VCs learning new tricks to weather the
downturn
By Matt Marshall
Mercury News
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.
|
