Ask the Wizard

I received an email the other day asking what books I found useful as an entrepreneur. I realize this is a simple question, but I always find these kinds of things challenging because a) I don't read a lot of business books and b) I think too often people's lists are more about "look how smart I am" than "here are a couple things I found interesting".

I'll mention two books that I think are relevant to entrepreneurs and then one book where I'm making a real stretch, but I quote the book all the time so I might as well include it in the list.

The Places in Between. Summary: Non-Fiction, Scottish dude Rory Stewart walks across Afghanistan from Herat to Kabul in January 2002 in the middle of a war. Relevance to entrepreneurs: Very high. Starting a company is long on improvisation and short on thinking about the odds of success and that sums up this book. As the Afghanistan Security Service tells the author just days before he embarks on his journey - "You are the first tourist in Afghanistan. It is mid-winter - there are three meters of snow on the high passes, there are wolves, and this is a war. You will die, I can guarantee". Taking his journey one step at a time, and always always making the best out of his current situation, The Places in Between is a great parable for entrepreneurs who must approach business the same way - without a security net. Additionally, no matter how hard it gets for you, and it might get pretty hard, you will be able to look back on this book and think "I've got nothing on this guy".

Fooled by Randomness OR The Black Swan. Summary: Philosophy of Randomness. Author Nassim Taleb essentially believes that business people (and the media and historians and everybody else) oversimplify rational explanations of past data, and underestimate the prevalence of unexplainable randomness in that data, which leads them to underestimate the chances of outlying events, which he calls Black Swans. Relevance to entrepreneurs: Very High. Learn to think about potential outcomes more probabilistically and learn to stop thinking that you see simple patterns where luck, chance and other factors probably played roles. Fooled by Randomness is the quicker read. Tip of the hat to FeedBurner investor Brad Feld who recommended Fooled by Randomness to me about a year ago (i think, maybe it was two years ago. Boy, it's all blurring together).

Conversations with my Agent Summary: Mostly fiction. Author Rob Long describes the conversations he has with his Agent as he leaves his highly successful role as writer and coproducer of Cheers and begins to create a new show from scratch. Relevance to entrepreneurs: I'm stretching here, but work with me. The beauty of being reminded that we live in a 'what have you done for me lately' environment in which the people who've been around the block a few times probably aren't as dumb and random as they seem is a great read for entrepreneurs that can't understand why VC's say up when you think down, and why customers say black when you think white.

Posted by Dick at 10:37 PM | Permalink | Comments (8)

We'll see if I have the ability to write a short post on this blog. If there were ever an opportunity, here it is. Some VC's will ask entrepreneurs to sign a no-shop agreement as part of signing a term sheet. As usual, Brad Feld has thoroughly dissected the VC perspective on no-shops and I found this follow-up to his own initial post on the subject to be a very worthwhile read.

First, the very basics. Signing a VC term sheet with a no-shop clause basically means that you, the entrepreneur, will not continue to look for other investors to fund your company on favorable terms while you and the investor behind this term sheet hammer out your final agreement. Since the time between term sheet and closing the financing can be 30-60 days, you are obviously very committed to getting this deal done. Note that there is a wide range of VC behavior and you'll hear stories that run the gamut from assorted entrepreneurs. Most no-shops have a time limit associated with them like 30 days.

Here's my general thinking on no-shop agreements. I don't think you should sign no-shops for your A round, but I care less about them as the company progresses and you raise later rounds. I wouldn't sign one during the A round because during this time, you are spending an inordinate amount of time on financing. It's a full-time job for the CEO. Because you need money to really make progress, the no-shop on an A round really backs you into a corner. You *have* to get the deal done, because you need the cash to make progress, and thus, you are much more vulnerable to a potential investor trying to trade down on you as you progress...there can be any number of reasons/excuses for trying to retrade the deal, but all of them are bad for the entrepreneur who's signed a no-shop on an A round deal. So, all things being equal, I think signing a no-shop agreement on an A round is a bum deal for the entrepreneur.

In later round deals, eh, I don't care so much about this term for a couple reasons. First, I like to raise money when we don't need it (yes, I realize i wrote "I....we....". So shoot me). By getting out and doing a round when you don't need the money at all but know that you will 6-8 months down the road, you can be patient and aggressive and try to build the syndicate you want (yes, I realize I've now switched to the second person...enjoy the roller-coaster that is my lousy writing education). Where were we....Secondly, since you have money in the bank and you're growing the business, in theory, things should be getting better and better on a month to month basis. If the investor tries to re-trade the deal on you while you're under no-shop, you are in a lot better position in this later round situation than you are in an A round. Walk away from the deal if they try to retrade it and once the no-shop expires, start working with others.

The challenge with this advice is that if you're in a position of strength in a B or C round, it's probably easier to get the no-shop removed in the first place anyway, but nonetheless, I generally think it's something to avoid in an A round where you don't have a good feel for the investor's track record on these things, and something to be less concerned about in a later round as long as you've got money in the bank, you're growing well, and you've given yourself loads of time to get a financing done well ahead of the need.

Full disclosure - I have never signed a financing term sheet with a no-shop, so I couldn't tell you much about how hard these are to negotiate out. Other full-disclosure, every time I write "I" in this blog, I generally mean "me and the other cofounders and members of the executive team", but "I" feels so much more rewarding, you know?

Not such a short post after all.

Posted by Dick at 01:59 PM | Permalink | Comments (1)

There is an old saying that the Military always fights the last war, and I think the same holds true in many respects for entrepreneurs. Armed with "lessons learned" from the last endeavor, successful or not, entrepreneurs dive into the next effort reminding themselves to make sure they don't XYZ this time. This is one of the reasons I like having a Board of Directors, as the board can act as a rudder in many ways, making sure you don't veer too far off course in your effort not to repeat past mistakes.

Two companies ago, we all felt we hired a sales executive too soon, and in our last company, Spyonit, determined not to ramp sales until it was time, we waited too long. After feeling like too many enterprise software deals slowed us down in a previous company, we entered FeedBurner with the mantra "no enterprise deals". I can think of countless examples.

None of this is to say that these lessons learned are necessarily bad or wrong, they're just the lessons that might be more aptly applied to restarting the previous company, not necessarily the right lessons for this new company in this new environment in this different economy. This is one of the great challenges in providing advice to entrepreneurs and startups. You might be very good at helping them build version 2.0 of the company you just built, but the advice may be wholly inappropriate to what anybody else is getting ready to do.

Are there any lessons we've learned that I think are appropriate to any new company? Yes, I can think of a couple right off the bat.....and after another twenty minutes I thought of a third.....I still wonder whether these are truly appropriate to any new company or just abstractions that make sense for a certain class of companies, but what the heck, here they are:

Lesson One: At some point in the company's first two years, the executive team needs to become passionate about revenue. This may seem obvious to the point of inviting ridicule, but there's a difference between "concerned about revenue" and "passionate about revenue".. In the first year or two of the company's life, the passion has to be almost single-minded around the product or service. There is then a transition in which the management team needs to *also* become passionate about the customer, and then finally *also* passionate about revenue. Some people are revenue animals and some aren't. If you're founding a company and you're not a revenue animal, then you need to understand that you should bring somebody in to run the company who is a revenue animal at some point. It's no fun trying to run a company as CEO if you're passionate about the product but you wish the Board would stop freaking out just because you missed the numbers last quarter. If the executive team is only concerned about revenue, that's not good enough.

Lesson Two: It is easier to not start spending one new dollar in expenses this month than it is to stop spending one existing dollar of expenses next month. This is true for travel, infrastructure, marketing, development tools, web services like salesforce.com, on and on. If you engender a strong sense of capital efficiency in the company, it's much easier to KEEP spending under control than it is to GET spending under control.

Lesson Three: Goals, not competitors. When you focus on your company's goals, you are focusing on something you have control over, you make strong decisions, and everybody knows what success looks like. When you obsess about your competitors, you are focusing on something over which you don't have control, you make bad decisions, and nobody is sure what success looks like, since the company's actions are in reaction to a third party. Being fiercely competitive is fine, you can hate that your competitors are performing better than you, and you can be hyper-paranoid about what might happen to your business, but the best way to compete in the market is to focus on those things you can strive toward independent of what anybody else does. While this point may sound like motherhood and apple pie, in reality, it can be extremely challenging because everybody else (the media, your mom, customers, vendors, etc.) are looking at the landscape and constantly commenting that X is doing this and you're not, or X is gaining market share from you, etc. So, clearly some part of creating goals is going to be based in market realities, and some part of market realities is going to be driven by existing and emergent competitors. Nonetheless, I am confident that nobody understands where or when their ultimate competition will emerge, and by obsessing about existing competitors instead of clearly defined goals, you make it that much easier for the unforeseen competitor to swoop in and bonk you in the head with the Mallet of Justice(tm).

Posted by Dick at 10:47 AM | Permalink | Comments (4)

I get so many search referrals to this blog with queries like "restricted stock vs. options", probably because i wrote a post titled "restricted stock vs. options", it's time to finally write about "restricted stock vs. options". This is a simple yet complicated topic, and I will undoubtedly leave out a bunch of stuff and get ten things wrong, but other than that, I hope this will prove helpful and enlightening. Please refer to Volume II of "Ask Dr. Phil, The Startup Years" for anything I might be leaving out here.

You can look up most of the basics like "what is restricted stock" or "what is an option" or "who shot JR" on the Google. I won't define terms here, I'll just talk about some pros and cons of when you might use restricted stock instead of options or vice versa and why. Big tip of the hat to Brad Feld and David Hornik who filled in a bunch of blanks for me on this.

When would you issue restricted stock instead of options? In a startup, one time that you might do this is very early on for a few executives or very early 'founder-ish' hires. The reason you might issue restricted stock instead of options generally has to do with tax treatment. The general deal with options is this - you get an option to buy stock at some price. The day you exercise that option is the day you start holding the stock. If you sell the stock before you have held it for a year, you pay income tax on the gain, even if you held the option itself for 4 years (and if you sell after you've held the stock itself for a year, you pay long-term capital gains). You can imagine lots and lots of cases in which the only time an employee would exercise their options is when they are about to turn right around and sell the stock, so in these cases, the employees are looking at income tax. Enter restricted stock. Maybe. Probably not though.

Restricted stock, on the other hand, is also really a stock grant that promises vested stock to the holder, but can work like so.....you're granted the stock, but it is restricted in that the company has a right to buy it back on the cheap according to a vesting schedule. So, the good news in this case is if you file a special 83b election with the tax man (more on this below), then the date the long term capital gains clock starts ticking is the date you buy the restricted stock (even though it is at risk over the course of the vesting schedule). So, good news is better clock ticking on long-term capital gains treatment and bad news is that you actually have to purchase the stock or pay tax now on a grant of stock that's priced below fair market value. So unlike options, you've got cash out of pocket on equity that's not going to be liquid, in all likelihood, for quite some time. One reason you might consider this approach more right at startup time is that the common stock hasn't yet acquired much/any value, so the purchase price or income tax can be next to nothin. You don't wanna have to buy $100k worth of restricted stock in shmucky.com only to watch shmucky.com go out of business 18 months later when the market for pre-washed online shmucks dries up or you quit, etc.

Is that all? No, that's not all. If that were all, the tax code and business would be simple, and you might see a lot more people getting restricted stock at startup time than options, and the chances of the tax code and company reporting requirements and so forth being simple are unlikely.

A non-tax restricted stock vs. options consideration for entrepreneurs and startups is that there are lots of issues involved with having too many stockholders. These range from things like inability to run as a pass-through entity like an S-corp if there are too many stockholders to things like requirements of x% of the stockholders on approval of mergers to all sorts of other reporting requirements that make it unattractive to have so many actual stockholders as opposed to options holders.

Then there's the tax kicker regarding why more companies don't just offer restricted stock grants instead of options to more people. This is the stay tuned for more bad news part that I mentioned earlier. Let's say the fair market value of the common stock is now $3 and you grant some employee 10k shares at zero cost to the employee with a four year vesting schedule. In order that the clock start ticking at grant time on the long term capital gains treatment, the employee files a special 83b election with the IRS. This election essentially says "i want to establish cost basis in the stock now and a gain (or loss) will be recognized only when i sell". As part of this, you then have to pay income tax on the difference between the grant and the fair market value now, at the time of grant. Six months later the employee quits or the company goes bankrupt and in either case the employee has no vested shares. Does the employee get to now claim a loss? What do you think the answer is going to be? You are right, the answer is no way, the employee is out the tax bill plus whatever they paid for the restricted shares.

So, ok, what if you don't file special election 83b? In that case, you pay no tax at grant time but only when the grant vests (more accurately, as each chunk vests). HOWEVER, at that time, you now owe income tax on the difference between what you paid for the stock and the fair market value at the time the stock vested. If the stock has appreciated, you now wish you'd been granted options. Very bad. Not good. Bummer. Since the potential tax liability on such stock could be massive if it really appreciates, anybody in their right mind files an 83b election, since that's kind of the whole point.

Having said all this, when do restricted stock grants make the most sense for a startup? Again, they make the most sense in the early going, before the common has any real value at all, and even then only for a handfull of executives so that there aren't too many stockholders. The too many stockholders issues have little to do with transparency and everything to do with all the extra burdens heaped on companies with certain numbers of shareholders....burdens that startups don't need while they're trying to run fast and grow over the first several years.

Thus, you see some savvy executives who might come into a company in the very early days that understand the benefits of asking for restricted stock instead of options, and in those cases restricted stock can be a better deal for the executive and can make sense and this is not a ridiculous request. As you grow and finance the company and add more employees, however, options plans are more appropriate as they don't force employees to come out of pocket now with cash they might not be able to recoup later.

NB: I'm not referring in here to "Restricted Stock Units", which are another subject altogether. When you hear that companies like Microsoft have stopped granting options and started granting restricted stock, what they are really talking about is something called restricted stock units, which are a promise to grant unrestricted shares according to a vesting schedule, and you don't need to worry your pretty little head over those right now.

Clear as mud? Good. The Wizard is all about sleight of hand and misdirection. <Poof>

Posted by Dick at 03:37 PM | Permalink | Comments (5)

I've gotten a few questions about convertible debt as an alternative to an equity seed round. I've never done a convertible debt deal, but since I keep getting questions about this, I did some digging around, and this wouldn't be the first time I've decided not to confuse experience or knowledge with expertise, so here goes.

There are a couple things to like about convertible debt and a couple of things not to like. Let's assume we're talking purely about convertible debt as a way to get ramped up in advance of doing a first bigger venture round.

Thing to like about convertible debt #1: You can get a deal done quickly. Your service really took off and you need to spend 100k on infastructure right now, you found a great vp engineering you have to hire right now, you need to buy 10 tickets to the Web 2.0 conference right now. Whatever, convertible debt will be generally be a faster way of seeding the company than raising an equity round.

Thing to like about convertible debt #2: If you do the convertible debt with a venture investor, you've now got somebody involved who's motivated to help you do your venture round, and you aren't flying so blind if this is your first time into the breach.

Both of these things to like are more than offset by a couple things to hate, in my mind.

Things to hate about convertible debt #1: Unaligned interests between the investors and entrepreneurs. This would be a good topic for a full post because there are lots of situations you can get into in which the investors interests and the entrepreneur interests are unaligned and they're probably all bad. In this case, successful serial entrepreneur turned successful serial investor Josh Kopelman has done a great job of elaborating on how interests can be unaligned with convertible notes as a seed funding approach. Also see the post Josh refers to by Brad Feld, who has written about pre-A round financings a couple of times himself.

Because the note will generally convert at a 20%-40% discount to the price of the qualified financing, the bottom line here is that you don't want an investor who's thinking "hey, if we can keep this A round down to a couple million valuation, then my notes convert at this nice low price and meanwhile the company's made all this progress....". You want somebody alongside you that's financially delighted to see you get a great price on the follow-on venture round. I can imagine that angels and other investors that prefer convertible notes will take umbrage to the suggestion that their motives are at loggerheads to the entrepreneur's here, but I don't like any situation in which you even see the suggestion of unaligned interests because it can potentially motivate wacky behavior. This is a reason to actually be wary of capped participating preferred and preference multiples as well, but that's another story.

Things to hate about Convertible Debt #2: The note holder doesn't want to convert on the venture round. Ruh Roh, George. You can set up the terms so that the note holder can be bought out or converted, but how much luck do you think you're going to have attracting a top firm to your venture round with convertible that won't come along? Why aren't they playing? What do they know that nobody else knows?

Things to note about any funding process #1: While a convertible note deal may get done a lot faster than a seed equity round, these processes all take time. We once did a B round financing with multiple investors in which structure, board makeup, etc. would change significantly from the A round financing, and this whole thing took about two months. We then later on did a B1 financing with one new participant in which literally nothing changed at all and the investor was as helpful as possible and it couldn't have been simpler and this process took two months. Why? Because no lawyer has ever used the "accept all changes" button in MS Word, that's why. And because documents need to be updated and t's crossed and i's dotted and all this is a giant pain in the ass and it always takes two months.

Despite this, you could argue there are a couple cases in which you the entrepreneur might want to play Convertible Debt Jeopardy. There are a variety of reasons anybody might take issue with this, but let's spell it out, since it's certainly a possibility for some kinds of companies. Let's say your startup is doing very well, and you need to grow. You've also been approached by some companies about a potential acquisition, and you'd like to entertain those, but you need cash to grow now. Convertible here could make sense because if you go ahead with the acquisition, you pay off the note and the capital turns out to have been very cheap indeed, and if you don't go ahead with the acquisition, voila, you've got somebody who can now help you go put a real venture round together and you were able to ramp into growth through the acquisition discussions. Note, however, that lots of seed round convertible debt investors might demand equity-like protections from this and negotiate for language that says if the venture round is pre-empted before they convert, they get a return of X. As always, everything's negotiable, even if the people across the table from you say "that's standard".

This post should not be taken to mean I don't like debt. There are lots of disagreements among entrepreneurs and investors about debt at various stages of the company and for various reasons. As always, we'll get to that in another post.

UPDATE: post updated to correct horrible spelling errors, a misplaced percent sign and a missing zero - generally shoddy craftsmanship.

Posted by Dick at 11:25 AM | Permalink | Comments (2)

You are one lucky dude. You have a simple vanilla Series A term sheet from a venture fund that's done a bunch of A round deals. You and your investor get along and are looking forward to working together. The company is brand new. You have an attorney who does divorce deals normally but has done a few incorporations in his day to negotiate the term sheet and handle all the follow-on negotiations on the Articles, which should be no big deal, right? After all, how many Articles of Incorporation variations can there be especially when you're working with a very vanilla straightforward term sheet. You're raising a million bucks, the legal fees on this financing will net out at, what, 5 to 10k at the most, right? You can probably get anybody to represent you because this should be pretty cookie-cutter, right? You poor deluded fool.

There are a bunch of things to think about regarding legal representation and legal fees.

Rule #1: Making mistakes on your legal agreements now will cost you in spades down the road, both financially and otherwise. Do not skimp on representation. Do not focus on hourly rates (more on that below).

Get attorneys who have worked in your general area before (eg. internet consumer software or enterprise IT software) and who have done all kinds of work across this area (eg, financings, corporate creation, contracts - especially contracts, patent/IP work, M&A work, options plans, etc.). Geographic proximity to you is entirely unimportant, so don't worry if you're in an area that doesn't have lots of this expertise. FeedBurner's current counsel is Cooley Godward's office in Broomfield Colorado. We are in Chicago. I'm not sure I could point to Broomfield on a map other than to wave my finger generally over the denver area and say "it's thereabouts".

My cofounders and I were extremely fortunate that one of our spouses worked at the first firm that represented us in a previous company, but not everybody's in the position to have immediate access to a trusted and capable firm. So, what are some of the ways you can go about finding great attorneys? Simple: call or email a bunch of other startups in your general market and ask these people how they like their representation. I'll save you the hassle of emailng or calling me and tell you that we love our representation. Startupping, Mark Fletcher's excellent new resource for entrepreneurs, also has a bunch of helpful suggestions in this area in the forums, and you can always ask questions of a lot of people at once over there.

Rule #2: Financings will cost you a lot more in legal fees than you think they should.

Back to the opening paragraph. You're doing a straight A round financing on a blank slate company with a venture fund that's done loads of these. I would expect to pay up to $30k on all the legal fees associated with an A round financing. Why so much? Because you are paying the legal fees for both your attorney and the VC's attorney when these two attorneys negotiate against each other. "Did I read that correctly?", you say, rubbing your eyes. Yes, you read that correctly. You pay your attorney to negotiate all the docs and you pay the VC's attorney to negotiate against your attorney. Some percentage of the money you are raising will go to pay the attorney of the firm who is negotiating against you on the money you are raising. This is chapter 1 in the "Life's not Fair" manual that comes with running a startup.

Unfortunately, this puts you in a position of thinking "well, i don't want to really negotiate this point, because I'm paying twice to negotiate this point". That's no way to live, so here's how you (try) to deal with this. First of all, up front, get the venture firm's attorney to cap their fees. They will respond to this request with "we will if your guy will", and your guy will respond to this request with something like "we will if they will but our cap will be higher because we also have to do all the paperwork and file the articles and blah blah blah" or they might say "no." or they might say "ok, we'll cap ours at 30, which is fine since we only anticipate spending 20". Take a deep breath and keep at it, you want both sides to cap their fees before you get started here. Helpful investors that are really going to be your partner can put the squeeze on their counsel to cap their fees. Of course, you might reasonably say that a super helpful investor would pay their own legal fees, and I'd agree with you. This is one of the areas that I shake my head at and say "this don't seem right", but I've never been in a situation where the venture firm paid their own fees. In a financing where you have multiple investors, however, you should definitely make sure you're only paying one firm on the other side.

You may be thinking right now that I'm stupid to pay both sides' legal fees in any negotiation. If you can negotiate that you're not paying the other side's fees on the deal, good for you. Go for it. While I have never not paid the other side's fees, I'm sure some companies in huge demand have the leverage to negotiate for this prior to signing term sheets. As always, never take "it's standard, all our deals are like this" as a reason you should just accept the point.

The last point I would make on financing legal fees is that you can use the Wizard's very own patent-pending-financing-legal-fees-negotiation-tactic. Here's how it works. Before the two sides start negotiating, I call both sides and start swearing about how upset I'm going to be if this costs more than some reasonable amount. I'm generally informed that it's going to cost a lot more than that reasonable amount, upon which I call and email both sides again and the investors and swear a lot more about how capital inefficient this is and what a waste it is, and since I actually feel this way and am by now swearing in the office about the cost, it has the added effect of not sounding disingenuous.

Rule #3: Expensive attorneys can be less expensive

Referencing the Wizard's first rule of legal representation, one of the reasons you want people who've worked in this area before is that they can end up costing you a lot less money, even at a much higher hourly rate than other attorneys, to get pieces of business done. In the past, we've seen very expensive attorneys get financings, patent filings, contracts, and other work done for companies at 1/4 the total cost of similar work by another legal team and the resulting work is likely a lot more thorough if the firm's had lots of experience in this area. Our previous company (spyonit) setup costs were a lot less than my first company's setup costs in which I'd used a "cheap" non-researched attorney, even though the spyonit attorneys were lots more expensive and spyonit was a more complex company. Don't skimp on seemingly pricey attorneys as a means of saving money. It can easily backfire. This is to say nothing of the trouble and costs you could incur down the road if you sign a contract with troubling indemnification clauses or the options plan is messed up in some obscure but critical way, etc.

If you can find attorneys who also believe in what you're doing to the extent they feel like this will be a beneficial long-term relationship, that can also help a ton with short term fees. If your counsel feels like building this relationship is more important than getting another 1500 bucks out of you this month, that's obviously a good thing. This is easier said than done, however, and probably even more difficult in the valley at the top firms.

My opinion about legal representation does not cross over to audit representation, in which I think going with one of the cornerstone firms is a good way to ensure you will get raked over the coals on audit fees a few years down the road. Lots of auditors will mark down their fees in the first year or two while you're just getting started, but the really big firms will come back and bonk you on the head with ridiculous fees a couple years down the road, while some of the smaller, hungrier, and no less competent firms will keep their rates aggressive AND will give you more general attention.

Posted by Dick at 09:31 AM | Permalink | Comments (1)

The Wizard was out of town on vacation and what the Wizard learned on vacation is that the family makes no distinction between the evils of working or blogging on vacation. I'm back with a series of posts I wrote on the plane(s) based on assorted emails I've received.

First up, another important term in a venture financing term sheet, the liquidation preference. This section of a venture term sheet essentially defines how much money the people financing this round will have the right to pull out of the company on an exit before anybody else gets anything. Once again, Brad Feld has written an extensive and thorough post on liquidation preference, so I won't retrack all that ground here. Rather, I'll dive right into some of the key thoughts and distinctions and assume that you'll do the work of reading Brad's post first, or after this, or sometime.

I like FAQ's, and I got a lot of Liquidation Preference questions, so let's do this as a FAQ.

What is the liquidation preference?
Already with the questions that are answered in Brad's post? The liquidation preference simply (or complexfully) defines the money that will be returned to a particular series of the company's stock before the holders of any other series of stock. The Series A term sheet, for example, (always a good example because it's the easiest!) will define how the series A preferred shareholders will/can be paid before the holders of the common stock.

What the hell does the liquidation preference section really mean?
Here's what's going on. What your investors are doing here is making sure they get paid out on a subpar exit. Let's say you raise series A 5 million at 5 pre for a 10 post and then sell the company for 8 a year later and through the magic of simple examples, you never vested any options so the series A owns 50% of the company in preferred stock and the common owns 50% of the company in common. On the 8 exit, your investors have to be able to turn around and look their investors in the eye and NOT say "we lost a million bucks but the founder made 4 million" because that would "suck" and nobody would invest in their fund again. The liquidation preference defines the order and quantity in which an exit is paid out. The investors with a "liquidation preference" get paid first AS DEFINIED IN THIS SECTION, and then others are paid out.

Liquidation is bad. That means something happened that i didn't want to happen and we went bankrupt, so if I am a confident entrepreneur, I don't need to pay attention to this section, right?
Well, that was more of a rhetorical question, but no, that's not correct. This section defines how the moneys are going to get doled out on almost any kind of non-ipo exit, good or bad. Pay careful attention.

What's the difference between liquidation preference, participating preferred, capped participation, and a preference multiple?
I was afraid you would ask that. Let's see if I can really boil this down with examples. Here's sample language for a liquidation preference section of a term sheet that's about as vanilla and entrepreneur friendly as you could want. Maybe you'd like to start with the question "what does a vanilla liquidation preference section look like?"

Sure, I'll start with that. Uh, what's some sample language?
Great. Here's a very pro-entrepreneur liquidation preference language on a Series A term sheet.

In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive, in preference to the holders of the Common Stock, a per share amount equal to 1x the original purchase price plus any declared but unpaid dividends (the “Liquidation Preference”).
After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock.
Upon any liquidation or deemed liquidation or Fundamental Change (as defined in the articles of incorporation, as mutually agreed in the negotiation of the definitive documentation), holder of the Series A Preferred shall be entitled to receive the greater of (i) the amount they would have received pursuant to the prior sentence, or (ii) the amount they would have received in the event of conversion of the Series A Preferred to Common Stock [with some blah blah blah exceptions].

This is what you would call your straight 1x non-participating liquidation preference section. What this section is saying is that when there's an exit, the series A investors can choose to EITHER just take their investment out before anybody else gets anything (but only their original investment) OR convert to common and share in the proceeds pro-rata with everybody else. It doesn't really get any more pro-entrepreneur than this. If you get this language in a term sheet, good for you. It will depend entirely on how much you've accomplished, the economic climate, what round you're raising, the demand for the deal, etc. Chances are very good you won't see this language on a Series A term sheet for a new venture run by founders without a track record or insufficient demand for the round. Don't stress, it's not the end of the world.

So, what's a preference multiple?
Well, you see that 1x in the pro-entrepreneur language above? That might say 2x or 3x and that would mean your Series A investor have a 2x or 3x preference multiple on an exit. Let's say you raise 2 on 3 pre for a 5 post-money, but the liquidation preference is a 3x multiple. Although the investors own 40% and the common 60% (again assuming no vested options....options are like friction in physics examples....the math is so much easier without them), on a 10 million exit, do you think the Series A investors are going to want to convert to common and share pro-rata or do you think they'll just take their 3x preference multple thanks. The math is easy - they take their multiple and get 6 million instead of 4.

What's the concept behind a preference multiple?
Your investors put two million into your company on month 1, and you have so far put in no million but have come up with something that can attract 2 million at 3 pre. Good for you. A month goes by and somebody offers you 4 million for the company. You've only been working 2 months. No preference multiple? you get 2.4 million and your investor loses 1.6. But wait! you say, couldn't the investor just block the sale? Sure, the investor will have a blocking right. Ask most investors how they feel about blocking a deal when the entrepreneur or management team all say "time to sell!".

Can I negotiate a preference multiple out?
Go for it. As I've said before, too many entrepreneurs focus on valuation at the expense of everything else, and I would strongly encourage that you pay careful attention and energy on the liquidation preference and run through multiple scenarios to see what different outcomes entail.

Are you going to talk about particpating preferred? Did you already talk about it but in such a ponderous manner that we slept through it?
Participation, or the Double Dip as Fred Wilson likes to call it. Let's say instead of the language in the second paragraph in my example above where we saw "After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock.", in term sheets with participating preferred, you'll see:
"After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.

See what's going on here? In a term sheet with participating preferred, the Series A investor doesn't need to decide if they want their preference or to convert to common and participate pro-rata. They do both. Some smart folks realize that participating preferred (aka participation) is only really fair at smaller exit values where the clause is in there to protect the investor and if the company does very well, the investor shoudn't participate inequitably. That leads you to your next question, right?

Um, what were we talking about again? I was just watching Escape from Witch Mountain on TBS
Right. Enter capped participation. Essentially "participating preferred up to a point". Again, I lift language freely from Brad Feld's liquidation preference post and include his example here:

After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis; provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.

You see how these variations on the theme can have very different meanings but start to look very much alike.

This is a great overview, but what do i care about?
You should run multiple scenarios on your liquidation preference language that help you see who gets what in different exit scenarios. Rest assured on an A round that you are likely to see strong investor preferences (some multiple or participation) and you may or may not be able to negotiate them away, but you can certainly try different angles. Everybody should be comfortable with a cap on participation, for example. Remember that you should never take "we always do it this way" as a valid answer to any of your questions or negotiations. Everything is negotiable. The valuation is under pressure? Maybe you agree to that if the liquidation preference changes. Maybe you take a term sheet with a lower pre-money valuation but more favorable liquidation preference language.

Any gotchas?
Well, sure, there are always gotchas. For example, when the language states that the investors can choose to convert their series A preferred to common, you want to check the Conversion section of the term sheet and make sure that conversion looks something like:

The holders of the Preferred Stock shall have the right to convert the Preferred Stock into shares of Common Stock. The initial conversion rate shall be 1:1, subject to [blah blah blah]

....and of course you should always watch out for "blah blah blahs" in the language.

As always, I've left out a bunch of stuff but the post is already five times longer than I'd originally intended.

Posted by Dick at 11:00 PM | Permalink | Comments (4)