Next Things First

Venture Capital Deal Terms by Rob Coppedge
March 2, 2009, 5:13 pm
Filed under: Uncategorized

John Cook posted a very interesting piece on VC deal terms last week – for those of your that missed it, take a look:

Of the 128 companies surveyed by Fenwick & West, 41 percent of the deals included liquidation preferences — special rights that allow VCs to cash out first if the startup is acquired. That’s about the same level as the previous quarter. Even more interesting, is that VCs increasingly got liquidation preferences that required two to three times of the initial investment. Fenwick found that 23 percent of VCs got multiple liquidation preferences last quarter, up from 16 percent in the third quarter. That’s bad news for entrepreneurs, since if a positive sale occurs there can be little leftover for the founders who conceived the business.

To read more, click here.

Since liquidation preferences are a term that always gets under our skin, we posted a few comments to John’s article. Since so many of our colleagues use these preferences (and we know they have a place) we tried to be nice. However, I would bet that data would show these preferences have a surprisingly destructive  impact on value. Since they only really “matter” in underperforming companies – or at least deals which were unrealistically assessed at the time of the investment – one has to wonder what impact knowing they are going to see disproportionally less of the upside has on management teams.  Someone has to come in and run the business every day… and I don’t know any VCs who want to have to step in and do that work.

…Terms like liquidation preferences have grown in popularity to offer downside protection – and in certain cases (especially in overly complex capital structures) they can serve an important purpose.

However, they have become emblematic of the personality disorder facing the venture capital industry over the past decade. Ours should be a business of aligning incentives with entrepreneurs and getting actively involved in building value. As preferences layer on top of preferences, however, it is not uncommon to see the returns gobbled up before management can even get a seat at the table.

While there is a need to mitigate downside risk and protect later stage investors, I worry that this deal term is over used – and often times used incorrectly. When success is created by motivating entrepreneurs (or at least not “demotivating” them), deal structuring is important. As is the perception of being “in this together”.

I remind myself often that “getting it because we can” can not be the basis for VC/entrepreneur negotiations -even during this sort of an economy.


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