A Publication of the NJ Technology Council and the Education Foundation
June 2002
Vol. 6 Issue 5
VENTURE CAPITAL:
“HELLO OLD FRIEND” —
CLOSING A ROUND WITH YOUR EXISTING INVESTORS
BY ED WARD M. ZIMMERMAN, DOUGLAS N. BERNSTEIN & BENJAMIN BURDITT
In the current venture market investors have deep pockets but short arms. During the last six months, when
investors have written checks, those checks have largely
been second, third or even fourth investments into existing portfolio companies. These “follow on rounds”
inevitably end with the existing investors and management renegotiating material provisions of the deal
documents from the last round.
Funding in this market often takes the form of “flat
rounds” (the same valuation as the last round) or “down
rounds” (a lower valuation than the last round).
One of the most significant problems in re-financings is structuring a “liquidation preference” that retains
management’s incentive to build value while ensuring
that the investor has enough protection to prevent monetizing at a low valuation.
Understanding this critical issue entails understanding what makes preferred stock “preferred.” When
institutional investors buy equity they almost always
receive preferred stock. “Preferred Stock” gets its name
from, among other things, the liquidation preference
(the right to receive an amount of money in a liquidation or a sale of the business after payments to creditors
but before —or in “preference” to—common stock
holders). That amount, the “preference payment,” is
usually described as a multiple of “X,” where “X” represents the amount originally invested. The terms of the
preferred stock generally also provide for dividends and
“participation.” “Participation” means that after the
investors receive the preference payments, they will
“double dip” by “participating” with the common stock
in dividing up the company’s remaining value on a pro
rata basis. In 1999, term sheets typically showed liquidation preferences of 1x plus participation and
dividends. Current term sheets often bear dizzyingly
high preferences of 3x, and always feature participation. This change has a dramatic impact on all of the
company’s stakeholders. For instance, a management
team holding 50 percent of the outstanding stock can
find itself with only five percent of the cash in a sale at
more than three times the amount its VCs invested. At
some point, the management team realizes that even
with an unattainable sale at five times the VCs investment, management just won’t make any money—the
liquidation preference has “de-equitized” the team.
Some of the best VCs show restraint when structuring down round deals to ensure that management’s
incentives remain. They use numerous tools including
repricing existing stock options, which can yield a happy
management team but adverse accounting consequences. Alternatively, VCs will often “cap” their
participation or preference. This makes it economically
rational for VCs to convert into common upon a liquidation event, if the value is high enough. Caps also reward
management on the theory that the company’s substantial merger price indicates that management has earned
its keep.
VCs may also agree to “out of turn payments.” This
establishes a right for management to either receive a
fixed amount upon liquidation or to receive a payment
ahead of schedule (literally, “out of turn.”). These out
of turn payments usually come either right after the
preference payment and before the participation or
right after the new money gets its preference but before
the first round institutional investors.
Obviously, this points to sensitivities in the carefully negotiated relationship between new capital
Continued on back
Ed Zimmerman is a
partner at Lowenstein
Sandler PC and chairs
the Technology &
Internet Group.
Doug Bernstein is an
associate in the
Technology & Internet
Group at Lowenstein
Sandler PC.
Benjy Burditt is a
co-founder and senior
vice president of NYbased Scripps Ventures.
A Publication of the NJ Technology Council and the Education Foundation
June 2002
Vol. 6 Issue 5
VENTURE CAPITAL:
“HELLO OLD FRIEND” —
CLOSING A ROUND WITH YOUR EXISTING INVESTORS
Continued from front
providers and existing funders. Unfortunately, early money
(angels, friends and family who invested in common stock) often
receives the worst end of the bargain. This has led to the centrality of pay-to-play (also called “put up or shut up”) arrangements
in current deals. Pay-to-play refers to mandating that existing
investors will only retain the rights arising from the original deal
documents if they put in fresh funds. Pay-to-play has broad
applicability—VCs brandish it to deprive investors of board
seats, approval rights, anti-dilution protection, preemptive rights,
and even portions of liquidation preference. Investors frequently
invoke pay–to-play retroactively to present an ultimatum to an
existing investor who plans to sit out the current round—put up
or else.
Investors are also emphasizing provisions granting them additional operational control and increased board presence.
Staged funding provides another example of this mandated
accountability to projections. Investors now seek to absolutely
eliminate capital market risk (the risk that the current round will
not fund the company through to profitability, causing the com-
pany to return to the capital market for more funding) from their
portfolio companies. They do this because (1) they do not want
their management teams spending inordinate amounts of time
pounding the pavement for funding when they should be running
the business; (2) they do not want to be “crammed down” by new
money or have new investors de-equitize the management team
further; (3) they do not want to fund a business that will ultimately be liquidated due to cash constraints. That said, they do not
want to throw all of their money into the company at once—they
would like to see how the company performs first. At the same
time, good VCs also generally work with management to help
find a new lead investor, which has become the holy grail of second stage venture funding and can even be a condition of getting
the existing investors to reinvest.
Cutting a new deal with existing investors can be extremely
complex and time-consuming. Perhaps the most important lesson learned is that if your company has only six months of burn
rate remaining, you are probably on the verge of entering precisely these negotiations—so consider starting now, while you
still have funding.