edison (also a favorite of Steve Jobs):  “Vision without execution is hallucination”.  Ingersoll said that another key to Skybox’s success is that it has had a patient board of directors, which enabled Skybox to say “no” to Google twice, before finally agreeing to be acquired earlier this year.

If a company offered its employees unlimited vacation time, would anyone show up to work?  Return Path CEO Matt Blumberg revealed that when his company instituted that policy it experienced no higher vacation rates.   The author of “Start-Up CEO” said that his employees are encouraged to take as much time off as they can while maintaining high performance and achieving milestones.  “We don’t count the hours they work, so why should we count the hours they don’t?”

Sols CEO Kegan Schouwenburg

“We went from the cobbler to standardized mass manufacturing and now today we are going to change all that with digital manufacturing”, announced Kegan Schouwenburg, CEO of Sols Systems.  Sols captures a 3-D model of a patient’s foot, makes therapeutic adjustments in a web-based app and manufactures a final product with a 3-D printer.  Schouwenburg also demonstrated the direct to consumer version of the service where a customer can scan his or her own foot with a smartphone and order a custom fit insert.  “One super cool thing about digital manufacturing: no waste”, Schouwenburg said.

Despite recent mega-exits like WhatsApp, Tumblr and Waze, billion-dollar exits are rare, so much so that they’ve been designated the name of a mythical creature, a unicorn.  Every VC chases them.  “Birthing a unicorn is hard”, proclaimed CB Insights CEO Anand Sanwal.  Sanwal’s data shows that only one percent of exits are unicorns, while 72% are below $200 million.  Sanwal said that we may not be in a bubble yet, but valuations are “frothy”.  Although billion dollar valuations require lots of capital raising, some of the recent unicorns raised money late at higher valuations, or never, including Shutterstock and former Cornell Entrepreneurship Summit presenter Wayfair, and Anand said that “these are the companies we should celebrate”.

In Part I of this two-part series, I explained how a favorable pre-money valuation can be undercut by a large option pool baked into the pre-money cap table.  In this Part II of the series, I will concentrate on one other deal term that can serve to undermine a negotiated valuation:  liquidation preferences.  Failure to focus sufficiently on liquidation preference mechanics could also lead to a distortion of incentives and serious strategic issues down the road.

First, a simple scenario.  You’re a startup founder negotiating a $5 million Series A round with a VC and you agree on what seems like a generous pre-money valuation of $10 million.  The company issues the VC preferred shares constituting one-third of the overall equity of the company ($5 million/$15 million post money).  The company grows nicely over the next seven years and receives an acquisition offer of $30 million.  You can hardly believe your good fortune as you quickly calculate that you, your co-founders and angel investors will collectively reap $20 million (2/3 of $30 million).  But your lawyer takes a look at your charter and delivers the bad news: the common holders’ share of the proceeds is actually only $11 million.  What happened?    

In most VC deals, the investors receive shares of preferred stock in exchange for their investment.  Although this form of security is usually associated with a whole range of economic, management and exit rights superior to common stock, the name preferred derives from one of the most important of these rights, namely the liquidation preference.  In its simplest form, the “liq pref” (as VCs often refer to it) is the investor’s right on a sale of the company to receive a certain amount of the proceeds off the top before the common holders receive anything.  In the real world, however, liquidation preference provisions are more complicated, so I’ll describe the typical variations and how they could end up impacting the acquisition proceeds waterfall in spite of the negotiated pre-money valuation.

The amount of the initial preference is usually not less than the amount invested, and is often a multiple of that amount, e.g., 1.5x, 2x, etc.  It’s also not uncommon for accrued but unpaid dividends to be added to the initial amount.  What happens next depends on whether the preference is participating or non-participating.  With participating preferred, the investor first receives the agreed-upon initial amount before the common holders receive anything, and then shares the balance of the proceeds (if any) pro-rata with the common on an as-converted basis.  With non-participating preferred, the investor does not share with the common after his initial preference amount.  But remember, preferred almost always has a conversion feature allowing a preferred holder to forego his preference and convert to common.  So with non-participating preferred, the holder has a choice to make, depending on what yields the most proceeds for him: either the preference amount, or his pro rata share on conversion.  With participating preferred, the holder generally does not have to make that choice; he gets the initial preference, and then he gets his pro rata share of the balance on an as-converted basis (but see below regarding capped participation).

In the above hypothetical Series A deal, the VC agreed to a $10 million pre-money valuation, thus receiving 1/3 of the overall equity, but also negotiated for and received a fully participating 2x liquidation preference with annual 10% cumulative dividends (payable on a sale).  The math works as follows:

 

Initial Preference                                             $13,500,000

            2 x $5,000,000            $10,000,000

            10% x 7 yrs.                $  3,500,000

 1/3 Participation                                               $ 5,500,000

            1/3 x $16,500,000       $  5,500,000

 Proceeds to Preferred                                       $19,000,000

 Proceeds to Common                                       $11,000,000

Companies will often try to limit the sting of the “double-dip” participation feature by negotiating a cap on the participation that follows the initial preference.  The cap is expressed in terms of a multiple of the investment amount, usually in the range of 2x to 3x, and the cap almost always includes the initial preference amount.  This is called capped participation, and participating preferred with no cap is referred to as full participating preferred. 

On the surface, both non-participating and capped participation seem better for the founders, but in practice both could lead to a distortion of incentives for the preferred and unintended consequences for everyone.  With full participation, the interests of the common and preferred will always be aligned; both classes will always be incentivized to seek the highest purchase price.  But with both non-participating and capped participation, there could be a range of prices in which the preferred have no incentive to seek a marginally higher price because within that range the common receive 100% of the marginal increase in price and the preferred receive no additional consideration. 

The two examples below illustrate this point.  Both examples assume a 1x liquidation preference on a $10 million investment, and a $10 million pre-money valuation where the investor is issued 50% of the equity.

EXAMPLE ONE: NON-PARTICIPATING

Acquisition Price

Proceeds to Preferred

Proceeds to Common

$10,000,000

$10,000,000

$0

$15,000,000

$10,000,000

$5,000,000

$20,000,000

$10,000,000

$10,000,000

EXAMPLE TWO: PARTICIPATION CAPPED AT 1.5X

Acquisition Price

Proceeds to Preferred

Proceeds to Common

$10,000,000

$10,000,000

$0

$15,000,000

$12,500,000

$2,500,000

$20,000,000

$15,000,000

$5,000,000

$30,000,000

$15,000,000

$15,000,000

 

Because neither of the above examples is fully-participating, the investor at some point will elect to convert to common and forego the liquidation preference, in each case at the point at which the purchase price is high enough so that the investor receives a higher pro-rata share on an as-converted basis than he’ll receive without conversion.  But notice that in each case there’s a range of purchase prices at which the investor stops receiving additional proceeds on the liquidation preference (on the lower end of this range) and before it makes economic sense for the investor to convert (at just above the upper end of the range).  In the first example, because there is no participation, the investor receives no additional proceeds between a $10 million and a $20 million purchase price (just above the latter being the point at which the investor would convert and take his 50% share).  So assuming the VC is looking to exit and the company receives an offer of $10 million, the investor would have no incentive to seek a higher price unless he believed the price could exceed $20 million.  Similarly, in the second example with a 1.5x participation cap, the investor would have no incentive to seek a price higher than $20 million (at which point he’s capped out at $15 million), unless he believes a $30 million price is achievable currently (above which he’d convert to common and surpass $15 million in proceeds). 

The foregoing phenomenon has been referred to by commentators as the dead zone or the zone of indifference.  I’ll call it the “range of indifference” just to be different.  Once the VC is in the range of indifference, he has no incentive either to negotiate for a higher price, or to defer a sale altogether to build more value in the company.  Even if the investor believed the Company may be worth 50% more in two years, he would have no incentive to take that risk because he’d receive no additional proceeds from the higher price.  The common holders, of course, would have the exact opposite set of incentives and would seek either to negotiate for a higher price or to continue to build value in the company in the hope of selling for a higher price down the road.  This distortion of incentives resulting from the range of indifference actually gets even more complicated as the company completes additional rounds of funding and particularly when an investor in a later round such as a Series D has priority over earlier rounds of preferred.

In any seed or early stage round negotiation between a company and a VC, one of the first and most contentious issues to be negotiated is valuation.  A company’s pre-money valuation will determine how much equity will need to be issued to the investor for any given amount of investment, and thus on its face would appear to be the most critical term in any term sheet.  But as I will show in this two-part series, a favorable pre-money valuation can be undercut by a large option pool baked into the pre-money shares outstanding and/or by a generous liquidation preference.  In this Part I of the series, I will concentrate on the option pool.

VCs almost always insist on a pool of options to be set aside for grants to key employees, both to recruit new talent and to retain existing talent. Startups and emerging companies are typically cash poor and thus have no choice but to use stock as compensation currency.  Options (or restricted stock) also serve to incentivize the management team with the chance to ride the upside potential of the company.  The existence of an option pool in and of itself is not controversial; the way it’s structured can be – if founders are paying attention.

Option pools are typically expressed as a percentage of the post-money shares outstanding on a fully-diluted basis, usually in the range of 10% – 20%.  So if the post-money number of fully-diluted shares (i.e., outstanding shares plus all shares that are subject to options and other rights to acquire shares) before adding the option pool is one million, a 10% option pool would consist of approximately 112,500 shares (112,500/1,112,500 = 10%).  So far so good.

Where the option pool gets interesting is in its impact on price per share of the VC’s investment, which in turn dictates the number of shares and the percentage of total equity to be issued to the investor.  Price per share is calculated by dividing the pre-money valuation by the pre-money number of shares outstanding, typically on a fully-diluted basis.  The issue then is what constitutes “fully-diluted”, i.e., which rights to acquire shares are included in calculating the total number of “fully-diluted” shares.  Should the options to be included in total shares be limited only to those that are outstanding (in other words, those that have been granted but not yet exercised), or should it be viewed more broadly to include options that have been authorized but not yet granted as in the option pool to be agreed upon with the VC?

If option pool shares are included in the pre-money fully-diluted outstanding, the price per share will be reduced and more shares will get issued to the VC.  Accordingly, whether or not the option pool gets baked into the pre-money fully-diluted outstanding shares is an issue with real consequences, as it determines whether founders get diluted disproportionately or just pro rata with the VC.  If the shares in the option pool are included in the pre-money fully-diluted shares, the founders get diluted disproportionately by the option pool shares; if the option pool is excluded from the pre-money shares outstanding, both founders and the VC get diluted proportionately.

VCs will almost always include the option pool in the pre-money shares outstanding.  A typical term sheet submitted by a VC will contain a provision on this point as follows:

“The purchase price per share is based upon a fully-diluted pre-money valuation of $[_____] (including an employee pool representing [__]% of the fully diluted post-money capitalization).”

Most entrepreneurs obsess on the portion of the foregoing sentence preceding the parenthetical; they should focus on the parenthetical as well.  Simple illustration: Assume a pre-money valuation of $4 million, one million shares outstanding, a VC investment of $1 million and a 15% option pool.  Now assume the company is sold for $10 million (the liquidation preference impact on valuation will be explored in Part II of this two-part series).  The difference in outcomes is illustrated in the charts below:

Pre-Money Valuation $4,000,000
Founders Shares   1,000,000
VC Investment $1,000,000

Scenario 1:  No Option Pool

Founders Shares 1,000,000   (80% post)
Price per Share $4 ($4,000,000/1,000,000)
VC Shares 250,000 ($1,000,000/$4) (20% post)
Proceeds per Share $8
Proceeds to VC $2,000,000
Proceeds to Founders $8,000,000

Scenario 2:  Option Pool Not Baked into Pre-Money

Founders Shares 1,000,000   (68% post)
Price per Share $4 ($4,000,000/1,000,000)
VC Shares 250,000 ($1,000,000/$4) (17% post)
Option Shares 220,588 (15% x 1,470,588 = 220,588)
Proceeds per Share $6.80
Proceeds to Employees $1,500,000
Proceeds to VC $1,700,000
Proceeds to Founders $6,800,000

Scenario 3:  Option Pool Baked into Pre-Money

Founders Shares 1,000,000 (65%)
Price per Share $3.25 ($4,000,000/1,230,769)
VC Shares 307,692 ($1,000,000/$3.25) (20% post)
Option Shares 230,769 (15% x 1,538,461 = 230,769)
Proceeds per Share $6.50
Proceeds to Employees $1,500,000
Proceeds to VC $2,000,000
Proceeds to Founders $6,500,000

As indicated above, the consequence of the option pool getting baked into the pre-money shares is that the founders get diluted from 80% to 65%.  In absolute dollar terms, the result becomes more dramatic as the proceeds on the sale of the company increase. The VC, however, remains at 20%.

As between the VC and the founders, the VC actually has the better argument here.  The pre-money valuation is predicated on a management team capable of successfully implementing the business plan.  If the founders themselves do not constitute a complete management team, any equity needed to recruit talent should come out of their basket.  The pain to the founders could be mitigated by limiting the option pool to a reasonable level.  As a general rule, the pool should be just enough to cover the grants expected to be made until the next funding round.  The founders should endeavor to present a credible plan showing how many options the company will need to grant to satisfy its recruiting and retention needs up to that next round.

The other way to approach all of this is to treat the pre-money option pool placement as an alternative to lowering the valuation.  In the above example, by putting a 15% post-money option pool in the pre-money calculation, the VC was essentially asserting that the company is effectively valued at $3.25 million, not $4 million.  But the term sheet will not say “the effective pre-money valuation is $3,250,000.”  That’s for the founders to figure out.

My next blog post will explore the other major valuation buster, liquidation preference, which could have an even more dramatic effect on the founders’ bottom line.