Secrets of Sand Hill Road
Page 21
To illustrate the effect of antidilution, let’s assume that despite your best efforts, things don’t work out well and you are sitting here in eighteen months having consumed the cash but without having made the requisite progress. You still believe in the company (as do your original venture investors), but your valuation is going to be reflected nonetheless in the less-than-planned progress. As a result, Momentum Capital is willing to invest a new $2 million in the company, but only at a $6 million pre-money valuation.
The first question is whether the existing antidilution provisions apply here. The answer unfortunately is yes—because the valuation being proposed is lower than either of the valuations in the Haiku or Indigo term sheet. If you do the math, you’ll see that the initial prices per share being proposed by Momentum are about ninety cents (had we been in Haiku land) and seventy-eight cents (had we been in Indigo land). The valuation of course is the same, but the per-share price is different because we have a different number of total shares outstanding between the two venture deals. (Hopefully you can see that the way to calculate the per-share price is to divide the $6 million pre-money valuation by the total number of shares outstanding.)
But that’s not the full story. These per-share prices will not be the prices per share that Momentum ultimately invests in the company. Why is that? Because Momentum wants to invest $2 million and own 25 percent of the company ($2 million divided by the $8 million post-money valuation). However, when we factor in the antidilution protection that Haiku and Indigo each receive as part of the deal, the company needs to issue more shares to them, which in turn dilutes the ownership of Momentum. Thus, we find ourselves in a circular model—the additional shares issued to Haiku/Indigo reduce Momentum’s ownership, requiring that we therefore lower the actual price per share to Momentum and thus issue them additional shares, which lower effective per-share price then requires that we recalculate the antidilution protection, and so on.
Eventually we will get our Excel model to iterate enough times to converge on the right answer, but that’s no easy task. And now for the painful part: How much are the different antidilution provisions going to cost in terms of additional shares awarded to each of Haiku and Indigo? Let’s take a look at the capitalization table for each Momentum transaction.
Here’s the capitalization table had we taken the Haiku term sheet and then done the Momentum deal:
Shareholder
# of Shares
# of Shares Issued in New Deal
# of Shares Post-Deal
% Ownership
Founders
4,000,000
—
4,000,000
44.0%
Haiku Capital
1,333,333
156,863
1,490,196
16.4%
Option Pool
1,333,333
—
1,333,333
14.6%
Momentum Capital
—
2,274,510
2,274,510
25.00%
Total
6,666,666
2,431,373
9,098,039
100.0%
And here’s the capitalization table had we taken the Indigo term sheet and then done the Momentum deal:
Shareholder
# of Shares
# of Shares Issued in New Deal
# of Shares Post-Deal
% Ownership
Founders
4,000,000
—
4,000,000
19.4%
Indigo Capital
2,580,645
7,741,935
10,322,581
50.0%
Option Pool
1,161,290
—
1,161,290
5.6%
Momentum Capital
—
5,160,290
5,161,290
25.0%
Total
7,741,935
12,902,225
20,645,161
100.0%
That’s a pretty big difference—the founders’ ownership differs by more than two times between the two options. Often what might happen in practice is that Momentum would make its deal contingent upon Haiku/Indigo (particularly Indigo) waiving its antidilution protection, or at least modifying it to a broad-based weighted average. In addition, Momentum might insist that, in order to lessen the dilutive impact of the round on the founders and employees, the existing investors increase the size of the option pool (and suffer the attendant dilution from that as well) so as to be able to provide additional option grants to the remaining team members. After all, Momentum is unlikely to want to fund the business if it believes that the remaining team is not adequately incented to stay with the business and help return it to growth mode.
Regardless, you want to avoid putting yourself in that pickle if at all possible. Antidilution provisions are very common in venture deals, so it’s unlikely that you’ll be able to raise venture money without such a provision at all. However, as you’ve seen, the difference between weighted average dilution versus a full ratchet is very meaningful. So no matter your level of confidence in your entrepreneurship skills, you’d be well-advised to pay careful attention to the full set of economic terms in a term sheet.
Evaluating the Governance Terms
Now that we have a good sense of the different economic terms, let’s take a look at the key governance terms in the two original term sheets below.
Governance Terms
Haiku Capital
Indigo Capital
Auto-convert
$50 million IPO or majority of Preferred vote
$100 million IPO or majority of Series A
Protective Provisions
Majority of Preferred vote
Majority of Series A
Drag-Along
Triggered by majority vote of Board + common + Preferred
Triggered by majority vote of Board + common + Series A
Board Composition
2 common + 1 Preferred
1 common + 2 Preferred
When we look at the broad difference between the two term sheets, we notice that the Haiku term sheet has used our capital “P” Preferred in its voting thresholds, whereas Indigo has used Series A preferred only. While it’s impossible to fully know the implications of this downstream, in general it’s simpler to have a capital �
��P” Preferred vote as the baseline precedent at an early stage versus setting up a series-specific vote this early in the company’s life cycle. This wouldn’t of course have mattered in the Momentum Capital financing round since it came early on (Haiku and Indigo on their own could each control their respective votes), but the governance setup might have influenced the terms that Momentum demanded. For example, if Momentum were following the Indigo term sheet, it might have also demanded a separate set of auto-convert and protective provisions to be voted on only by itself (the Series B).
To be clear, there is no rule that says that all subsequent investors get the benefit of the same terms as did earlier investors, but in my experience this is often the starting point of the discussion: if it was good enough for those investors, why isn’t it good enough for me as the new investor? No doubt the best retort to this argument is: “This time things are different.”
For example, maybe the company was in a distressed situation in a previous round of financing and thus had to offer slightly more onerous terms to entice an investor. And now the company is firing on all cylinders and can therefore command more company-favorable financing terms. All of these are fair arguments to make—and you should make them if you ever find yourself in this situation—but don’t underestimate the value of precedent. It establishes the starting point from which you need to negotiate; whether or not you think that’s fair, it’s often the way these negotiations go. A little planning when you are doing the current transaction for the eventuality of future transactions can go a long way.
Equally important is the board composition proposed by the two venture firms. Haiku is proposing a common-controlled board—that is, the majority of the board seats are controlled by common. The biggest implication of this is that Haiku on its own would not be able to hire or fire the CEO or control any corporate actions that require board approval. Indigo is less founder friendly in this regard, proposing that it get two boards seats to only one for common. This means that Indigo controls the board and thus has material influence on all major corporate actions.
So with the benefit of the full set of terms—economic and governance—how do you now think about which term sheet is better?
Sorry. It was a trick question again. The whole exercise exists to point out that there are pros and cons to every deal, and there usually is no definitive right answer. Some of the decision depends on how confident you are in the company’s future (and yourself as CEO), how much money you really need now to accomplish your goals, and how much you are willing to gamble on the downside in order to give yourself more upside.
A lot of these depend on contingencies that are hard to predict at such an early stage, so in many cases keeping things simple is probably the better course. But, hey, you’re an entrepreneur, so maybe taking a gamble is the best way to go!
Importantly, though, as we’ve tried to point out in this discussion, you need to think beyond valuation alone and consider the combined implications of the full set of economic and governance terms.
CHAPTER 12
Board Members and the Good Housekeeping Seal of Approval
Now that we’ve raised money and are off to the races, we should turn our attention to the ongoing affairs of the business. The CEO, of course, is responsible for the day-to-day operations of the business (as well as the long-term vision), and I have boundless respect for CEOs and their startup teams. While they are the ones who eat, sleep, and breathe their startups, they are not alone in their care and shepherding of the company. It’s critical to understand that a company’s board of directors has a role to play in a startup.
Thus, this chapter talks about the role of the board of directors and how the board influences the path of the startup and potentially the ability of the founder to keep steering the ship. Boards, including the founder, also have to operate under various well-defined legal constraints that can materially impact the degrees of freedom of a company. Understanding what those are and how best to accomplish the goals of the startup without going to jail or bankrupting yourself personally is probably worth the effort!
Private versus Public Boards
There are a few important distinctions between boards of private startups versus those of public companies that are worth noting, as they can affect the overall direction and decisions of the startup.
First, for public companies, board members are typically elected by the common shareholders. Recall that, in most cases, public companies do not have common and preferred shares outstanding (though it is the case that some public companies—e.g., Facebook and Google—have dual classes of common stock that may have different voting provisions). As a result, other than the potential voting differentials, there is a single class of shareholders who at least in theory have one goal in mind: to maximize the value of the company for the benefit of the common shareholders.
As we’ve discussed, private startups typically diverge from this model. The board composition is generally dictated by the terms negotiated in the course of a financing round. And as a result we tend to have not only multiple types of shareholders—common plus different series of preferred stock—but also often specific enumerated parties that control access to board seats. In our VCF1 term sheet, for example, the board was designated to have a representative from common, one from VCF1, and a third to be elected by the common and preferred together.
Second, the impact of board decisions can also vary between public and private companies because of the presence of the protective provisions that often accompany the VCs’ preferred shares. Public companies are much simpler in that respect. If, for example, the board of a public company decides to vote in favor of an acquisition, the acquisition is likely to happen. Of course there is a need for a shareholder vote, but recall that that vote is likely just going to have one class of stock voting, and we certainly don’t have different contractual says in the matter (other than the dual-class voting rights) depending on what type of stock a shareholder has.
Again, contrast that with the private startup situation. In the acquisition example, not only does the board need to vote in favor of the deal but also we might have multiple series of preferred stock whose vote is required based upon the protective provisions. If our startup has gone through multiple rounds of financing and we weren’t able to stick with the capital “P” Preferred voting threshold in the protective provisions, we could have a preferred series of investor who has a small economic stake in the company but a disproportionate say in the acquisition outcome by virtue of having a series-specific protective provision vote.
Finally, the presence of other terms (in particular antidilution and liquidation preferences) can also affect decision-making in a private startup. In public companies, because we don’t have multiple classes of stock with these varying terms, the calculus is pretty simple: grow the value of the equity for the benefit of the common shareholders.
As we’ll see in the next few chapters, preferred investors and common investors are not always aligned. Particularly in the case of an acquisition where liquidation preferences may come into play, the interests of the two parties can diverge significantly. So, while the board has certain fiduciary duties to keep in mind—which we’ll cover shortly in chapter 13—there are still ways in which the board dynamics and the presence of common and preferred shares can create interesting challenges when trying to make decisions on big corporate actions, such as fund-raising and acquisitions.
Dual Fiduciaries
Here’s the fundamental issue to keep in mind when dealing with private startup boards and corporate decision-making in general: the VCs are dual fiduciaries. What does that mean?
Well, as a board member, a VC (just as is the case for public company board members) has a fiduciary duty to the common shareholders of the company. More to come on this in chapter 13, but suffice it to say that this means that the board member needs to always keep in mind how her vote helps maximize the lon
g-term value of the stock held by the common shareholders.
But as a GP in a venture capital firm, she is also a fiduciary to her LPs, who have given her money in order to maximize the value of the investment dollars they have committed to the venture firm. And as we briefly noted above, there are times where the GP’s economic interest—as a holder of preferred shares with different rights and privileges—may diverge from those of the common shareholders. Therein lies the rub.
The Role of the Board
Let’s come back to the role of the board more specifically. We’ve hinted at a number of the board’s responsibilities, but it would be good to dive into a bit more detail.
Good boards do most of the following things.
1. Hire/Fire the CEO
A foundational role of the board is to put in place the person who has day-to-day responsibility for the operation of the company. The CEO has all her executives in the company reporting to her (and thus she has the ability to hire or fire any of them), and the CEO herself ultimately reports to the board. Well-functioning boards recognize and respect this distinction by giving the CEO the freedom to run the company as she sees fit, subject to the constraint that she is ultimately accountable to the board for the results of the company. Though it can be tempting, particularly in smaller startups, for the VC board member to engage more closely with the CEO’s executives, this can inadvertently undermine the CEO’s authority and create management challenges for the startup.