Monday, February 16, 2009

Down Rounds and Valuation

There is a small company here that has just relocated to be in Silicon Valley and it has a Term Sheet from a VC who effectively underwrote its financing on the presumption that the VCs would be able to secure a co-investor here in the Valley. The VCs now want to renege on the term sheet and change the raise and pre-$. Sounds like another "vulture capital" story doesn’t it? Well perhaps ... or perhaps not.

So one of the worst things that can happen to a company and the investors, is a "down round." It's one of the main reasons VCs push back on valuations. If the company cannot create enough value on a funding round to justify a larger pre-$ on the next round, everyone is in serious trouble. The VCs hate down rounds, not because it changes their ownership (this is a common misconception among entrepreneurs)--the VCs are naturally trying to own as much of the company as they reasonably can, but there are simple and reasonable limits to this, which if they are ignored by the VCs will be corrected by the market anyway.

In a down round, what the previous round holders lose they make up for on the next round--net net, they typically end up at the same place--no big deal. But the founders, ouch! The team is usually okay because the new investors boost the ESOP to incentivize the team, taking that boost out of the founders and the previous investors. What VCs hate about down rounds is having to tell their limited partners that they effectively lost money--the value they are carrying the investment at has gone down, and this is never a fun conversation ;-(

Now from the VC side, the company has missed some required accomplishments in order to attract a co-investor, like the new version of its product, which can be sold here vs. the old one which can’t, the building of a team, and others--but as in most cases, communication and misunderstanding are largely behind the issues, and the end result is ... do the VCs stick to the original deal which will almost certainly result in a down round, or do they work with the company to restructure? The company on the other hand, does it wheel out the lawyers and try to force the original deal, or does it have conversation(s)?

Back to my recurring theme of team, team, team--once the VCs have funded, even partially, they are in the same boat as the entrepreneurs, generally they don’t propose deal changes that don’t make sense from a shareholder’s perspective. For VCs deal terms get renegotiated by teams frequently--e.g., management carve out in acquisition overtakes liquidation preference, anti-dilution, and earn out rarely finds its way back to the investors but ends up in the pockets of the team, etc….

It will be interesting to revisit this case, and the urban myths it creates over the next several months, because it could go either way. Wheeling out the lawyers rarely works, because (in my experience) the only ones that win are the lawyers and litigation makes you a poor investment risk in the future regardless of whether you are successful or not. Unfortunately, the reality of most situations is that both sides are right, and ironically wrong at the same time. If the entrepreneurs cave, are they opening the door for future renegotiation? Should they argue the case of whether they delivered or not, whether it was miscommunication or not?

At the end of the day its largely irrelevant--it is what it is, deal with it! I suspect the right solution is for everyone to compromise--for the VCs to put up more cash to give the company more runway so it can have the best possible chance of delivering the up round needed (which goes against the post money problem by making it even higher), but at the same time give the VCs a claw back provision or warrants or some other mechanism to turn a Down Round (if there is one) into a flat round, so that everyone wins. For sure, while everyone is arguing the "he said she said," the chances of the company hitting its milestones are getting smaller, and that’s in nobody’s interest!

Monday, February 2, 2009

Heading for the exit ...

One of the key criteria that LPs [limited partners] use to evaluate a VC fund is their ability to get exits from deals and return capital. I was doing an interview a while back with a group of LPs who are interviewing entrepreneurs to get a better picture of how entrepreneurs pick VC funds---quite a good idea, I think. One of the questions was how to weigh the VCs ability to get exits vs. other criteria. As I’ve mentioned before, my key criteria is to work with a partner who has personally built a similar company in the same space, or at least has empathy with me as an entrepreneur, so they can add real world experience and actively help me build a successful company. So for me, ability to generate an exit is very low on the VC check list.

Now, as a VC, I should defend that position ;-) I have sold several companies, and the first time, I followed the advice of older, wiser heads, and engaged an advisor--it worked out OK, but the advisor was not so good, and had little experience in our space. The result was an OK exit, but it should have been much better. So this put me off advisors, and the next time I did the deal myself.

The problems with doing it yourself are many but you should never sell your own baby. You are too close to be effective and are often negotiating with your future employer—and, in a way, against yourself. Having a third party act as the buffer is far more effective, not just from ability to play the missing man scenario but to have an experienced transaction architect look at your deal unemotionally and optimize it for you--and themselves ;-)

I heard a story about a VC who wanted to go with his entrepreneurs to negotiate a trade sale of one of his portfolio companies. The company was about two thirds through the negotiation, and the entrepreneurs didn’t want the VC to come. Now I think the VC getting involved at this stage was a really bad idea too, but not for the same reason as the entrepreneurs who had been told by a trusted advisor that the VC would “try to screw them” and that’s why he wanted in on the negotiations.

This is rubbish, in any transaction in which the team adds value going forward they have the leverage and at an exit there is little percentage in trying to “screw” the entrepreneurs since VCs don’t stay in business long if they damage their wellspring of deals. And the acquirer tends to be more inclined to try to “screw” the VCs ;-) See previous posting.

Interestingly, the VC wanted to be in the negotiations to prevent the entrepreneurs negotiating a better deal for themselves at the expense of the other investors and shareholders, a classic case of hyeung yao to smooth the deal. There is some validity to this concern as its easy for an acquirer to load up fat retention bonuses, option packages, and employment contracts to sweeten the back end of a deal for the entrepreneur that are not shared with the remainder of the shareholders. VCs may have a bunch of magical powers endowed beyond their preference shares, but they also have serious legal obligations to represent the interest of all shareholders, especially the minority common shares and ESOP.

Anyway, I learned from both ends that it's better to find a really good banker who can make the transaction work for you. There are a lot of boutique i-banks that specialize in certain verticals--like telecom, optical, semi, medical, etc--and (not surprisingly) these boutique specialists are usually former entrepreneurs who have founded and sold their own businesses and thereby realized how much better it is to have a third party do it for you. The really good ones I found were serial entrepreneurs who learned firsthand how to build value and transacted that into very solid knowledge of what makes an acquirer want to buy your business. With all due respect to VCs, I think those boutique firms are far better assets for generating an exit than most VCs are. Tech company sales are a highly specialized transaction area and VCs can’t be good at everything ;-)

Answers to questions:

John, Dave, Bill, Judy – thanks for all your various questions around what VCs are funding in this environment. I will write a blog on that next, and follow it with what they are actually doing ;-)