New Deal Terms in a Down Market

In a down market, to which many of the current players in venture capital are unaccustomed, you see some strange things. In order to attract capital, investors (who are lacking self confidence, on the one hand) and entrepreneurs (who are desperate, on the other) will sometimes resort to bizarre financing structures in order to get a deal done. A couple of cases in point, which illuminate the current landscape:

First, it is well known that nervous investors are attempting to shore up their position as they subscribe to shares in a company by creating what I call a supercharged participating preferred. 'Supercharged' means that, upon a liquidity event (either a company sale an IPO), the holders of the preferred get a multiple of their money back (the amount of the initial investment, plus accrued dividends) before the inferior shareholders take anything off the table. 'Participating' means that, after the preferred holders have raked in, say, two or three times their initial investment (expressed in either cash or stock depending on the structure of the liquidity event), the preferred holders then share in the remaining upside in proportion to their interest on an 'as if converted' basis.

The norm for supercharged preferred, if there is a norm in these troubled times, is somewhere around a 3x recovery for the preferred investor, meaning three times its cost and accrued dividends. As investment capital has become more difficult to access, however, some truly bizarre 'superchargers' have been encountered, including one reported by my partner, Jay Rand at 12x. Were that investment in fact a personal loan, not only would the laws against usury be involved but, perhaps, a criminal prosecution for loan sharking. In today's private equity world, however, the penalties are milder – loss of one's investment as and if the morale of the common shareholders, usually identical with the managers, is destroyed.

A second wrinkle, again brought to my attention by Jay Rand, has to do with a company which had completed a successful Series A round, but had hit the wall. Were professional venture financing available for the Series B round, the Series B could be expected to demand supercharged participating preferred in preference not only to the common shareholders but to the holders of the Series A (the first venture investors) who for one reason or another (perhaps having nothing to do with the fortunes of the company), have elected no longer to play in subsequent rounds. Since it is tough to get members of the VC community to favor a company which the existing VCs have abandoned to its fate, the entrepreneur/founder in this case had no option but to finance the company himself. And, when he decided to put up $500,000 as a Series B investor, lo and behold, he behaved just like a professional Series B investor … his deal terms brutalized not only the common shareholders, i.e., himself but also the VCs in the Series A round. If the company is sold, in other words, the first money out (the first profits) will go to that individual who is ordinarily the low man on the totem poll … the founder. As the saying goes (if it is any consolation to the Series A), what is sauce for the goose is sauce for the gander.

Next, a relatively new wrinkle has cropped up as a consequence of publicity involving the so-called Atlantec case … a litigation settled after 15 days of trial for a significant amount of money,[1] the allegation being that the venture capitalists had assumed control of the board of the company and arranged the terms of follow on investing, a 'washout' round, with themselves … a classic 'inside trade.' As I reported (along with one of my students) in an article in 1995, the VCs arranging inside trades, particularly if dilution is severe, are not entirely protected by an offer to the other shareholders to 'play' in the round. Even though a shareholder does not elect to play (and absent a specific contractual condition to the contrary), Kevin Garlitz and I wrote, based on omens and indicia here and there, that the fiduciary duty of the controlling board members continued to obtain and the inside trade could be subjected to what the Delaware courts call 'enhanced scrutiny' … meaning generally recovery for the 'washed out' minority. Slowly but surely, the venture community is coming to understand that there was substance to what Kevin and I had to say in 1995. And, the reaction of sophisticated financial engineers, attempting to counter this risk on behalf of the VCs, has been interesting … albeit, on reflection, a natural adjustment.

Thus, as a general proposition, the law of corporate governance suggests that a director is a fiduciary to all the shareholders particularly in the context of a trade in which the director or her firm is personally involved. However, with certain exceptions, the shareholders, voting in their capacity as shareholders, are allowed to pursue their own specific and personal outcomes, even though shareholders of different classes may suffer as a consequence. The upshot has been a subtle shift in the control mechanisms favored by sophisticated counsel to the VCs, faced with the natural desire of the venture investors to enjoy as much residual control over this portfolio companies as possible. At first glance, the way to assert control over a company is to arrogate to oneself a majority, or at least a blocking minority, of the board. Were the VC syndicate to enjoy the right to nominate a majority of the board, the old rule was that there was no reason for the VCs to go after further controls … beating a dead horse, as it were. However, the better view is that controls in the stock purchase agreement (board nominations are ordinarily contained in the stockholders agreement) should assume greater significance … hence, a focus on the negative covenants in the stock purchase agreement. That is to say, the stock purchase agreement provides that the company shall not do X, Y or Z without consent of a specified percentage of holders of the Series A, B, and/or C preferred, meaning the VCs. The VCs still have a board seat but that board member abstains when any vote comes up which might involve an allegation that she violated her fiduciary duty to all the investors. The VCs then rely on their veto right in the stock purchase agreement to push the company in the desired direction.

[1] Atlantec was a San Jose based manufacturer of Hubs for interconnecting LAN's. The Company was founded in a garage in 1987 by two engineers who invested $30,000 apiece. Alantec went public in 1994 and in 1996 was sold to FORE Systems for $700 million. Shortly after the IPO, the founders sued the VCs who invested in the down rounds and VC representatives on Atlantec's Board of Directors, claiming that Board of Directors had breached their fiduciary duties to common shareholders in approving 'washout' rounds. The case went to trial before a jury and was settled after 18 days of trial testimony, for a reported $15 million.