Violating the old cliche, no news in 2001 was bad news. An unknown number of portfolio companies quietly faded into history like neglected tulips. And what was normally considered bad news for entrepreneurs and venture capitalists, a down round, was actually reason for celebration.
“The really good companies were doing down rounds, or if they’re really lucky, flat rounds,” says Chris Aidun, head of the VC practice at Weil, Gotshal & Manges LLP. Facing market realities like this, VCs have changed the tenor of the legal advice they seek from their attorneys, like Aidun.
VCs now give the legal documents behind the deals much more relative attention, and, as a sign of the times, those documents have become the roadmap for cramming down equity. However, as layers of equity are compacted, the erosion of value may threaten the future of some venture funds entirely.
VCs want more attention from more-senior partners for less money, a demand they pass through to their service providers that they’re receiving from their portfolios, which are in turn demanding more time in increasingly complex situations.
“Twelve or 24 months ago, terms fell in a very narrow band,” says Jay Hachigian, head of Gunderson Dettmer’s Boston office. “Today, you see very dramatic differences in term sheets.”
Now, every term is negotiated, and deals take months to close. New investors want rights that may impose on previous investors, and the previous investors may split on their willingness to accept these terms.
Ed Reitler, partner of Reitler Brown LLC, says new investors ask for liquidation preferences of 3x to 5x, and they request negative covenants which give them the right to block asset sales, a disposition of the company and the use of proceeds from the investment.
They also request uncommon investment vehicles. Instead of convertible preferred stock, new rounds have been completed on debt instruments that convert into convertible preferred equity at the next round of financing at a discount of, in some cases, 30% to that series of stock. That moves new investors ahead of all other equity and on par with creditors if the company doesn’t make it.
Not only do they want guarantees and the right to block certain actions, they want to be able to cash out through redemption clauses and even more onerous agreements.
“Other than the really hot companies, VCs are saying I have the right to compel you to sell if I lose faith in the company,” Aidun says, referring to drag-along clauses, which allow the VCs to dissolve the company at will.
If the zeitgeist of 1999 was the closing party, 2001 was the year of the down round. Investors in those companies that were good enough to get funding depend on their attorneys to structure deals in a way that they can party like it’s 1999 if and when the deal finally pushes to exit.
In many cases, down rounds have squashed the valuations, which puts the investors in the sticky situation of how to split the equity. VCs typically protect the equity reserved for active employees at 10% to 20%, but when new investors buy 50% of the company, that doesn’t leave much for other investors.
In most cases, past investors have to pay to play – or in other words invest in the current round to protect their past equity positions. This has created a strange survival of the fittest situation where some VCs and angels are forced out of their investments.
“Not everyone’s going to have the dry powder to participate and you’re going to see some hard feelings because of it,” Reitler says. “There’s nothing you can do about it.”
Some angels and VCs are forcibly shown the door, and those relationships may be long to heal. They may also leave the door open behind them for litigation.
“An issue bubbling under the surface on down rounds relates to directors’ fiduciary responsibilities,” Aidun says. Along with VCs and angels, other non-participating investors get squeezed. Often, founders who are no longer involved in the company see their stakes significantly reduced.
VCs play an interesting role in these scenarios, because if they are company directors they carry fiduciary responsibilities to all the shareholders, but as investors in the current round they will also be erasing those shareholders’ equity.
“In three years from now, if one of these companies is a roaring success, then one of the crammed-down founders might think, Wait a minute, here’s a way to make some money,'” Aidun says.
In the relatively young venture industry, the scenario really hasn’t been tested, but it came close about five years ago. Two founders of Alantec Corp. sued three top-flight VC firms for wrongfully diluting their positions in 1991 and depriving them of their equity during a down round.
In 1991, Alantec had met a similar fate to many companies today, but when the company ended up reaching a successful exit, the founders felt that their stake in the exit had been unfairly reduced by $40 million, according to their reported estimate. An undisclosed 1997 settlement reportedly netted the two founders $15 million.
Since the case didn’t go to trial or reach a judgment, lawyers have no benchmark to predict how the courts would decide future suits, and lawyers don’t like to get into situations they can’t predict.
The directors’ best defense in the situation may be to show they had no other choices but to accept the dilutive terms or go under. Aidun says the transaction is subject to challenge unless an independent committee of directors, a majority of disinterested stockholders (which VCs typically are not), or a judge approve it.
Under that scenario, the VCs will likely find themselves in front of a Delaware judge defending their actions.
Casualties have begun to emerge among the VC firms who found themselves on the wrong side of these deals, and lawyers may spend their time in 2002 working out the terms of fund liquidations. Recently, several VC / limited partner relationships have gotten a little rocky when VC firms have hit fund-raising roadblocks, cut back their fund’s sizes or split up entirely.
“In the last year or so, a lot of VCs have had to dance a little differently with their LPs,” says Michael Littenberg, head of the emerging companies and technologies practice at Schulte, Roth & Zabel LLP. He mentions anecdotal experience with VC funds that have cut management fees and LPs that have refused capital calls. “The partnership agreement tends not to be as important as the relationship,” he adds.
It’s so rocky that at a recent Manhattan breakfast meeting with a group of VCs and LPs, one VC looked accusingly across the table at an LP, asking him to answer for a rumor going around town that LPs were prepared to balk on as many as 20% of upcoming capital calls.
“I think there’s a lot of people who wouldn’t mind their commitments being canceled,” says Aidun, an LP himself.
This year, some VC firms might succumb to the cyclical effects of the downturn, because an unheralded number of VCs out there raised funds at unfortunate times and now sit without adequate means to make new investments. They can’t raise new money, and they don’t really have anything to do. The LPs in the funds are wondering what’s going on.
“People are going to say, I can’t live in this limbo,'” Aidun says. No new product markets are developing, and nothing points to any kind of good market any time soon.
Asset sales and liquidations are two ways to get out of the business. And by hook or by crook, some VCs may be seeking to unload their funds and get out of the industry. It beats grinding out a fund to its bitter end or being forced out, as was the case with the management of the San Vicente Group in 2001.
Again, deal terms may stop VCs from exiting cleanly. Companies slipped in some terms when VCs weren’t paying attention, such as the right of first refusal to buy shares of the company before it hits the secondary market.
In more extreme cases, executives and other investors have cosale rights, entitling them to sell their shares along with any other investor that finds a buyer. That could make it hard for folks to entirely liquidate their positions.
Structural issues like these around funds and deal terms make this a very interesting time to be in the industry.
“I spend all of my day on wacky scenarios like a company in California where the whole board resigned,” Littenberg says.
It’s interesting, that is, if you’re not the CEO or VC becoming a future case study at Harvard or Stanford business school.
“If two, three years from now the IPO market is hot and these companies are rolling out, it will be interesting to see how hindsight judges us,” Aidun says.