Writing as The Deal Professor for The New York Times, Steven Davidoff has been examining the many cases in which a venture backed company is “successfully” sold, yet the entrepreneurs who built it receive very little. The headline-grabbing case, three months ago, was the sale of Bloodhound Technologies. The five members of the founding team, all of whom had left the company in 2000, received a total of $36,000 on a $82.5 million sale. One founder actually received a check for $99.
Most venture-backed exits don’t receive that amount of attention, yet there’s suspicion that many are similarly disadvantageous to founders.
After years as founders, angel investors, venture capitalists, and even participants in shareholder lawsuits, my partner and I can say with certainty that the time to address so-called founder economics--that’s how much you, the founder, are going to get when you leave your company--is when the first money is raised. Founder economics need to be addressed again at every subsequent round of funding. If you wait until the exit or liquidation is upon you, you’ll have very little leverage.
Re-negotiating the capital structure during each round of financing helps to avoid an ever-increasing stack of liquidation preferences, cumulative dividends and other preferred terms. And it enables the entrepreneurial team to benefit from the increase in shareholder value that they’ve created.
Yes, venture capital is governed by the golden rule: If you have the gold, you make the rules. But there are still plenty of opportunities for entrepreneurial teams to negotiate, protect and strengthen their stakes.
The best situation is the one is which you and your team have clearly created economic value for your shareholders. Generally, this means you’re raising money at a higher valuation than your last round (an “up round”) and that valuation is confirmed by qualified outside investors.
In this situation, you want your team to be moving forward on terms that are roughly equal to those of your existing investors.
To do that, you’ve probably got to eliminate or water down many of the provisions of the preferred stock. One way to do this without sending your investors into a fit is called tapering. As your company hits various milestones - raises more money, reaches a particular valuation, or achieves operational or revenue goals - the features of the preferred stock are gradually and automatically phased out. This makes a potential renegotiation of deal terms easier for venture capitalists to accept.
If you’re in the unfortunate situation of raising a down round, you can expect that your stake, and those of the other shareholders, is going to be diluted dramatically.
In this case, the company may very well be distressed, and looking for an acquirer. But you and your team may still have some leverage. The investors want the highest price for the company. You and your management team may not have much incentive to go after that higher price, because between dilution and any liquidation preferences, a higher price will barely affect you. So in many cases, the board of directors will agree to a carve-out of the sale proceeds (above an agreed-upon target amount) for the founding team or for senior management. They want the highest price for your company, and they may not be able to get it without you.