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08/17/2005

Preferred To Death

Most people assume that the biggest source of financial tension within a venture backed start-up is the financial tension between entrepreneurs and VCs that is created as a result of the preferred stock agreements that VCs routinely insist on. While this situation can indeed be a major source of tension, a far more common and often far more destructive source of financial tension is the tension that develops between the VC investors themselves.

Generally speaking: the more VC investors in a company, the greater the inherent level of inter-investor financial tension. For companies that have raised multiple rounds of preferred financing (and had a few ups and downs along the way) this tension often erupts into highly distracting and even debilitating conflict, forcing entrepreneurs to either play the role of peacemaker or to choose sides and wage war against one investor faction or the other.

Having been involved in a few of these fights myself and having observed more than a few from afar, I think there are some structural ways to significantly lower the level of inter-investor tension and thus the probabilities of conflict, but first let’s explore the typical sources of conflict.

When You Need It The Least, You Get It The Most
The most common cause of inter-investor conflict is poor investment performance. If a start-up is failing to execute on its business plan, investors generally get nervous and one can almost feel an “every man for himself” attitude start to overtake the group. Some investors might want to change management, some might want to change strategies, some might want to “stay the course” and still others might just want to sell and get the hell out. While investors no doubt often have principled disagreements over what’s best for the company in such situations, more often than not, a particular investor’s preferred path is heavily influenced by their specific financial position relative to the other investors.

For example, take a company that has raised a substantial amount of money by issuing four separate series of preferred stock. Typically the last series of investors will be first in line to recover capital in the event of a sale. This means if a company starts to go south, the last series of investors will typically push hardest for an immediate sale while the first series of investors, who realize that they will likely realize little if any proceeds in a distressed sale, are much more likely to advocate “staying the course” or some kind of restructuring.

These situations can get even more complicated when one takes into account not just the financial incentives of each investor, but their individual fund dynamics. Some investors may not be willing to do a “down round” of financing because they are in middle of raising money, while others may not have enough money left over in their funds to make a new investment even if they wanted to. These fund dynamics can add a layer of complexity and confusion to inter-investor conflict that is incredibly frustrating.

The irony for entrepreneurs is that this is worst possible time for them to have their investors engaged in a debilitating and distracting cat fight. After all, this is the time that the entrepreneur clearly needs as much help as possible, but to his eyes it often appears that the VCs are too busy fighting each other over who gets the first class suite on the Titanic to bother helping the company.

When One Person’s Home Run Is Another’s Base Hit
A similar, though somewhat less common, situation can occur when a start-up is doing very well. In this situation, investors may disagree about the best path to maximize the return on their investment. The typical catalyst for such a conflict is a buy-out offer from another company. Once again, each investor’s preferred path is highly influenced by their relative financial position. In a reverse of the downside scenario, in this scenario it is the early investors who are typically pushing hardest for a sale, while it is the later investors who are most vested in “staying the course”. This difference is due to the fact that the early investors often stand to make a much greater investment return than the latest investors.

For example, if the early investors bought stock at a post money valuation of $2/share and the latest investors paid $8/share, a sale at $10/share would net the early investors a 400% return, but the later investors would net only a 25% return. In such a situation, the later investors may well want to “let it ride” but many early investors will be screaming to cash out.

These “upside” conflicts are usually easier to work out, however sometimes they can be just as nasty as a downside conflict with investors threatening to file lawsuits and all other sorts of crazy things in an attempt to get their way. In these situations usually the management team is aligned with the early stage investors (as their options are in the money) although it’s not uncommon to see the management team split as well between the founders, who have very low cost stock and therefore stand to make good money and professional managers who joined later on, and thus have options that are only marginally in the money.

The Nuclear Option
Much of the underlying tension in both scenarios comes from either overt or implied threats by one investor class or another to exercise the VC equivalent of the Nuclear Option. Each class of preferred shares has so-called protective provisions. These provisions essentially give each class of preferred stock veto-power over a set of company decisions. One common protective provision is that a majority of investors in a particular class of preferred stock, say the Series A investors, must vote to approve any merger or sale for it to be valid or must vote to approve any new round of financing. In this way, any class of preferred investors can essentially veto a sale or new round of funding. In the case of the new round of funding, vetoing it can effectively kill off the company if it is in distress, while in the case of selling the company, vetoing it (or simply not voting for it) can kill the deal outright.

Investors insist on such “blocks”, as they are often called, to avoid situations in which they invest in a company at a $100M valuation only to have the other investors, who invested at a $20M valuation, sell for $80M. This obviously wouldn’t be fair, so it’s not like blocks are an inherently unreasonable term.

However, in addition to “blocks”, most investors get preferences, or the right to get their investment (and sometimes multiples of their investment) back before the other investors. Theoretically preferences encourage investors to invest at higher valuations than they might otherwise.

The problem isn’t that blocks or preferences or preferred stock are inherently bad, but that each new issue of preferred stock builds up a separate layer of blocks, preferences and other terms. After just a few rounds of preferred stock, companies are often saddled with so many different terms and provisions across the various issues of preferred stock that getting simple board consents can be harder than ratifying the SALT II treaty.  Major decisions, such as selling the company or raising a down round or hiring new management, are almost pre-ordained to set off World War III.

Can’t We All Just Get Along?
Having been through what seems like World War III, IV, and V and few times, I have developed a 5 step method to preferred investor harmony:

  1. Never have more than three classes of      preferred stock outstanding. Roughly speaking, the amount of investor tension and the chance of      “going nuclear” is a log function of the number of preferred stock series      outstanding. Having any more than      three series outstanding is just begging for investor Armageddon. If you find yourself on a board debating      the merits of Series G stock, you should immediately stop what you are      doing and proceed directly to recap the entire company.
  1. No Class Blocks For Sales: Allowing an individual class of      preferred stock to block a sale of the company is simply a recipe for      trouble. You are better off giving      a class a higher preference than giving them a block. By all means don’t give them both as      there’s no real justification for both. If you must give a sale block to a preferred stock, at least make      it conditional in that they can’t object to sale above a certain share      price.
  1. Keep      It The Same Stupid: To the      extent humanly possible, the terms on each class of preferred stock should      be the same as the others. That      means the same protective provisions, the same conversion terms, group      votes on as much as possible, etc. The more everyone is in the same boat the easier it is to make      harmonious decisions.
  1. Drag Along’s Are Your Friend: Drag-along provisions, provisions that      require investors to support certain actions whether they like it or not      as long as enough of the other investors vote for them, are a company’s      best friend as they preclude all sorts of childish and destructive      behavior on the part of a rouge investor. They are somewhat draconian, but you will come to love them when      you have to line up consents for a new financing or a sale.
  1. Manage Expectations: When recruiting additional series of      preferred stock it’s important to let them know what the expectations and      intentions of the existing investors are. If the existing investors have resolved that they will hit the      first M&A bid above $50M, by all means tell new investors that. On the flip side, if a late stage investor      plans to not even consider selling before they make a 100% return they      should let the company know that before they put their money in.

Inter-Investor Agreements?
While these suggestions are all ways to keep the peace within an investor syndicate using existing preferred stock purchase documents such as the Stock Purchase Agreement, the Investor Rights Agreement, and the Articles of Incorporation, fact is these documents are really written to address issues between the investors and the company, not issues between investors.

The more experiences I have with such situations, the more convinced I have become that it might make sense to have a separate “inter-investor agreement”, similar to an inter-creditor agreement often found in debt financings. Some of the things the inter-investor agreement might spell out in more detail include: A) What milestones investors will use to determine progress or lack of progress B) What actions they agree to take if such milestone are met or not met C) What happens in the event one investor’s fund runs out of money or needs to sell their stock D) Expectations and processes for resolving disputes short of all out investor war.

Such a document might not be necessary if the 5 step method is followed, but either way, I think VCs need to explicitly address the issue of inter-investor financial tension head on as it is bound to become an issue sooner or later in most venture funded start-ups.

August 17, 2005 in Venture Capital | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.