VCs learning new tricks to weather the downturn
By Matt Marshall
Mercury News
Posted on Thu, Aug. 01, 2002
siliconvalley.com
Venture capitalists have been known to negotiate tough terms with the companies they fund, but they've developed a new bag of tricks to ensure they stay on top during this brutal downturn.
Employees of Silicon Valley's high-tech start-ups are likely to end up near the bottom of the heap; they might want to ask questions before letting their management accept more money.
Take, for example, one arcane but high-octane clause, the so-called ``senior liquidation preference,'' that VCs are slipping into their contracts with start-ups.
Under this provision, VCs demand all of their money back first in the event the start-up is sold -- before management or employees see even a dime of return on their options. Lately, those terms have worsened: The VCs are demanding that they get double, or even triple their money back before employees see anything.
``In the 18 years I've been in this business, I've never seen that before,'' said Barry Kramer, a lawyer at Fenwick & West in Palo Alto, who published a study last week that analyzed the terms of venture financing for Bay Area start-ups. ``We're changing the rules of the game,'' he said.
Problem is, the terms can create some odd incentives for the rank-and-file. Employees might prefer to see the company go it alone -- even if it risks killing the company -- than watch it get sold at a good price for investors.
One example is San Francisco's Bravanta, a Web service start-up that received funding in February from a group of venture capitalists led by the Sprout Group's Beth Hoffman in Menlo Park. Hoffman demanded, and got, a ``3x'' liquidation preference, meaning that she and the other new investors would get back three times their $11 million before earlier investors, management or employees get anything. Employee options would be worthless.
Put another way: If the company is sold for $33 million or less, her firm and a select group of investors who joined her -- including Doll Capital Management, St. Paul Venture Capital and Menlo Ventures -- will claim the entire proceeds. If the sale is for more than $33 million, the rest is divided up among all the investors based on the percentage ownership of their shares.
Here's why the terms seem so tough that they're almost wacky: In today's market, Bravanta's management would be lucky to get $33 million on a sale. That is more than the investors privately valued Bravanta before they invested, around $25 million.
Sure, a sale would be great for the new investors, who would triple their money. But the terms could kill the employees' motivation to close such a deal. Employees might rather drive it into the ground, or work to achieve quick short-term goals to boost bonuses, ignoring the long-term health of the company.
Hoffman did not respond to a request for comment.
Other investors, St. Paul's Brian Jacobs, and Menlo's Sonja Hoel, said they did not want to comment on why the 3x liquidation preference was negotiated, saying the reasoning should be explained by Hoffman since she was responsible for the negotiations. Jacobs and Hoel benefit from the clauses, and sit on the company's board.
Still, Jacobs suggested the board might revisit the tough terms. The board is now considering a resolution that would grant the employees a certain stake of the proceeds, he said, even in a sale of under $33 million.
``The terms we're seeing now are worse than I've ever seen,'' said Jacobs, who has invested for 15 years. ``Venture capitalists have leverage to ask for all kinds of things . . . My guess is that it is a bit of an overcorrection.''
Bravanta Chief Executive Brendan Keegan said he, too, was taken aback: ``I was probably not as cognizant going in as I was coming out. . . . It's so new.''
He has worked to find other ways to boost employee incentives. Employees earn cash bonuses if they meet personal goals set with managers, extra prizes if they go beyond the call of duty, and more bonuses if the company meets its milestones.
Marketing manager Gina Lopuck, one of Bravanta's 55 workers, considers her short-term bonuses more valuable to her than her options. ``I'm an immediate gratification person,'' she said. Her performance has won her a bike, a home computer system, a coffee pot and a cordless phone, she said.
The irony of the tough terms for Bravanta is that Bravanta itself provides software to companies to help them manage incentive and award programs over the Web.
Bravanta is not alone. Redwood City's Ceon, which makes software for telecommunications space, also swallowed a 3x during its latest round in late March. Brooke Seawell, a venture capitalist at Technology Crossover Ventures, one of the investors in the round, chose not to comment.
According to Fenwick & West's survey of 74 Bay Area financings during the second quarter, 56 percent of them contained senior liquidation preferences. And of these, 41 percent had multiples such as 2x or 3x.
Much of the impact of the tough terms have yet to be felt. With their stock prices drubbed by the stock market, public companies have weaker currencies to acquire start-ups. Sales of private companies haven't been robust, but they might be over the next year or so.
``There's a lag,'' said Ravi Chiruvolu, a venture capitalist at Charter Venture Capital, who is concerned by the trend in liquidation preferences.
To be sure, they can make sense in some cases, he notes. The details are complicated, but an investor might want to protect his investment against dilution from earlier investors who also demanded preferences. But Chiruvolu said he has been forced to take leadership during negotiations of his deals, making sure employees are aware of the harsh terms. All too often, he says, venture capitalists don't bother to disclose the arcane details to management or employees. ``The default is not to disclose,'' he said.
For those who can stomach more grim statistics on this and other tough contract clauses, F&W's survey is at www.fenwick.com/vctrends.htm. |
