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VC
Ratchets and Liquidation Preferences
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Real Life Example: ICG Invests Add'l $25M in Logistics.com, Stake Now at 97% Wonder who was left holding the remaining 3%???? Seeing the Forest for the Trees From: "Curt Sahakian" <cpart@PartneringAgreements.com> Ron, I saw the discussion about the distinctions and features of different ratchet's and liquidity preferences.... I can't help but chime in. :^) The commentators seem to be seeing the trees, but they are missing the forest. If you are taking VC money these provisions come with the territory. No matter how they are done, they are all ugly and dangerous to the founders and early investors. If you are already talking about ratchets and liquidity preferences you are already in trouble... and you are unlikely to find the solution you need in the text of the investment agreements. It's sort of like coming to consciousness and discovering someone gave you a date rape drug. The deed has already been done and there is not much you can do about it. Well... almost nothing. A founder may be able to exercise extra-contractual leverage to renegotiate the deal. But even here you have to plan ahead. To renegotiate the deal you have to have something they want. They already ensconced themselves into your company, so you can't use that. The only other leverage that a founder can generate in these circumstances is based on the strength of the founder's personal relationships with other key employees as well as the founder's personal ongoing value to the company (especially relationships with revenue generating customers). The personal relationships with the key employees can be buttressed by making sure that they have congruent equity interests with the founder. If you are going after VC money don't skimp on the equity to that small group of people who can make or break you in a confrontation with the VCs... and make it subject to the same contingencies as yours. Also make sure the weaker ones have termination agreements that will enable them to afford to get up and walk with you if you ask them to. If in doubt, be a little on the generous side with equity. The bigger the equity disparity between you and your key execs, the more tempting it is to the VC's to dilute you out and then redistribute the now open points of equity to other executives. Keeping them motivated may be more important to the VCs than keeping the founder motivated... and they can get more bang per point of equity. There are other things you can do to create a personal and economic bond between and among your subordinate compatriots and ensure that everyone helps protect the other when the going gets tough. One thing you can do is to make sure one or two of them are on the Board of Directors (but first get an undated letters of resignation from them so their heads don't get too big). If and when the VCs start skulking around soliciting "frank opinions" about you from your key executives... their job is to convince the VCs that you are irreplaceable and then warn you about what is underfoot. The VCs will say things to these other board members that they won't say to your face. If they handle themselves properly they can serve as an early warning system. If the founder has the ability to get up and walk with several key members of the management team (especially ones with strong customer relationships) and disrupt the ongoing viability of the company in the process... he doesn't need "no stinkin contract" or at least he has a substitute for an unfair one. The VC's have set themselves up to be in a position to say "what's the money worth to you today." The only viable counter is "what's the company worth to you today". The one catch to all this is that the company has to be worth something for it to work. You can't play chicken with the VCs over a company they don't care about. But then again if it isn't worth anything, why bother with dancing with them in the first place? If you have a difference of opinion as to the company's value maybe you should try buying it from the VC with paper... cut back the fast spending / fast growth approach and start living off of customer or partner money instead of investor money. Also - REAL IMPORTANT - you must be respectful, polite and graceful in how you use this leverage. If you overplay your hand, or get obnoxious, they will just blow you away and move on to the next deal. Bottom line: The best protection against a ratchet is to plan ahead and (a) maintain strong personal relationships and shared economic interests with your key employees so that you can act as a group if you are faced with potential dilution by a VC, (b) maintain your own indispensability to the company including your relationships with key customers and employees (and don't be so quick to hand them off to employees who owe their primary loyalty to the VCs). Also, if you can, get a provision that permits you to refuse subsequent rounds of financing without getting ratcheting out of your own company. If you can get this, then you at least have the option of turning the burn rate way down low before you run out of cash, then just hunker down and do the best you can to keep the company going. This probably means giving up hope of hitting that big home run (what the VC was in the game for)... but leaves alive the opportunity to grow your company more slowly using customer money instead. Unfortunately this type of provision is often unattainable in VC fundings, at least with the larger funds. Here is a link to a more detailed discussion of the above: Curt Sahakian, Esq. 847-676-2774 Fortune Article on "Ratchets", "Cram Downs", "Washouts" and "Hiding the Baloney" The following was contained in a PDF file that accompanied a message sent by vranczynski@mindspring.com, published in TMR 9-5-2001. http://www.fortune.com/indexw.jhtml?channel=artcol.jhtml&doc_id=203966 The Silicon Valley Smackdown Venture capitalists are a gimlet-eyed, cynical bunch even in the frothiest of times. Two years ago, while entrepreneurs and investors were still running spreadsheets to calculate how great their options-fueled fortunes would be in 2009, VCs were quietly protecting themselves against a downturn by inserting a host of obscure provisions, covenants, and clauses into startups' contracts. Said provisions, and the means of exercising them, go by names more evocative of a WWF match than of the honorable and holy task of creating wealth through technological innovation. Some examples: "the full ratchet," "the cram-down," and "the washout." Ouch. Unfortunately, now that the tech IPO market has collapsed like one of Stone Cold Steve Austin's patsies, these little-noticed provisions are being activated at hundreds of troubled tech companies. For you spectators and investors out there, here's a guide to some of the more dastardly moves being used by VCs these days. Pretend that you are the founder and chief executive of a private company that makes data storage equipment. Let's call it Network Icebox. Now that your hopes of going public are history, you are left to squabble over the fate of your hapless company with Kane Ventures, the VC firm that funded it and owns 20%. Your goal: Raise more money so that Network Icebox can last long enough to achieve your dream of world domination. Your opponent? Kane's VCs, who want a return on their money, or at least their original investment back so they can put the money elsewhere and continue collecting fees for managing it. You own 40% of the company (the rest is owned by other VCs and angel investors with minor stakes), but that doesn't mean you've got the upper hand. Here are some of the moves you need to watch out for: The Cram-Down Say you've run out of operating money and need $5 million to keep the company going for six months. Last year, believing your company to be worth $50 million, Kane Ventures bought 20% of your company's private stock for $10 million. This year, Kane thinks your company is worth only a total of $20 million. They'll consider investing again, but only at the new, lower valuation, in what is known as a "cram-down" or "down round." In return for their infusion of $5 million, they get an additional 25 percent of the company. So suddenly your 40% stake, which was worth $20 million a year ago, would henceforth be worth $8 million. And after you sell Kane the new $5 million worth, your stake is down to 15 percent, valued at $3 million. You need the money. You take the cram-down. The Full Ratchet As Kane descends upon you in mid-cram-down, you discover they inserted a "full ratchet" clause into the term sheet you signed last year. The full ratchet basically gives Kane the right, in the new round of financing, to retain their stake's former valuation while everyone else's stakes evaporate. So while your startup's total valuation drops from $50 million to $20 million this round, Kane Ventures still owns $15 million worth (the original $10 million investment, plus the latest $5 million round). You thought you still owned 40%, worth $8 million? After Kane drops the full ratchet on you, it has the controlling interest--75%--in Network Icebox. The remaining equity--all $5 million worth at this point--gets divided among the company's other investors. The Washout A VC with a controlling stake will force a severe cram-down, sometimes combined with a ratchet, in order to "wash out" unwanted investors or management teams. In other words, you are no longer in control of the company you founded. You have been washed out. You tender your resignation. Hiding the Baloney Okay, this term isn't really making the rounds of the VC community--yet. But it's an apt heading under which to file the many variations on the following maneuver: merging two troubled companies that have nothing in common in order to avoid shutting both down. How does this technique work? Imagine now you're a partner at Kane Ventures. Six months ago you expertly washed out the management of Network Icebox with a cram-down/full-ratchet combo. You still think Network Icebox has great technology and could be huge someday, but, alas, it has burned through all its cash and will cease operations next week. You're also invested in RicoShot Inc., a wireless-access company with no future whatsoever but $15 million in the bank left over from its second round of funding last fall, when the company had a valuation of $50 million. Do you shut both companies down and distribute RicoShot's remaining $15 million to your limited partners? Heck no. You use a merger to hide the baloney! Now you've got a single company with a valuation (on paper, at least) of $70 million and $15 million in cash. The real value of the new company may be closer to zero than $70 million, but this maneuver, also known as a dowry deal, at least lets everyone keep the dream alive--not to mention your management fees on that $20 million. Winners and still champions of Silicon Valley: the venture capitalists. Messages on "Ratchets" and Liquidity Preferences From: "Williams, Darrell" <darrell.williams@tdfund.com> Ron: Someone is confusing anti-dilution ratchets (that are triggered in subsequent "down rounds" of equity financing) with liquidation preferences (that come into effect if the company is liquidated or sold). They are separate deal points that are designed to address different circumstances. The liquidation preference (1 to 3 times the amount of capital provided by investors plus accrued dividends) requires distribution of all net liquidation proceeds (including proceeds related to a sale of the company) to the investors holding preferred stock BEFORE any distributions are made to holders of common. A 1X preference (return of capital) is very pro-common/founder and is usually a non-starter (definitely a non-starter in the current investment environment). A 3X preference is near the top of the range but still quite prevalent, particularly these days. The liquidation preference is important to the investors, particularly in situations where the investors are providing a step-up in valuation to the common stockholders. A participating feature is also a typical deal structure component. First the investors receive the liquidation preference. The remaining proceeds are distributed to all equity holders (common and preferred) on a pro-rata basis. The ratchet has to do with the treatment of preferred stock in a down round. In the event that the company raises capital in the future at a valuation that is below the post money valuation of the current round, the investors in the current round are protected to the extent of their ratchet, of which there are two types. Full ratchet makes the investors completely whole. Investors get enough new shares such that the total number of shares held multiplied by the new (lower) per share price equals the amount of capital the investor provided in the first place. Weighted average anti-dilution works less to the favor of the preferred investors (they don't get completely whole) and is less dilutive to the common holders. To the question on future management incentive, the board can agree to increase management equity (through the stock option pool or through other means) to make up for the common dilution incurred as a result of the anti-dilution enjoyed by the preferred shareholders. This of course assumes that the current management remains highly valuable to the company and that the down round itself is driven by factors other than management performance. The liquidation preference comes into play at the end times when all parties are moving on. After the ratchet occurs, the parties involved still must figure out a way to live with each other (or not). The negotiation and structuring around these two provisions can create a wide variety of flavors. Clearly, entrepreneurs and investors should have their eyes wide open to the implications of these provisions. Darrell Williams From: vranczynski@mindspring.com Ron, The attached PDF (from Fortune magazine via the Garage.com clipping service) has a good explanation/example of a ratchet. Liquidation preferences are a different thing, and could be used on a VC's stock investment or other financial instruments such as a bridge loan. Let's say a VC backed company is in trouble and needs $10M just to survive long enough (get prototype approved, to market, whatever) to get acquired by another company. Let's say the same VC provides the bridge financing, but with a 2x liquidation preference. Doesn't matter if it was a straight up loan or via additional stock purchase (things can get complicated here; lots of former lawyers and ex investment bankers amongst the VC ranks). When the company gets sold, the holder of that $10M gets 2x his money, or $20M, off the top from the sales proceeds BEFORE the remainder gets divvied up amongst shareholders (possibly including himself as an earlier investor). If the company gets sold for $100M, then $20M first goes to the holder of the liquidation preference. The remaining $80M gets split up per stockholders. Now change the example to the company selling at only $30M. Now the lion's share of the proceeds goes to repaying that 2x liquidity preference, and vastly dilutes what's left over for stockholders. Ratchets can drastically change the percentage ownerships. Liquidity preference can leave ownership ratios intact, but take so much in upfront repayment that the remaining stock holders have little left of the "pie" to divvy up. Either situation can get quite nasty of course. Hope this helps. vic |
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