VCs: More Than You Bargained For

Eager to secure the financing their startups need, many entrepreneurs pay too little attention to the fine print. That can be a very costly mistake

By Gabor Garai

http://www.businessweek.com/smallbiz/content/jan2004/sb2004016_2442_sb020.htm

When entrepreneurs begin negotiating with venture capitalists, they are invariably preoccupied with making sure they maintain at least 51% ownership of their companies. That way, they figure, they will keep control of important corporate decisions about strategy and growth. In the process of focusing on ownership, however, entrepreneurs often gloss over the fine print that spells out who will get what when the startup eventually achieves success. Based on how ownership is divided, those unnoticed elements in a deal can pack quite a surprise, since venture capitalists may well be entitled to a much more lucrative payday than entrepreneurs in their innocence ever imagined.

While founders tend to focus on ownership, venture capitalists’ sights are set on the pot of gold at the end of the rainbow — in other words, how much money they’ll make when the outfit is sold. Over the last few years, as valuations declined and investors became harder to find, venture capitalists have moved the pendulum ever further in their favor when it comes to negotiating ownership rights. An example helps illustrate my point.

EXPENSIVE EDUCATION. Imagine you are negotiating with a venture group for the $3 million of financing you have been seeking, in exchange for a third of your company. Not bad, you think. Your outfit is being valued after the funding at $9 million, you’ll get the money you need, and retain two-thirds ownership.

However, in your rush to close the deal, you pay little attention to the fact that the venture capitalists are receiving preferred stock, while you retain common stock. Sooner or later, you’ll learn why it’s called preferred.

For example, the financing agreement guarantees the preferred stock a 10% deferred (cumulative) dividend, so that after five years the venture capitalists are entitled to a 50% return on their investment, or an additional $1.75 million. However, the agreement provides that should the company be sold or liquidated, the preferred-stock owners can forego the dividend and instead collect a "guaranteed return" of three times their original investment. So if the company is sold for $30 million, the venture capitalists would be entitled to $9 million right off the bat. And that isn’t all. The preferred stock is "participating" — meaning that it is also entitled to a percentage of the remaining proceeds based on ownership — in this case, one-third of the remaining $21 million, or $7 million.

EXPANDING SLICE. Thus, even though the venture capitalists technically have only one-third ownership, they wind up with $16 million of the $30 million sale price, or more than half of the proceeds. Should the company become much more successful and, say, be sold for $100 million, the venture capitalists would be looking at the same three times their original investment, or $9 million, plus $30 million (one-third of the remaining acquisition price), for a total of $39 million. Here, while the percentage is reduced to "only" 39% of the purchase price, it still represents a handsome payday.

What if the startup goes public? In that event, the venture capitalists would convert their preferred stock into common and be entitled to the one-third stake they started with. But the amount involved would likely be as much or more than if the company were sold, since public offerings provide valuations far in excess of the $30 million divestiture described previously, or even the $100 million scenario.

What can entrepreneurs do to protect themselves from sharp-penciled venture capitalists?

LEVERAGE AND INCENTIVE. First and most important, they must pay close attention to the provisions surrounding preferred stock and, as much as possible, negotiate for limitations on the investors’ specified entitlements. As just one obvious possibility, venture capitalists might be given a choice between a guaranteed multiple of their investment and a percentage of proceeds from divestiture based on ownership, but not both. Or it could be that the venture capitalists receive three times their investment and share in the purchase price, but only to some maximum, say $50 million in the example previously cited. The possibilities for compromise are nearly endless, and it’s up to entrepreneurs to engage professionals in their corner who understand the nuances of different approaches.

The terms of any deal hinge to a great extent on the perceived leverage each side can bring to bear. If entrepreneurs are desperate, they might give away more than they would like. Likewise, if venture capitalists are extremely committed to a deal, they might give up more than they would prefer. One thing is clear: As the economy improves and venture capital becomes more widely available, entrepreneurs could increasingly have more negotiating power than they realize.

Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.