Startup Bonds

The VC-Preferred Model

• How VC's take control of the Company
• How the interests of VC's and entrepreneurs become misaligned

The VC business model
VC’s are generally structured as limited partnerships with one or more individuals acting as the general partner and the outside investors in the fund acting as limited partners. This structure has been mirrored by funds that opt for the new LLC form of business entity where the general partner can be formed as an LLC.

Each fund has a fixed term—usually ten years. Investments are made in stages throughout the ten year period and the fund is liquidated at the end of the ten year term. The proceeds of the liquidation of the fund are generally shared among the limited partners (investors) with a carried interest (“carry”) percentage (usually twenty percent) retained by the managers—the VC partners. Rules for how the carry is shared between the partners can become sophisticated and resemble partnership agreements in that senior partners can negotiate larger percentages than junior partners. In addition to the carry, the VC partners share a management fee, usually in the region of two percent of the total fund per year. So, a $1b fund will translate into a $20m/year management fee for the VC.

In the first few years of the life of the fund, the VC will invest in a portfolio of investments, usually 10-30 startup companies. During the last few years, the VC will work towards liquidating the shareholding in those companies. The time from investment to exit for a startup company is generally expected to be around seven years, so the fund would usually like to make the bulk of its investments during the first three years so that the portfolio can be liquidated before the end of the ten year term.

The returns demanded by VC’s are relatively high. According to Bob Zider, ‘How Venture Capital Works’, Harvard Business Review[1]: “In return for financing one to two years of a company’s start-up, venture capitalists expect a ten times return of capital over five years. Combined with the preferred position, this is very high-cost capital: a loan with a 58% annual compound interest rate that cannot be repaid”. Zider goes on to explain: “Investors in venture capital funds are typically large institutions such as pension funds, financial firms, insurance companies and university endowments—all of which put a small percentage of their total funds into high-risk investments. They expect a return of between 25% and 35% per year over the lifetime of the investment”.

Home run focus
The VC business model is based on the chance that one or more of the portfolio will hit a home run—that it will result in a huge return to the fund. This is usually achieved through a high-profile IPO. So, VC’s are heavily focused on finding the next Google or the next Cisco systems.

Under this portfolio theory model, each company in the portfolio has to be a candidate for a home run. Considering the high failure rate of portfolio companies, the VC’s focus on investments that have a potential investment return of 5x or 10x or even higher within a 5-7 year period.

Preferred stock
VC’s almost always structure their investments in the form of preferred stock. Like common stock, the properties of preferred stock are prescribed in state corporation codes and the corporate articles and bylaws. Preferred stock represents an equity interest in the Corporation but it is considered a hybrid of both common stock and debt.

Preferred stock is in a junior position to debt when it comes to liquidation and bankruptcy and although preferred stockholders cannot usually force the Company into involuntary bankruptcy, VC’s can add these rights to the terms they demand in exchange for the funds they invest. However, preferred is senior to common stock—dividends to preferred holders come before payments to common stockholders and preferred holders often come out of liquidation owning the assets of the Company while the holders of common usually come away from a liquidation with nothing.

As more than 90% of venture startups end in liquidation[2][3], the vast majority of patents and intellectual property developed by the founders ends up in the hands of the VC’s, and the founders find themselves post-liquidation with no legal claim of ownership over the ideas, inventions or intellectual property they created.

Common stock usually has advantages over preferred when it comes to declaring dividends, however preferred stock under the VC Preferred model, is convertible to common—so convertibility allows the preferred holders achieve the best of both worlds—upside potential as common stock and downside protection when treated as a creditor. Preferred acts as a second class of common stock with a liquidation preference[4].

Preferred and common stock structure allows for differential pricing. The SEC mandates that common cannot be lower than 10% of preferred. Closer to IPO, the common should be repriced to at least 90% of the preferred share value. If the Company had only one class of stock, and the employee were issued stock at a price lower than the market rate, then the difference between the issue price and the market rate at the time of issue is taxable as unearned income. However, under the preferred/common two-tiered stock structure, the Company is able to issue common stock to employees at prices significantly lower than the price at which preferred stock is sold to investors. In addition to providing the control mechanisms the VC’s seek, there are significant tax benefits to this two tiered common/preferred stock structure.

Preference shares
Preference shares are essentially common stock with additional contractual rights provided in the stock purchase agreement. The preferred stock is issued under provisions of the Company’s articles of association and bylaws. The articles in most technology startups provide the board of directors a ‘blank check’ to create preferred stock as and when it is needed. The articles and contractual rights can be trumped by the law of the state of Delaware, or the state in which the corporation was formed. Delaware has certain statutes controlling how preference shares can be issued and the rights of the corporation and preference shareholders. VC’s are accustomed to these statutes and prefer Delaware corporations as they feel comfortable with the Delaware law in this area.

Preferential rights are contractual and strictly construed by the Delaware courts, but preferred stock also has a common stock characteristic. The question facing the court in Jedwab[5] was whether the rights of preferred shareholders should be treated as contractual or fiduciary (as shareholders). The Jedwab court answered: ‘both’. Preference rights are contractual; ordinary stock rights are fiduciary... However, as stated in the paper by Mitchell, The Puzzling Paradox of Preferred Stock (And Why We Should Care About It) [6], before we can apply the Jedwab rule, we must know which rights of the preferred are preferences, and thus contractual, and which are shared, and thus fiduciary.

Convertibility
The complex preferred stock structure is unpalatable to Wall Street investors and other investors in the public stock markets as it creates a complex capitalization structure and seriously affects the value of common stock. So, immediately prior to IPO the preferred stock converts to common, and the contractual rights of the preferred shareholders are lost. Conversion of preferred to common is normally set at 1:1. One preferred share converts to one common share, however anti-dilution provisions such as the following can adjust this conversion ratio.

The[7] Series A Preferred initially converts 1:1 to Common Stock at any time at option of holder, subject to adjustments for stock dividends, splits, combinations and similar events and as described below under “Anti-dilution Provisions.”

Anti-dilution Provisions:
In the event that the Company issues additional securities at a purchase price less than the current Series A Preferred conversion price, such conversion price shall be adjusted in accordance with the following formula:
[Alternative 1: “Typical” weighted average:
CP2 = CP1 * (A+B) / (A+C)
CP2 = New Series A Conversion Price
CP1 = Series A Conversion Price in effect immediately prior to new issue
A = Number of shares of Common Stock deemed to be outstanding immediately prior to new issue (includes all shares of outstanding common stock, all shares of outstanding preferred stock on an as-converted basis, and all outstanding options on an as-exercised basis; and does not include any convertible securities converting into this round of financing)
B = Aggregate consideration received by the Corporation with respect to the new issue divided by CP1
C = Number of shares of stock issued in the subject transaction]

This form of anti-dilution is known as the ‘weighed average’. A more extreme formula is sometimes chosen called the ‘ratchet’ that essentially mandates that all future dilution resulting from the sale of additional shares is at the expense of the common shareholders, and that the VC will suffer no dilution from future rounds of funding. This is clearly a little unfair on the entrepreneurs and according to Fenwick & West publications, some form of weighted average anti-dilution protection was used in about 95%[8] of 4Q 2006 VC financings, the same as in 3Q 2006.

Ownership structure
Common shares make up a large fraction of the Company’s outstanding shares. One study finds that, among firms about to go public, almost half the shares are in the form of common. The study finds that median VC share ownership is 53%; median founder ownership is 12%; median manager ownership is around 7%. (Because these are medians, not means, they need not add up to 100%.) The balance of the shares is owned by non-VC investors, other employees, and business partners[9].

Participation rights
When future funds are raised by the Company, usually in new classes of preferred stock issuances, the current VC’s negotiate rights to participate in those future rounds:



Right to Participate Pro Rata in Future Rounds:
All [Major] Investors shall have a pro rata right, based on their percentage equity ownership in the Company (assuming the conversion of all outstanding Preferred Stock into Common Stock and the exercise of all options outstanding under the Company’s stock plans), to participate in subsequent issuances of equity securities of the Company (excluding those issuances listed at the end of the “Anti-dilution Provisions” section of this Term Sheet and issuances in connection with acquisitions by the Company). In addition, should any [Major] Investor choose not to purchase its full pro rata share, the remaining [Major] Investors shall have the right to purchase the remaining pro rata shares.

Unlike the anti-dilution provisions that result in ‘free’ stock in the form of adjusted conversion rights, these participation rights provide the VC with the opportunity to maintain their shareholding percentage but the VC is forced to ‘pay to play’.

The no-shop term sheet provision
Prior to investing the Company, the VC’s usually present a term sheet to the entrepreneur that outlines the significant provisions of the investment such as the amount of money to be invested, the number of shares the VC will receive in exchange and the preferences they want writing into the preferred stock. The provisions of the term sheet are usually unenforceable, except for a provision that restricts the entrepreneur from shopping the term sheet to other investors, and effectively soliciting bids from other investors.

No shop/confidentiality
The Company agrees to work in good faith expeditiously towards a closing. The Company and the Founders agree that they will not, for a period of [six] weeks from the date these terms are accepted, take any action to solicit, initiate, encourage or assist the submission of any proposal, negotiation or offer from any person or entity other than the Investors relating to the sale or issuance, of any of the capital stock of the Company [or the acquisition, sale, lease, license or other disposition of the Company or any material part of the stock or assets of the Company] and shall notify the Investors promptly of any inquiries by any third parties in regards to the foregoing. [In the event that the Company breaches this no-shop obligation and, prior to [________], closes any of the above-referenced transactions [without providing the Investors the opportunity to invest on the same terms as the other parties to such transaction], then the Company shall pay to the Investors $[_______] upon the closing of any such transaction as liquidated damages.] The Company will not disclose the terms of this Term Sheet to any person other than officers, members of the Board of Directors and the Company’s accountants and attorneys and other potential Investors acceptable to [_________], as lead Investor, without the written consent of the Investors.

After the term sheet is signed, the due diligence process commences and through the no-shop clause, the entrepreneur is locked in to dealing with only the one lead VC. The VC, on the other hand, is under no obligation to make the investment or to observe the provisions agreed in the term sheet. This arrangement puts the VC in an unusually powerful position, as will be discussed later.

Liquidation preference
One of the most important provisions of the VC-Preferred model is the use of liquidation preferences. This provision means that when the Company is sold, or liquidated, the preferred-holding VC takes its money out of the proceeds before sharing any of the proceeds with the common shareholders.

In the event of any liquidation, dissolution or winding up of the Company, the proceeds shall be paid as follows [either 1, 2, or 3]:

1) First pay [] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. The balance of any proceeds shall be distributed to holders of Common Stock.

2) First pay [] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, the Series A Preferred participates with the Common Stock on an as-converted basis.

3) First pay [] times the Original Purchase Price [plus accrued dividends] [plus declared and unpaid dividends] on each share of Series A Preferred. Thereafter, Series A Preferred participates with Common Stock on an as-converted basis until the holders of Series A Preferred receive an aggregate of [_____] times the Original Purchase Price.]

A merger or consolidation (other than one in which stockholders of the Company own a majority by voting power of the outstanding shares of the surviving or acquiring corporation) and a sale, lease, transfer or other disposition of all or substantially all of the assets of the Company will be treated as a liquidation event (a “Deemed Liquidation Event”), thereby triggering payment of the liquidation preferences described above [unless the holders of [___]% of the Series A Preferred elect otherwise].

Essentially, the founders and other common stockholders have to stand in line behind the VC when proceeds of a sale are distributed. So, a VC investing $10m in a startup may hold preference stock representing only 20% of the outstanding stock of the Company, the other 80% representing common stock held by founders and employees. If the Company is sold for $50m, under a 1x liquidity preference, the VC will take the first $10m (1x the $10m investment) and the remaining $40m will be shared with the common stockholders, so the common shareholders would receive 80% of $40 and not 80% of $50m. Many entrepreneurs are surprised to discover the impact of liquidity preference, and are only informed by the legal counsel at the time of the acquisition.

In 2006, according to Fenwick & West, one of the most active law firms in the VC financing business, the liquidation preference for series ‘A’ financings in Silicon Valley was almost uniformly at a 1x[10].

A liquidation preference of 1x is not too unpalatable to entrepreneurs, however, VC’s sometimes demand liquidity preferences of 3x, 5x, 7x—even as high as 12x the original purchase price.[11] Clearly, with a liquidity preference of 5x, and an investment of $10m, the VC stands in line to receive the first $50m of the proceeds of any acquisition. The founding entrepreneurs receives nothing from common stock for any acquisition less than $50m.

Liquidity preference creates a significant discrepancy in the way VC’s and common shareholders view acquisitions, and lead to many entrepreneurs being shut out from receiving any of the proceeds when the companies they founded are sold.

The role of VC partners
The partners in VC firms are responsible for finding new investment opportunities, sitting on the board of directors and directing the management of portfolio companies. As much as 40% of the VC partner’s time is spent prospecting for new investments[12] and this involves reviewing business plans and listening to pitches from entrepreneurs.

So, 40% of the VC’s time is spent prospecting, and at least 20% of the partners time is spent on internal management at the VC firm, this means that no more than 40% of the venture partner’s time is available to manage his/her portfolio companies. With, say, 5 portfolio companies under the partners control, less than 5% of the partner’s time can be spent on each portfolio company. The amount of time available for each portfolio company may be considered low bearing in mind that, under the VC-Preferred model, the VC partner is effectively in control of board of directors and the management decisions for each company in his/her portfolio.

Treatment of founder’s stock
Founders stock is usually issued as vesting shares of common stock. Often a large proportion is vested by the time the VC’s gain an interest in the Company. However, to tie the founders to the Company and reduce the incentive to leave before the VC has achieved a successful exit, the VC’s sometimes eliminate the prior vesting of the founders with a legal provisions such as this example:

Founders’ Stock:
All Founders to own stock outright subject to Company right to buyback at cost. Buyback right for [__]% for first [12 months] after Closing; thereafter, right lapses in equal [monthly] increments over following [__] months.

Syndication
VC’s syndicate their investments[13] and it is common practice for one investor to lead a round and bring in other venture capitalists to co-invest. One VC will act as the lead investor, negotiating the terms, then invite other VC’s to participate in the round. This is a significant aspect of the portfolio strategy of the VC as it enables the risk to be spread beyond the companies that the VC invests and controls directly. Through syndication, the VC is able to acquire shareholding positions in startups that are under the control of other VC’s in the syndicate.

Syndication ties the venture investors together but it requires a common, standardized, structure in the way the VC investments are made. This standardization leads to remarkable similarity in the terms sheets offered by VC’s to entrepreneurs.

The syndicates have proved to be highly profitable over the years and the larger, more successful venture investors have a legion of smaller, newer funds that are eager to co-invest in their deals. To join a syndicate, it’s in the interests of new VC’s to offer the same standardized terms as the older, established VC’s and to bring new opportunities to the established syndicates. As will be discussed in more detail, the syndication aspect of the VC preferred model provides disincentives for new VC’s to compete in a free market by offering different investment terms that may be more appealing to startup entrepreneurs. It also encourages these new-entrant VC’s to offer investment opportunities to the syndicates rather than keep them exclusively to themselves.

VC candidate selection process
A traditional rule of thumb for the VC business is that for every 100 investment proposals received, 10 will be considered seriously and 1 investment will be made. These numbers have become more distorted in recent years as VC’s are bombarded with investment proposals from investors. Today, for each investment that a small VC makes, over two hundred business plans and proposals from entrepreneurs are rejected[14]. The number of rejections is even higher for the large VC funds that attract more business plan submissions. Furthermore, many VC’s admit that they do not consider unsolicited business plans at all—they only consider plans that they receive from their favored law firms, other VC’s or trusted contacts.

After submitting the business plan through the lawyer or the appropriate channel, the entrepreneur with an attractive offering will be invited to make a presentation to the VC. The presentation takes around an hour, during which time the VC asks questions and gauges the attractiveness of the opportunity.

If the deal is attractive, it will be circulated by the VC to others in the syndicate. If approved by the partners in the VC firm and the syndicate, a successful candidate will receive a term sheet, due diligence will commence and the terms will be negotiated with the lawyer representing the entrepreneur.

Cisco Systems, before it became one of the most profitable venture investments of all time[15], was rejected by more than 75 VC’s. Google and other hugely successful companies were rejected by several VC’s before finally raising the funding they needed to grow the business. The selection process and the criteria adopted by VC’s have been criticized as being somewhat unstructured and unpredictable. However, the number of opportunities presented by entrepreneurs is so large that VC’s are usually able to assemble a profitable portfolio.

Reporting of investment results
The VC community has resisted attempts to compile or track the investment results of individual firms. The success rates for each VC are generally kept under wraps and are not available to the public.

Ever larger funds
Portfolio theory is effective at reducing the risk when the investments are split across a number of portfolio companies. The larger the portfolio, the smaller the risk from failure from any one. As a result of the successful track record some VC’s have achieved, VC funds are attracting more investment and growing larger[16]. However, the number of partners in each firm is not growing by the same proportion. A VC partner can only sit on a handful of boards of directors, so the result of this trend is that VC’s have to make larger investments in their portfolio companies. As we will discuss elsewhere, this can lead to the VC wishing to inject more money into a startup company than the founders would choose.

Participants in the VC-Preferred ecosystem
As well as the established VC’s, there are several groups of participants in the VC-Preferred model. New VC’s are benefitting from the VC-Preferred model in that they do not have to invent a new financial instrument or establish new business practices. New VC’s simply need to follow the VC-Preferred model and the law firms and other resources are available to help them achieve this at minimal cost.

There are a handful of large law firms in Silicon Valley that are dependent upon the VC-Preferred model. They derive a large proportion of their revenues representing VC’s and VC-backed startup companies. As noted earlier, most VC’s will not consider unsolicited business plans. The law firm acts as gatekeeper for the VC screening entrepreneurs and business plans. The VC then gives the law firm business by insisting portfolio companies use the firm.

Executives such as CEO’s, CFO’s and general counsels are often repeat-players for VC’s and their syndicates. Individuals will often move from one portfolio company to another and their careers are intertwined with the VC’s with which they align.

As with law firms there are a number of recruiters, auditors, financial advisors and other service providers in the technology sector that derive their incomes from VC firms and VC-backed startups and are dependent upon the VC-Preferred model.

[1] Harvard Business Review, 1998 reprint 98611.

[2] Unfortunately, and surprisingly, there are no good figures available to measure the success rates of technology startups in Silicon Valley or elsewhere. Companies grow and launch their initial public offerings on the capital markets with great fanfare, but when they die, they normally do so quietly and outside of the public eye. By measuring the rate of company formations with the Company liquidations, most observers agree that the success rate is significantly lower than 10%. VC’s openly admit that less than 10% of the companies they fund are successful. Some of the top-tier VC’s on Sand Hill Road are revered by the investor community as they have seemingly managed to raise the success rate above 30%.

[3] Brian Headd, an economist at the SBA Office of Advocacy and author of a 2003 report on small-business closure rates admitted: “We don’t have very good firm age data” The SBA’s Office of Advocacy has convinced the Census Bureau to carry out a study of annual entry and exit rates of even the smallest businesses.

[4] See Liquidity preference below.

[5] 509 A.2d 584 (Del. Ch. 1986).

[6] 51 Bus. Law. 443.

[7] This and other provisions are extracted from VC term sheets.

[8] Source: Current Venture Financing Environment, 4Q 2006 Bay Area Venture Capital Terms Survey. Fenwick & West Publications. http://www.fenwick.com/publications/

[9] Steven N. Kaplan, Berk A. Sensoy, and Per Stromberg, “What are Firms? Evolution from Birth to Public Companies” 26 (working paper, January 2005).

[10] Financings that had participating liquidation preferences (LPs) in 4Q 2006 were 73% compared to 64% in 3Q 2006. Participating LP was uncapped in 64% of 4Q 2006 financings compared to 58% in 3Q 2006. 34 of 35 initial LP were 1X in this period. Source: Current Venture Financing Environment, 4Q 2006 Bay Area Venture Capital Terms Survey. Fenwick & West Publications. http://www.fenwick.com/publications/.

[11] The Deal.com 2002. “VC’s Reconsider Tough Terms for Entrepreneurs”.

[12] Paul Dali, partner with Dali Hook Partners, a Menlo Park VC firm. 2005.

[13] Venture capitalists often band together in groups to invest in companies. Conventional wisdom says they engage in this practice, called syndication, to better screen potential investments. More eyes, the thinking goes, yield better investments. But Raphael "Raffi" Amit, Wharton's Robert B. Goergen Professor of Entrepreneurship, says that's wrong. Venture capitalists syndicate because each one has different skills and information, so each can add value to an investment in different ways.

[14] Dr. Po Chi Wu, partner with Alameda Capital. Santa Clara 2005.

[15] Don Valentine, partner with Sequoia Capital, finally invested in Cisco and his investment has been reported to be the most profitable VC investment when measured by return on investment. Litigation ensued after the founders were forced out of the Company.

[16] Trend towards fewer but larger venture capital funds continues in US in Q2 2006.
04/08/2006. Source: AltAssets.
US venture capital firms raised $8.23bn in the second quarter of 2006, slightly down from the $8.27bn raised in the second quarter of 2005, according to Dow Jones VentureOne. The research shows a trend in recent quarters towards fewer but larger individual funds being raised.
The largest US venture fund raised this quarter was the $2.56bn Oak Investment Partners XII fund. In addition, five other funds raised this quarter were $500m or larger.
At the half year point, $11.5bn has been raised by US venture capital firms, about seven per cent more than the amount raised in the first half of 2005. The median size of funds closed to date in 2006 is $170m. In the first half of 2006 only 28 per cent of the funds that closed were smaller than $100m.

Stephen Harmston, director of global research for VentureOne, said, 'It still remains likely that 2006's fundraising will match or surpass the amount raised last year due to the significant level of interest investors have shown in this asset class of late, including interest in funds that will be closing later this year.'

How VC's Take Control of the Company

Control provisions in the VC term sheet
The VC-Preferred model enables the preferred shareholders to take significant control over the Company through the more obvious channels, such as board seats, but also through a number of less obvious provisions.

Board of directors
Elected by the shareholders, the board of directors has the ultimate management control over the Company. The board of directors acts as agent for the shareholders, and has fiduciary duties to manage the Company with good faith, care and loyalty. The powers of the board are mandated by Delaware statute and state business law, but some flexibility is provided through the Company’s bylaws and the articles of association.

No single director has power to act on behalf of the Company. The board operates as a single unit. For this reason, the board usually has an odd number of members, to avoid deadlock and majority votes are usually controlling. So, a startup founder on the board of directors has no power to make decisions unless he/she can win the support of a majority of the board members.

Preferred stockholders, according to Klein and Coffee[1], do not (usually) participate in the election of directors. However, under Delaware law[2], preferred holders are not restricted from contracting these voting rights. The contractual provisions of the financings, almost always provide for the holders of a class of preferred stock to elect one or more directors to the board. So, the VC buying series A preferred stock is guaranteed to elect its own candidate for the board. This is usually a partner from the venture fund. So, regardless of whether the founder has a majority of common stock the VC has its place on the board through its preferred stock and contractual rights.

Board of Directors:
At the initial Closing, the Board shall consist of [______] members comprised of (i) [Name] as [the representative designated by [____], as the lead Investor, (ii) [Name] as the representative designated by the remaining Investors, (iii) [Name] as the representative designated by the Founders, (iv) the person then serving as the Chief Executive Officer of the Company, and (v) [___] person(s) who are not employed by the Company and who are mutually acceptable [to the Founders and Investors][to the other directors].


The contractual provisions of the preferred stock financing usually also set limits on the structure of the board of directors. These limits are often written into the bylaws. So the structure of the board is set by the incoming investors.

According to Fenwick & West[3], where there are 2 investors, the board of directors tends to be made up of 5 members. Two are appointed by, and represent the preferred stockholders (investors), two represent the common stockholders (founders and employees) and the critical control issue resolves around how the fifth board member is elected. The fifth director is sometimes elected by the other directors, elected by a vote of outstanding shares and the seat is sometimes reserved for company outsiders. The same control issues arise where there is only one investor and the board is limited to three members. The preferred and common each elect one director in this situation, and the third board seat is allocated to a CEO recruited by the VC, or an outsider.

The outside director can often hold the swing vote and is often an associate or affiliate of the VC. As a result, the percentage of companies with VC-controlled boards was recently discovered to be close to 80-90%. [4] This is higher than previously measured because prior studies have failed to recognize that ‘independent’ directors align their interests with the VC—even if an independent director has the swing vote, the independent director is a repeat player in the VC-Preferred model and often acts as an agent for the VC.

Special authority to investor-appointed directors
Through contractual provisions, with amendments to the articles of association, the VC directors can establish special authority and essentially control any transactions above a certain threshold of size.

Matters Requiring Investor Director Approval:
[So long as [__]% of the originally issued Series A Preferred remains outstanding] the Company will not, without Board approval, which approval must include the affirmative vote of [____] of the Series A Director(s):
(i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company; (ii) make any loan or advance to any person, including, any employee or director, except advances and similar expenditures in the ordinary course of business or under the terms of a employee stock or option plan approved by the Board of Directors; (iii) guarantee, any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; (iv) make any investment other than investments in prime commercial paper, money market funds, certificates of deposit in any United States bank having a net worth in excess of $100,000,000 or obligations issued or guaranteed by the United States of America, in each case having a maturity not in excess of [two years]; (v) incur any aggregate indebtedness in excess of $[_____] that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business; (vi) enter into or be a party to any transaction with any director, officer or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such person [except transactions resulting in payments to or by the Company in an amount less than $[60,000] per year], [or transactions made in the ordinary course of business and pursuant to reasonable requirements of the Company’s business and upon fair and reasonable terms that are approved by a majority of the Board of Directors];[5] (vii) hire, fire, or change the compensation of the executive officers, including approving any option plans; (viii) change the principal business of the Company, enter new lines of business, or exit the current line of business; or (ix) sell, transfer, license, pledge or encumber technology or intellectual property, other than licenses granted in the ordinary course of business.

Voting rights
Outside of the VC community, it is unusual for preferred stock to have voting rights. These rights are usually restricted to common shareholders. However, under the VC-Preferred model, preferred stock has voting rights, and when combined with the veto rights below, voting rights form a significant is a source of power for the VC.

Voting Rights:
The Series A Preferred Stock shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except (i) the Series A Preferred as a class shall be entitled to elect [_______] [(_)] members of the Board (the “Series A Directors”), (ii) as provided under “Protective Provisions” below or (iii) as required by law. The Company’s Certificate of Incorporation will provide that the number of authorized shares of Common Stock may be increased or decreased with the approval of a majority of the Preferred and Common Stock, voting together as a single class, and without a separate class vote by the Common Stock.[6]

This provision not only gives the VC the power to vote on shareholder decisions, but also provides a veto right allowing the VC to block the Company from authorizing new shares to be issued.

Veto rights
One of the most significant decisions to be made by a corporation is the nature of the exit—whether, when and how the Company is to be sold to an acquirer or liquidated. The following provision provides the VC with a high degree of control over these decisions:

Protective Provisions:
So long as [insert fixed number, or %, or “any”] shares of Series A Preferred are outstanding, the Company will not, without the written consent of the holders of at least [__]% of the Company’s Series A Preferred, either directly or by amendment, merger, consolidation, or otherwise:
(i) liquidate, dissolve or wind‑up the affairs of the Company, or effect any Deemed Liquidation Event; (ii) amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws [in a manner adverse to the Series A Preferred];[7] (iii) create or authorize the creation of or issue any other security convertible into or exercisable for any equity security, having rights, preferences or privileges senior to or on parity with the Series A Preferred, or increase the authorized number of shares of Series A Preferred; (iv) purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, [other than stock repurchased from former employees or consultants in connection with the cessation of their employment/services, at the lower of fair market value or cost;] [other than as approved by the Board, including the approval of [_____] Series A Director(s)]; or (v) create or authorize the creation of any debt security [if the Company’s aggregate indebtedness would exceed $[____][other than equipment leases or bank lines of credit][other than debt with no equity feature][unless such debt security has received the prior approval of the Board of Directors, including the approval of [________] Series A Director(s)]; (vi) increase or decrease the size of the Board of Directors.


With these contractual provisions, the VC controls decisions involving the sale the Company, raising of financing, issuing of new securities and the sale of corporate assets. An acquisition offer that is acceptable to the majority—including management, the board of directors, and all the common stockholders can be blocked by the minority—the preferred stockholding VC. This can be a tremendous source of frustration when the interests of the VC and the entrepreneur are misaligned.

Drag along rights
The powers of the entrepreneur can be restricted by drag-along rights that effectively force the founders and other shareholders to vote with the VC when it comes to choice and timing of exits—selling or liquidating the Company.

Drag Along:
Holders of Preferred Stock and the Founders [and all current and future holders of greater than [1]% of Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options)] shall be required to enter into an agreement with the Investors that provides that such stockholders will vote their shares in favor of a Deemed Liquidation Event or transaction in which 50% or more of the voting power of the Company is transferred, approved by [the Board of Directors] [and the holders of a [majority][super majority] of the outstanding shares of Preferred Stock, on an as-converted basis.

Forced redemption
Many VC term shares provide redemption options that allow the preferred to force the Company to pay back the funds invested, with a premium.

The Series A Preferred shall be redeemable from funds legally available for distribution at the option of holders of at least [__]% of the Series A Preferred commencing any time after the fifth anniversary of the Closing at a price equal to the Original Purchase Price [plus all accrued but unpaid dividends]. Redemption shall occur in three equal annual portions. Upon a redemption request from the holders of the required percentage of the Series A Preferred, all Series A Preferred shares shall be redeemed [(except for any Series A holders who affirmatively opt-out)].


In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company. If a series A investor demanded redemption rights, then it could be very difficult for the Company to attract investors for series B and subsequent rounds. The series B investor could say ‘I want to invest to build this company, I don’t want my money being used to buy out the series A investors.’ Not only can redemption rights block the Company from attracting future investors, but it often prevents banks and other lenders from providing credit facilities. Although redemption rights may appear attractive to investors on the surface, there’s a good argument that they’re not healthy for the Company or the VC in the long run.

Appointment of officers & management
The board of directors has the power and responsibility to elect, appoint and remove the CEO and other officers. Founders are sometimes perceived as great inventors and technologists but not great managers. Professional managers are usually appointed to run the business. After taking control of the board through preferred stock, the VC usually hires in management to replace the founders[8] filling the CEO position and other key officer roles with individuals selected by the VC.

There has developed a pool of professional CEO’s, CFO’s, General Counsels, and other executives that are regularly placed in venture-backed startups by VC’s and derive their living from these assignments.

These executives are often repeat-players moving from one venture backed startup to another. Many VC’s have Entrepreneur in Residence[9] programs where they retain CEO’s and executives within the VC firm awaiting new portfolio companies to which they will be assigned.

Control asserted indirectly by VC’s--Appointment of legal counsel
Although they have little formal authority, in-house and outside counsel are often powerful forces within a startup company. There are several large law firms that specialize in representing VC’s and VC-backed startups. If the Company is not represented by one of these firms, then one of the first decisions made by the board of directors and management after the VC takes control is usually to replace the outside counsel with the VC’s law firm of choice. This long-standing relationship between the VC and the outside counsel selected to advise the Company can be used as a significant source of power for the VC. Many of these law firms are bonded to the preference share model and derive the bulk of their billing revenue serving their VC clients.

[1] Klein and Coffee, Business Organization and Finance. 9th ed 2004. P 302-306.
[2] Del. Gen. Corp. Law §242(b)(1) &(2).
[3] Source: Current Venture Financing Environment, 4Q 2006 Bay Area Venture Capital Terms Survey. Fenwick & West Publications. http://www.fenwick.com/publications/
[4] Cf. Steven N. Kaplan, Berk A. Sensoy, and Per Stromberg, “What are Firms” Evolution from Birth to Public Companies 28 (reporting that, by the time of the IPO, median VC directorships is 3, median management directorships is 2, and media outside directorships is 2.
[5] Note that Section 402 of the Sarbanes-Oxley Act of 2003 would require repayment of any loans in full prior to the Company filing a registration statement for an IPO.
[6] For California corporations, one cannot “opt out” of the statutory requirement of a separate class vote by Common Stockholders to authorize shares of Common Stock.
[7] Note that as a matter of background law, Section 242(b)(2) of the Delaware General Corporation Law provides that if any proposed charter amendment would adversely alter the rights, preferences and powers of one series of Preferred Stock, but not similarly adversely alter the entire class of all Preferred Stock, then the holders of that series are entitled to a separate series vote on the amendment.
[8] Even in venture-backed firms that do well enough to go through an IPO, founders’ involvement declines from the time the firms receive VC financing to the time of the IPO and thereafter. See Steven N. Kaplan, Berk A. Sensoy, and Per Stromberg, “What are Firms” Evolution from Birth to Public Companies” 23 (working paper, January 2005)(reporting that at time of IPO 43% CEOs are non-founders); Noam Wasserman, “Founder-CEO Succession and the Paradox of Entrepreneurial Success,” 14 Organization Science 149 (2003). See, also, Utset (2002) later note __, at 92-6 (describing the ‘founder’s disease’ – the VCs’ “assumption that entrepreneurs will be unable to make the transition to effective managers.”)
[9] Almost all definitions of ‘entrepreneur’ refer to an individual that bears the risk of forming a new enterprise. Meriam Webster, et al. These executives are not strictly ‘entrepreneurs’ as they do not form their own startups or bear the risks therein. Rather they are management agents of the VC waiting to be assigned to new manage startup companies after the VC’s invest and take control.

How the interests of VC's and entrepreneurs become misaligned under the VC-preferred model

The ideal startup investment structure aligns the interests of the VC perfectly with those of the entrepreneur. Unfortunately, this is not the case with the VC-Preferred model. This section describes a disparity in motivations and tolerance to risk and goes on to explore how the control in the hands of the VC can be detrimental to entrepreneur, the Company and its common shareholders.

VC's are from Venus, Entrepreneurs are from Mars--Differing motivations & tolerance for risk
The profiles of entrepreneurs and VC’s share similarities in that, contrary to some public opinion, both groups are averse to risk and take whatever steps they can to minimize their exposure to risk. However, the two groups take a very different approach to dealing with risk, and one group has the tolerance to bear significantly more risk than the other.

With ten year term funds, VC’s often invest as lead investors in a portfolio of around 10 companies, follower-investors in a further 20 companies and charge management fees, usually in the range of 2% of the funds under management. So, a $1bn fund will pay the VC firm, usually consisting of a handful of partners, $20m/year in management fees. With this virtually guaranteed flow of cash covering their salaries and costs for ten years, VC’s are somewhat buffered from the risks inherent in the portfolio, or any individual startup.

Portfolio theory[1] is based on the old adage “don’t put all your eggs in one basket”. The expected return of the portfolio is the probability-weighted average of all the possible returns after considering the risks. So, the portfolio return is the sum of all investment returns, but the portfolio risk is not the sum of all investment risks. The risks associated with any single company investment can be almost eliminated with more than 30 diversified investments in the portfolio. With a portfolios of investments, the VC’s also reduce the unsystematic risk (risk associated with one specific Company) to a minimum. Through syndication (discussed later), each investment is shared among several VC’s and the risk is further diffused. Following portfolio theory, the VC’s can bear the risk associated with one portfolio company in the knowledge that the other companies in the pool provide a hedge.

Under the VC-Preferred model, the startup entrepreneur on the other hand almost always has all his/her eggs in one basket and it completely exposed to the risk of failure of the one startup. Prior to raising VC funding, the entrepreneurs usually raise money to finance the seed stage of the Company through personal debt—often through refinancing their homes or borrowing on credit cards. So, the entrepreneur has a great deal to lose if the Company fails—his/her home (provided as collateral for seed funding), salary and benefits, shareholding in the Company and, as we will see later, the patents, ideas and inventions he/she created through the Company end up belonging to the VC.

With a startup failure rate of more than 90%[2], the question arises as to what would motivate a rational entrepreneur to bear this risk. Why would a rational person risk so much when the chance of success was less than one in ten? For several years, there seemed to be an unresolved dichotomy. Researchers were baffled to find that entrepreneurs do not have a higher tolerance, or appetite, for risk than non-entrepreneurs. They appear to be aware of the risks but take them all the same.

Research now seems to have finally resolved the dichotomy and provides a telling insight into the motivation of the entrepreneur. The recent study and paper[3] by Anne Marie Knott and Brian Wu was designed to address a long-standing puzzle regarding entrepreneurs. Why do entrepreneurs undertake ventures with substantially greater risk, while most psychological studies show they have no better tolerance for that risk? "Everyone assumes that entrepreneurs are these cliff-jumpers—able to take a leap of faith and confront unknowns that would deter the rest of us from even trying," said Knott. "In fact, it is more likely that they are skilled hang-gliders, with confidence that they can tackle any conditions." The findings of the study indicate that entrepreneurs are prepared to take these extraordinary risks because they have unusual confidence in their own abilities to succeed. With this belief in themselves, entrepreneurs realize there’s less than a one in ten chance of success but they take the risk in the confidence that they personally have what it takes to beat the odds. Entrepreneurs believe they can personally drive their Company to become the one in ten that achieves success.

Looking at the risk profiles and motivations of the VC’s and the entrepreneurs they fund may be vitally important in understanding the dynamics and the VC-entrepreneur tensions in these companies. The startup entrepreneurs have all their eggs in the one basket, they are highly exposed to failure in the one startup, they are risk averse but confident in their abilities to beat the odds and make the Company succeed. With portfolios of investments, VC’s have eggs in several baskets and the risk of failure in any one startup is offset, or hedged, by the risk of success in the others. By investing in a range of different business sectors and business models, the unsystematic risk is almost entirely eliminated. In the unlikely scenario that all the portfolio were to perform poorly or fail, the VC’s can always fall back on the management fees that usually account for several million dollars each year.

One of the most significant points made by this paper is that VC’s are much more likely to take risks with a startup than the founding entrepreneurs. Although highly exposed, the entrepreneurs take the risks because they are confident in their own abilities to beat the odds. However when VC’s invest in the Company, the entrepreneur loses control and finds himself backing the VC. As the risk tolerance of the VC is much higher than the entrepreneur, this leaves the entrepreneur in a precarious position. As we will see later, the VC’s focus on ‘home run’ successes and the rejection of ‘single’ smaller exits may be a reason for the excessive rates of failure in technology startups.

Effects of the VC-Preferred model
We now move on to explore how the VC-Preferred model, when combined with their differing motivations and risk profiles, can lead to a misalignment of interests and tensions between the VC and the entrepreneur.

The unusual VC-Preferred corporate governance structure
The VC-Preferred model has the effect of placing high levels of power and control into the hands of the VC. In their paper “The Vulnerability of Common Shareholders in VC-Backed Firms (Ganor, 2005)”[4], Jesse Fried and Mira Ganor describe the venture capitalists’ use of preferred stock and control rights as “..a highly unusual and perhaps unique corporate governance structure: one in which preferred shareholders, not common shareholders, control the board and the corporation”. The paper goes on to argue that the “structure leaves common shareholders vulnerable to opportunistic behavior by preferred-holding VC’s especially under current corporate law doctrines”.

The model is unusual in that VC’s not only take control of the startup companies in which they invest, they get to act as owners, creditors, managers at the same time and through liquidity preference, they get to stand in line ahead of the founders and common stockholders when the Company is sold.

Agency
Corporate governance is established through a chain of agency. The shareholders appoint the board of directors as their agent to direct the activities and operations of the Company. The board of directors then appoints the officers as agents to run the day-to-day operations. The officers then appoint managers and the agency chain continues down the organization chart.

Papers on the corporate governance structures of venture backed startups have often focused on agency-related issues. Under tradition corporate law, the outside investors relinquish control of their assets (investment funds) to managers (agents). Reporting from the management to the shareholders forms an agency cost and shareholders struggle with control issues when they disagree with decisions of management. However, under the VC-Preferred structure, the outside investors have almost full control of the Company and agency issues are somewhat unusual. Where the VC is actively involved in the Company, management is essentially performed by outsiders—VC partner who has less than 5% of his/her time to spend with the Company.

The agency problem as applied to VC backed startups is, at the very least, unusual. The VC Preferred model raises some serious questions regarding agency:

• As we have established, in the VC Preferred Model, the board of directors is controlled by the VC partner. In this position, the question arises as to whether the VC partner is acting as an agent to the shareholders of the Company, as he/she is duty bound to do by law, or whether he/she is acting as an agent for the VC?
• Another question arising from this arrangement is whether the primary link in the agency chain exists at all. It can be argued that there is no agency relationship from the VC to the board of directors as the VC is running the board and Company directly, not delegating its duties to another party.
• As the CEO and officers of the Company are selected, and appointed by the VC, and they wish to be repeat players in the VC-Preferred marketplace, are they acting as agents for the Company or the VC itself?
• One final question is who is acting as an agent and fiduciary for the founders and other common stockholders?

The concept of agency becomes somewhat distorted in the VC-Preferred model where a high degree of power rests in the hands of the VC partner.

Asymmetry of information
Traditional corporate theory is based on the assumption that management has inside information that is not freely available in the marketplace and this puts management at an advantage over shareholders. In the VC-backed startup, there is an asymmetry of information—the employees and management within the Company are communicating with customers and the market and gather ‘inside information’ that is highly useful. However, the insiders in this model, have to defer to the outside VC’s to make strategic decisions. The outsiders hold the power to make decisions, and the insiders do not.

Commercialization strategies and choice of exits
The VC-Preferred model can restrict the choice of exits open to startup companies. Where many founders would be prepared to hit a ‘single’ and pocket a few million dollars from their startup ventures, the VC-Preferred model is built upon the huge returns of one or more ‘home run’ successes from the portfolio. The veto rights discussed above, together with board control, allow VC’s to decide the type of exit for the Company. There is a tension and misalignment of interests in choice of exits that is at the heart of this paper.

Before investigating further the tensions between founders and VC, it is important to understand some of the challenges and steps in the startup process. Technologies developed by startup entrepreneurs can be commercialized through a variety of routes. The route that is taken usually determines the exit that is achieved.

The home run
The conventional route is to form a startup corporation, complete the contractual transfers of title so the Company owns the intellectual property, then develop the technology into one or more products, build routes to market involving sales, marketing and distribution channels, and reach profitability by selling the product through these channels. Building out the sales and marketing channels can be very expensive and take several years. To finance these costs, the Company raises private funds under Regulation D exemptions from VC investors, usually in several rounds of preferred stock. The Company then becomes publicly held by selling shares to the public in an IPO (initial public offering). At this point, the preferred stock is converted to common and the preferred rights of the VC investors are lost. After a lock up period of 6 or 12 months, the VC’s and other common stockholders are able to sell their shares to the public through the capital markets.

The value of the Company will usually increase from something in the region of $10m for the first round of VC funding to several hundred million (or even several billion) dollars following the IPO. So, the VC investors achieve a return on investment that is often higher than 10X through this process. This is the home run success that drives the VC business and provides the profits to finance the portfolio strategy that the VC’s adopt.

The ‘asset sale’ single
This IPO-driven home run success is achieved by a small fraction of startups. According to Fenwick & West Publications, there were approximately 8 M&A transactions for venture backed companies in the U.S. for every IPO in 2006 (335:56)[5]. For every startup that reaches IPO, many more are acquired en-route by larger corporations that are looking to grow through consolidation and sourcing of new products, new technologies and new revenue streams. Considering that these large, established corporations have often spent decades building sales, marketing and distribution channels and have efficient, global routes to market, they are often on the lookout for new products that they can sell through these channels—an acquisition of startups is an appealing growth strategy.

These corporations have sales and marketing channels in place already, so what they are acquiring from the startup is essentially a set of assets. The primary reason for acquiring the Company is to win the exclusive right to market the product and its supporting technology. The target startups’ cash flows are often insubstantial and insignificant from the perspective of the acquirer, so this is essentially an asset sale[6] transaction.

The most significant challenge of technology commercialization is not creating a new product but building effective channels to market. Many startups succeed in creating new products but fail to establish profitable and efficient routes to market. Recruiting and training a sales team is expensive. Establishing distribution channels can take many years, especially on a global scale. Startup entrepreneurs find that the channel is the most significant challenge they face in bringing their technologies to market.

From an economic perspective, it makes little sense to incur the cost of building new routes to market for each new technology or startup invention. Applying this model to Hollywood and the entertainment industry would mean building a movie studio for every new movie. Producing a movie and bringing it to market by building a whole studio with its own sales staff, international distribution arrangements would take many years, cost huge sums of money and would result in the vast majority of movies failing to reach the market. The established Hollywood studios have spent decades establishing their routes to market and the economically efficient route to commercialize a new movie is to deliver it through the existing channels by establishing licensing or other arrangements with the large studios. A new movie studio like Dreamworks doesn’t appear very often, and the studio is certainly a home run for the investors but the studio leverages its established routes to market to provide channels for ‘single’ movie hits with movie successes that are profitable for the studio and the entrepreneurs behind them. The vast majority of new ideas and creations coming out of Hollywood are commercialized as singles (new movies) and it is economically inefficient to attempt to commercialize them as home runs (new studios).

Commercializing a new technology can be even more expensive than producing a new movie. For successful commercialization, many new technologies and inventions require channels to market that take hundreds of millions of dollars and decades to establish. For example, new semiconductor technology cannot be commercialized by a startup company unless it can gain access to the manufacturing capabilities and channels that have been developed by established players like Intel and Fujitsu. The cost of establishing a semiconductor manufacturing plant, in China, is around $300m. Startups in the pharmaceutical sector also realize that the only way they can realistically reach a global market is to sell their inventions, in an asset sale, to large pharma companies such as Merck and GlaxoSmithkline. Startup companies that are able to develop products and technologies without asking for VC funding are often willing to sell their technologies to large corporations under terms that would not be attractive to VC’s.

Some acquisition transactions, such as the Google acquisition of YouTube, can be viewed as ‘home run’ successes for the VC’s that backed them. However, the typical asset sale looks more like a ‘single’ in the baseball world. Virtually every product in the Cisco line up was acquired through an asset sale[7]. The Cisco acquisition of Protego Networks is a good example.

Case Study—Protego Networks
Imin Lee left Cisco in 2002 to form a new company she named Protego Networks. She raised around $2m from angel investors and built a compelling new product that was ideally suited to Cisco’s customers. Protego Networks was acquired by Cisco in 2004 for $65m in cash. Cisco now has a new product line from Protego that has produced excellent results when sold through the Cisco channel and Imin Lee is back at Cisco as an employee. The angel investors received a profitable return on their investment and this is a good example of an invention reaching the market, with the founding entrepreneurs and investors making a profit along the way.

Interestingly, there were no VC investors in Protego, and as this paper shows, and Imin Lee admits, VC’s would have been unlikely to have accepted the offer from Cisco. Instead of taking the Cisco offer, several VC’s proposed investing $10m+ into Protego in a series A preferred round of funding. Portfolio theory and the VC-Preferred model force VC’s to seek a return of at least 10X, so the VC would have required at least $100m for its shares in an acquisition from Cisco or anyone else. VC investors would have rejected a $65m acquisition offer and would have taken the risk to push the Company toward IPO where much higher returns may be achieved. If VC’s had invested in Protego, the price for Cisco to acquire the Company would have increased from $65m to at least $500m[8].

So, following the VC home run strategy, the acquisition offer from Cisco would have been declined by Protego and the two companies would be left to compete with each other in this sector. Cisco’s strength is its brand and global distribution channels, but Protego has the product and technology available today. As the rejection of the acquisition offer would mean Protego and Cisco competing head-to-head, the question is whether Protego could build sales and marketing channels independently that could compete with Cisco and whether Cisco could build its own products and technologies that could compete with Protego. The chance of Cisco successfully building its own product line and pushing Protego out of business is something that Imin Lee as the entrepreneur was not prepared to accept. The risk of losing a market battle against a large global competitor like Cisco is something that a VC can accept—as any losses incurred from Protego being forced to shut down would likely be recovered by a home run hit from one of the other companies in its investment portfolio.

The $65m offer would be classified as a single rather than a home run but was clearly highly appealing to Imin Lee. If Protego had taken preferred stock funding from a VC, the focus on a home run success may well have led to Cisco launching its own competing product line and using its market muscle to force Protego out of business. Fortunately, Imin Lee had the authority to accept the offer from Cisco, the Protego product line now forms a profitable source of revenue for Cisco, the customers have new products available, and the angel investors in Protego have made a handsome profit.

The exit tension between founders and VC investors
Although an asset sale exit may be appealing to the founding entrepreneur, it may not be acceptable to the VC’s. An entrepreneur, like Imin Lee at Protego Networks, offered $65m for a startup company will likely accept, especially if he/she receives a good proportion of those proceeds. However, VC’s operating under the prevailing portfolio model will be forced to reject such an offer and drive the Company toward IPO or cash flow sale. For a VC, one successful exit has to finance nine or more failures, so the proceeds of that one exit have to be much higher than the founding entrepreneur would settle for. By rejecting an asset sale offer, ploughing more funding into the Company and driving the business toward a potentially more profitable exit, the VC’s are significantly increasing the risk of failure.

If the founding entrepreneur wishes to accept the asset sale offer, but the VC’s wish to reject it, we need to look at the corporate governance structure of the Company to determine which decision is made. Under the VC-Preferred model, through the veto rights written into the terms of the preferred stock agreements, the VC has the right to veto a sale of the Company. Essentially, the founding entrepreneur’s vote is overruled by that of the VC.

So, the ‘single’ asset sale exit route, although it may be the most economically efficient, and highly appealing to the common stockholders such as the founders and employees, is blocked by the VC investors through the control rights written into the preferred stock agreements.

Exit timing
As discussed earlier, VC funds usually have a term of 10 years. The timing of where the VC fund lies in relation to the portfolio companies can be an extremely important factor in the decisions made by the VC with respect to selling the portfolio companies. A fund that is close to the end of the term is looking to liquidate the portfolio investments. A fund that is in the first phase of its fund is looking to grow its portfolio. This can affect how decisions are made by the VC partner regarding the exit strategies of the portfolio companies they control. For example, if the VC takes on a new startup in year 8 of its 10 year term, it is likely that the VC will drive toward selling the Company very quickly. This may not be in the best interests of the Company—especially if it is in an early stage of growth.

Another issue arises with VC’s in the first phase of development. During the first few years in the 10-year life of the fund, the VC’s want to impress their limited partner investors with the strong portfolios they have assembled and they look for ‘home run’ candidates that will allow them to raise more funds from these investors in future funds. Startup entrepreneurs complain that VC’s in this position often refuse to allow portfolio companies to be sold at less than ‘home run’ returns. After they have developed their products, many startups find that they are unable to build the sales channels and routes to market necessary to reach customers in the volumes they need. An asset sale ‘single’ is the clear exit for these companies as large corporations with the sales and marketing channels in place already are looking to acquire new products that they can push through their channels and develop into new revenue streams. A startup in such a position often faces two alternative routes—an asset sale now or a shutdown in two years when the funding runs out. The logical choice for the entrepreneur is to select asset sale. However, if the VC is in the early stage of its funding cycle, it may be reluctant to accept an asset sale single, as this would need to be reported to its limited partner investors that they led to have ‘home run’ expectations. Disclosing portfolio failures does not reflect well on the VC. So, the VC in this situation may decide it is in the VC’s interests to continue to operate the Company for two more years, running the risk of shutdown, rather than accept an asset sale exit today that would need to be disclosed to its limited partners.

So, the current corporate governance structure puts the timing of exits in the hands of the VC and considerations other than the best interest of the common stockholders affect how exit decisions are made. Exit timing is often motivated by the VC to maximize value to the venture fund rather than maximize value to the entrepreneurs and stockholders in the portfolio companies.

Management
The appointment of new CEO and management following the first round of VC funding can have a detrimental effect on the Company. The founder often has the most passion, drive and the most in-depth understanding of the business and is the best person to run the Company. A founder is commonly perceived as the heart and soul of the Company and his/her removal from the CEO position can be damaging to the shareholders, employees, customers and whole community of interests.

A decade-long study of Silicon Valley (California) technology startups finds that companies were three times more likely to fail if at some point they altered the founder’s blueprint for employee relations than if they maintained their original employee model[9]. Steve Jobs was replaced at Apple by John Sculley, a professional manager from PepsiCo. Meanwhile, Bill Gates and Larry Ellison managed to stay in executive positions at Microsoft and Oracle. VC’s involved in the John Sculley appointment process admitted that replacing Jobs was a mistake[10]. Apple lost a significant lead in the industry and the Company’s value, higher than Microsoft during Job’s tenure as CEO, dropped to a fraction of that of Microsoft or Oracle after the professional management was installed by the VC-led board of directors.

Entrepreneurs often complain that managers appointed by VC’s have a tendency to spend cash more readily than the founders. This is not always frowned on by the controlling VC as this can lead to the VC’s investing more funds, taking a larger percentage holding of the Company, and more dilution for the common stockholders.

The VC-Preferred model can lead to less-effective management being appointed to run the Company.

VC-encouraged spending
As discussed earlier, increases in the size of VC funds is leading to an increase in the size of each venture investment. VC’s with larger funds are under pressure to invest more money into each Company in the portfolio—the VC’s are not geared up to make large numbers of small investments and favor small numbers of large investments. Some large VC’s, such as New Enterprise Associates (NEA), are reluctant to consider investment opportunities less than $10m—and look to invest more than $15m in each Company in the portfolio[11].

Each investment by the VC increases the VC’s percentage control over the startup, and decreases that of the founder/entrepreneur. A high-spending startup provides the VC with a good opportunity to accumulate a large shareholding position, focus on fewer larger investments, and through liquidity preferences, a higher share of the proceeds when the Company is sold.

So, it is in the interests of the VC for the Company to increase spending. As the veto rights are only available to the VC, the entrepreneur is in no position to veto the Company raising new rounds of funding or prevent the VC taking an ever increasing percentage of the total ownership. Ever larger investments provide investors with larger stakes and entrepreneurs with fewer rights.

Lack of alternative funding sources
There are over 3,600[12] VC firms worldwide, so it would be reasonable to expect competition among firms to attract entrepreneurs and alternative corporate governance structures. There are some minor differences in how these firms operate, however almost all VC’s operating today have adopted the VC-Preferred structure. The structure has been adopted in China, UK, and other parts of the world where the VC community is growing. The demand for funding from entrepreneurs so outweighs the supply of funding from VC’s that the suppliers of capital have not entered into market competition to make their offerings more palatable to entrepreneurs seeking capital.

As it is common practice for the VC community to syndicate deals, each one is encouraged to standardize on the VC-Preferred model of corporate governance. Syndication requires standardization. A VC that adopted an investment and corporate governance structure that was different would find its syndication options severely limited. The rules of membership of the investment syndicate govern how each of the VC’s structure their investments.

Before the dot com crash in 2002, angel investors became active backers of technology startups and provided several billion dollars per year to new ventures. However, after the crash, the angel funding for new companies dried up significantly[13]. Other investment options such as real estate became more appealing, but many angel investors were dismayed at the way their investments were diluted and their rights were lost when VC’s used contractual terms like the one below to condition their investments on having the rights to restructure and alter the relationships with the angel investors[14].

Existing preferred stock
The terms set forth below for the Series [_] Stock are subject to a review of the rights, preferences and restrictions for the existing Preferred Stock. Any changes necessary to conform the existing Preferred Stock to this term sheet will be made at the Closing.

In recent years, angel investment in technology startups has bounced back[15]. However, angel investment now operates in a very similar way to VC funding. The Band of Angels[16], and Garage.com[17] are examples of high profile angel groups that were setup to provide early state seed funding but have developed into VC funds. These angel funds now too follow the VC-Preferred model. Even with angel investment available, the terms are similar to those offered by VC’s and the options open to founding entrepreneurs are limited.

Shopping for the best deal among the VC community is also usually restricted. The no-shop provision of the VC term sheet discussed above prevents entrepreneurs from shopping for alternative investors after the term sheet is signed.

When raising several million dollars, the options open to entrepreneurs are limited. An entrepreneur that refused to accept the terms of the VC-Preferred model would find fundraising very difficult.

Lack of incentives for the employees and other common stockholders
The superior position of preferred stock over common stock can lead to a lack of morale and lack of incentive for employees, management and other holders of common stock. With control in the hands of the VC, liquidity preferences blocking the common stockholders from sharing in the proceeds of a sale of the Company, there may be little in the way of incentives for employees and those charged with driving the Company toward success.

The asset sale (single) exit becomes unappealing to the common shareholders after funds have been raised through the VC-Preferred model as these individuals realize that they have to stand in line behind the VC and preferred shareholders when it comes to sharing the proceeds of the sale of the Company. When management and the employees realize they will receive nothing from a ‘single’ asset sale, this can damage morale if a ‘home run’ is not clearly in sight. There is little financial incentive for management to drive the Company toward an exit.

The avoidance of venture funding
Entrepreneurs are increasingly being advised to avoid VC funding[18][19][20]. This means that they either abandon their startup ideas or they bootstrap—attempt to develop the business slowly through self-financing or moonlighting to support the startup phase of the business. This is a clear example of how the corporate governance practices of VC’s can be accused of stifling innovation and preventing new technologies from reaching the market. Inventions and innovations that are valuable to society may be suppressed because the entrepreneurs that understand the VC-Preferred model calculate that it doesn’t make sense for them to pursue funding under the VC-Preferred model.

[1] Modern portfolio theory (MPT) proposes how rational investors will use diversification to optimize their portfolios, and how a risky asset should be priced. The basic concepts of the theory are Markowitz diversification, the efficient frontier, capital asset pricing model, the alpha and beta coefficients, the Capital Market Line and the Securities Market Line. MPT models an asset's return as a random variable, and models a portfolio as a weighted combination of assets; the return of a portfolio is thus the weighted combination of the assets' returns. Moreover, a portfolio's return is a random variable, and consequently has an expected value and a variance. Risk, in this model, is the standard deviation of the portfolio's return.
[2] Discussed in another blog.
[3] Entrepreneurial Risk and Market Entry. Best Doctoral Paper award from the Small Business Administration by Brian Wu, The Wharton School, University of Pennsylvania and Anne Marie Knott, Robert H. Smith School of Business, University of Maryland.
[4] Fried, Jesse M. and Ganor, Mira, "Agency Costs of VC Control in Startups" (August 15, 2005). UC Berkeley Public Law Research Paper No. 784610.
[5] Source: Current Venture Financing Environment, 4Q 2006 Bay Area Venture Capital Terms Survey. Fenwick & West Publications. http://www.fenwick.com/publications/
[6] Use of the term ‘asset sale’ throughout this paper does not refer to the structure of the M&A transaction but the fact that the acquirer’s motivation for buying the startup is to acquire its intellectual property and other product and expertise related assets.
[7] “For more than 20 years, it has successfully used acquisitions, both large and small, to enter new markets and round out its product portfolios. With more than 100 purchases under its belt, the Company shows no signs of slowing down as it prepares to take its biggest leap yet into the consumer electronics and home entertainment markets”. http://news.com.com/Ciscos+acquisition+guru+speaks+out/2008-1041_3-6042499.html.
[8] Based on the VC taking a 20% stake for $10m investment, and requiring a 10x return from its stake.
[9] “Organizational Identities and the Hazard of Change,” Michael T. Hannan, James N. Baron, Greta Hsu, and Özgecan Koçak, Industrial and Corporate Change, October 2006.
“Organizational Blueprints for Success in High-Tech Start-Ups: Lessons from the Stanford Project on Emerging Companies,” James N. Baron and Michael T. Hannan, California Management Review, 2002.
“Employing Identities in Organizational Ecology,” James N. Baron, Industrial and Corporate Change, 2004.
After tracking the success of more than 150 start-up firms founded since 1994, Stanford Graduate School of Business Professor Michael Hannan and collaborators found that not only did altering the system for managing employees hamper success, but also such firms had long-term stock valuations that were nearly six times lower. His study, coauthored with former GSB professor James Baron and Greta Hsu and Özgecan Koçak, both graduates of the School’s doctoral program, is the culminating piece of research to spring from the Stanford Project on Emerging Companies (SPEC).
[10] Paul Dali, Venture Investor with Dali Hook & Partners and former Apple Computer executive. Interview recorded at Santa Clara University, 2005.
[11] Stewart Alsop, Partner NEA. 2005.
[12] VCPro Database. www.vcprodatabase.com.
[13] The funding from angels dropped to less than $1m per year according to Ann Winblad, Hummer Winblad Venture Partners.
[14] "During VC negotiations, angels are often worried about being diluted out, especially if they are unable to participate in subsequent funding rounds... the VC will radically rework the valuation, diluting the angel’s share." Angels Dance With VCs in the Pale Moon Light. M.R. Olson. The Angel Journal. Friday, 27 October 2006.
[15] According to the 2006 Angel Market Analysis, the Center for Venture Research at the University of New Hampshire “The angel investor market has shown signs of steady growth in 2006, with total investments of $25.6 billion, an increase of 10.8% over 2005, according to the Center for Venture Research at the University of New Hampshire. A total of 51,000 entrepreneurial ventures received angel funding in 2006, a 3.0% increase from 2005. The number of active investors in 2005 was 234,000 individuals. The sharp increase in total investment dollars was matched by a more modest increase in total deals, resulting in an increase in the average deal size of 7.5%, compared to 2005”.
[16] The Band of Angels Venture Fund, L.P. is a $50M venture fund comprised exclusively of institutional partners including three corporations, two university endowments, and a large pension fund. The fund is directed by Ian Sobieski and coinvests in deals that are subscribed by members of the Band of Angels. Initial investment sizes are typically $300,000 with total commitments for successful companies reaching $2.5M. Generally, either a member of the Band of Angels or one of the Fund's partners will take a board seat as part of an investment.
[17] Garage Technology Ventures describes itself as a seed-stage and early-stage venture capital fund.
[18] Most startups should avoid venture funding, not pursue it. Tom Foremski. Silicon Valley Watcher. http://www.siliconvalleywatcher.com/mt/archives/2005/07/thoughtleaders_2.php.

[19] Venture Capitalist and Venture Beat contributor Charles Moldow, offered some conflicting advice to entrepreneurs seeking capital, warning against venture funding in certain situations. Using the analogy “not many mice ever grow up to be antelopes,” Moldow infers that while every small company wants to be a big company, not every idea is venture worthy. A large investment for a company with miniscule pre-funding valuation is nonsensical, decreasing financial return for both entrepreneurs and venture capitalists. Stay Private and Avoid Venture Capital. By Andy Angelos, American Venture Network Regional Editor. January 23, 2007. http://www.americanventuremagazine.com/blogs/Stay_Private_and_Avoid_Venture_Capital/650
[20] Greg Gianforte has a soon-to-be-published book called: "Bootstrapping Your Business: Start and Grow a Successful Company With Almost No Money." says "Raising venture capital for early stage start-ups seems to be the prevailing path for most entrepreneurs; however, most would-be founders should reconsider".

 

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