VentureBeat

Ed Holloway said:

I had some similar issues with MojoPac last week:
http://www.edholloway.com/archive/2006/09/28/My-Mojo-is-Slow_2100_.aspx

I sure hope they get some fixes out, this is a great concept.

Thomas said:

Greed destroys.

Martin said:

You mention getting washed out, which is essentially getting diluted. Does this really matter as an employee? Yes, but only if it is a down round. If the price per share of the new financing goes up, your value goes up. If you are an employee with 1%, then after the round you are at .5%, who cares as long as the value of your shares is higher? You still own the same number of shares as you did before. Goes back to the old rule, would you rather own 100% of something worth $100,000 or 10% of something worth $10 million?

JB said:

The Cooley report and Martin’s posting don’t complete the real situation. Which is…far, far worse for employees (and common shareholders, including founders). Here’s how.

Typically, in companies that raise lots of money (or any down round, which most startups that began life pre-2001 have faced subsequently at least once) the original equity structure is totally demolished in favor of those that “pay to play.” Sometimes these “pay to play” financings are forced (coerced) by investors that smell an opportunity to increase their ownership stake and restructure clauses and preferences in favor of those that can continue to pony up money, money that they insist they have and on unconscionable terms. Management, typically new and hired guns, is unsurprisingly compliant. Why? They get what is called “carve outs” which is a guaranteed minimum payout (for the CEO and his favored executives), before any other common shareholder (or for that matter, prior investor) gets a penny.

So with carve-outs, restructures, etc. what hope can the common shareholder have? In the absence of a multi-hundred million dollar acquisition or IPO, the answer is: zilch, nada, zippo. Better for them to try their luck elsewhere. To Martin’s point about .5% or 1% or for that matter, 10%, I ask: does it matter when there is little left after the VCs take their cut (and liq prefs) and the execs their carve-outs which leaves (if anything) a measly amount to be split amongst the common shareholders.

VCs and partners that are fluent and have a track record of engaging in these practices include Worldview/Mike Orsak, Crescendo/Dave Spreng, TCV/Hoag. Firms/partners that seldom engage in these include KP/Doerr, Sequoia/Moritz, Redpoint/Yang and some others.

Employees and for that matter, execs, should demand a response from their CEO whether the CEO has a carveout advantageous to the CEO and (select) execs. If so, the employees are better workling elsewhere….

Matt Marshall said:

Martin,

I should have been clearer. Your analysis is valid. So then we move on to the question of whether value was created. In fact, what I’m told is that Visto’s value declined significantly. So employees’ have lost value. It is not a bigger pie. It is much smaller pie. That’s the reason investors pumped in more money: Because it is a smaller pie, they could get a lot more of the pie for the dollar amount they invested…

JB said:

A modification to my prior posting: “pay to play” financings are not just favored (recommended; coerced) by investors. As explained earlier, (new) management has a vested interest in pushing through the new round(s). They get their carve-outs established, their price of their stock options is a fraction of what it’d be otherwise, and they get to enter the good books of the investors for whom they are doing a favor (in return for which they get their back scratched as well).

The losers are the prior investors, common shareholders, and everyone else.

Matt Marshall said:

Folks, just wanted to add that Visto “up-round, down-round” question is still open. This latest round is turning out to be fairly complex, with all kinds of “classes” of investors and employees. Some are preferred, have liquidation preferences, etc, so while the company is now saying this is an up-round, the question is for how many, and I’m asking the company that, and will update as necessary…

Brian McConnell said:

I have been following the Visto story for a while, as I sold a business to them, very regrettably, for mostly common stock. I have been suffering in silence, but with the latest news, feel compelled to speak up.

Visto is a special case, and is likely to be Exhibit A for everything that is bad about venture backed private companies, from bloated and mediocre management, to insider deals that wipe out other shareholders.

My experience with them was that they were opaque about everything from financials to their capitalization structure. I own 500,000 shares and did not even receive so much as a form letter or phone call about the latest financing and its consequences. I have never seen even a rough financial report, nor any communication whatsoever how this deal affects me.

As a shareholder, I would give Visto an F- for transparency. I can understand why. They’ve burned through a staggering amount of money to build a lightweight email program for phones. NASA put remote-control robots on Mars for the same amount of money, a comparison that says all that needs to be said about current management’s efficiency in use of capital. They don’t exactly have a lot to brag about at the moment.

IMHO, unless they sack most of management and start over, you can probably stick a fork in this one. If they couldn’t be successful after 10 years and over 200M in funding, they either need to pull the plug or bring in a new team.

Martin said:

All of the above arguments are valid. I suppose however that it is the job of the founders to structure the original deal properly so that all the aforementioned carve-outs, liquidation preferences, etc… do not cause employee value to be diminished. The better VCs typically manage upside not downside and you will see cleaner deals. That said, when there is a “down” round, there is usually a reason — if value is lost, every shareholder loses except the new guys… Why is that? Becuase the company would go completely under without the new investors — they are in a position to demand favorable terms and the company would be forced to accept. Keep in mind, they are taking on the risk of a struggling investment and are trying to turn it around.

Anyway, I hate to go on and on, but if the original financing is structred in good faith, and the new invetments are “up” rounds, employees are more than protected bythe value of their shares. Everyone, including original investors, founders, etc… is washed out in a down round so it is not just the employees that got hurt.

Brian McConnell said:

I think the key thing in a situation like this is to communicate honestly with shareholders and employees.

In the case of Visto, that never happened. I’ve started several businesses, and have been around the block enough to know how private financing works, and I had no idea what was going on there. As I said, nobody ever called me to explain how the recapitalization or whatever took place affected my holdings.

I am quite sure the average employee, who knew nothing about venture financing, was completely clueless about the actual value of his/her options, etc. It might as well have been a random number.

This is why I think private companies should be required to publish their financials, at least internally, with the same criminal penalties for fraud and misrepresentation. At present, common shareholders and employees are often treated as second class shareholders, with little or no access to accurate information, and little recourse if they wake up to discover that their shares are worthless.

Some Concerned LPs said:

There is simply no way founders can structure a deal to protect against carve-outs and other malpractices which are typically engineered by VCs and compliant (new) management (brought in to wipe out everyone else).

The case that is most pertinent is Alantec vs Mayfield (and other VCs) of the mid 1990s. The company was doing ok but not great; VCs engineered a crisis with compliant management to oust the founders and under pretext of financial necessities, recapped the company on terms highly preferential to the “new” investors (all of whom were already investors; no new investor stepped in knowing they were treading on thin ice). Company later flipped at a great profit to those “new” investors. Lawsuit filed by founders and the VCs lost in trial and had to pay up to the founders and common shareholders who were left out earlier. Since then the VCs have not attempted to go the legal path and simply settle (Nishan, Epinions, Rapt, …)

Isn’t it telling that the venture partnerships with the poorest performance and most at risk with the LPs are the ones that resort to exploiting the few companies on their portfolio that are doing well? Killing the goose that lays the golden eggs is never a strategy for success. Rumor has it a few Worldview companies are in the same situation and an exit will bring out to public view the actions of certain Worldview partners. We LPs are more inclined these days to support the entrepreneurs and hard working employees that stand up against VCs that engage in these unconscionable practices.

Visto Ex Exec said:

Changing management at Visto (or any other company) isn’t a reliable prescription for sucess or redeeming shareholder value.

New management usually demands carveouts (in addition to those already in place for existing executives) , insist on raising more money (to ostensibly “execute on the new strategy”), and the “new” investors who go along (the usual suspects; virtually all of the new money is from a select few of the existing gang, a few having fallen out along the way) rewrite terms to their advantage further.

Martin said:

The lesson of course, always get it right from the start — ha! I’m joking of course, but that is the surest way to protect everyone who was there from the beginning…

Yann said:

Very good thread of discussion! This is an agency problem seen in many asset classes that can only be addressed by transparency and close watch to conflicts of interests.

Many startup companies are created with sound fundamentals, strategies and products, but often the financial plan (or timing) is wrong. Most investors know this. Initial capital allocation assumes perfect execution, and at the first hiccup, shady investors start squeezing out those without power: employees, earlier angels, founders, and last management. When you have bloated seriesA valuations, cyclical markets, general uncertainty of a technology or market, even a sound business will have up and downs. Google struggled along for a while before finding the right business formula. So in general, the concept of value going up and down is normal, and common shareholders should not be penalized for that.

Secondly, the agency problem has to do with representation of many by a few, who in turn steal value from the many. Management is supposed to represent the employees, so a carve out in essence is a slick legal way for mgmt to steal value from employees. This is similar to LBOs where mgmt gets a huge package for selling the company to private equity investors at a discount, with or without independent directors negotiating the sale.

Ultimately, mgmt involved in financial negotiations is representing the interest of ALL prior shareholders EQUALLY! That is the fiduciary responsibility, otherwise employees should have a rep on the board as in Germany. So there is a strong potential for conflict of interest, and any material change in the exit compensation of the manager (after a financing) should be disclosed clearly to all shareholders to mute conflicts of interest.

Instead of asking for regulation and criminal threats (look at what sarbox did), we could impose transparency (not just in the terms but in the impact). Basically, management should be obligated to explain the terms of the new financing to ALL existing shareholders, and management should be obligated to present some exit scenarios so everyone sees what everyone else can/will make.

If management is forced to be open and explicit about the terms and financial consequences, they will tread carefully. The need to be fair to employees and other common will force management to be fair in these.

So let’s push for transparency and accountability.

Ty Pike said:

There is no sure path to protecting anyone. There are some recommended ways however. Here are some:
a) do a lot of homework on your investors. See how many entrepreneurs they worked with in the past are STRONG references. Find out especially how the VC firm (and partner) react when the going gets uncertain or tough.
b) every employee should ask their executives and CEO if all common shareholders are equal or if there are preferences that place some common shareholders ahead of others (e.g., carveouts, etc.) Any management team where the executives rake in their money before (instead of alongwith; i.e., at the same time as) employees is not worth respecting or working for. If the executives say everyone is equal amd later, preferential clauses are discovered (as they will be at an exit) the company can be held liable for misrepresentation and fraud. I know of at least one company, portfolio of a firm that had trouble raising its new fund and friction amongst partners, where this is a ticking time bomb.
c) stay away from venture firms and partners with little operational experience, esp as entrepreneurs. If they haven’t started companies they are unlikely to empathize with entrepreneurs and employees. This worsens if the partner has a financial background.
d) Watch out for “stories” explaining why new money is needed, new management is brought in, etc. Ask if the new managers have the same clauses as all other common shareholders or if some animals are more equal than others. Watch for scapegoating of the previous team (or founders), as it is a timeworn tactic to disguise the greed of those new on board.

At the end of the day, pray or do what makes the winds blow in your favor. Luck matters as much as competency.

Martin said:

This is a great thread! Ty Pike, your post is excellent — its really about partnering with the right people, people you trust. The best VC firms are not out to get you, they understand the importance of the VC/Mgmt/Employee relationship vis-a-vis creating a valuable and successful company. The ones who get tricky, scheme for carveouts, excessive liquidation preferences etc… are the firms to be avoided. When everyone goes in realizing that their goals are aligned, and they engage in deals that reflect it, you don’t see these problems.

Dan said:

Matt, the quality of the comments and the feedback indicate this thread is worth preserving for the long term. It reminds me of two or three other threads in SiliconBeat that had a lot of high quality comments involving VC malpractices and how employees/common shareholders can watch out for their own interests.

The SiliconBeat threads and this one are at risk of being washed away by the ebb and flow of daily traffic. Could you please find a way to preserve them for easy and permanent access at Venture(and Silicon)Beat?

will said:

second that! . . . this is a must read for any entrepreneurs ( along with Kevin Law’s “Sidnet Whiplash” post from almost 2 year ago . . . Martin, Ty, Jerry, Yann, and Brian (+ the constant lurker LP) . . . you guys are great! thank you! … Matt, you need a forum with the ability for blog posts to become “sticky” and become a thread . . . web 2.0 for some reason despise forums but love blogs but each serves its purpose . . . just look at the vibrant forums on Craigslist and Mypace. . . it create stickiness for the site not driven by one-to-many content publishing . . . (so you can take some deserved breaks) . . . also it creates more content for crawlers which help you generate $ from advertising.

Dan said:

The comments are also educational in what tricks certain types of VCs resort to that affect founders and employees (excepting certain “favored” executives) negatively. Avoiding certain named firms and partners that resort to those tricks as part of their normal way of doing business will save entrepreneurs and employees heartburn and grief; working with others they can focus on building companies and upside instead of having to watch for their backs all the time.

All the more reason for Matt to make this thread (and its cousins in SiliconBeat) sticky and for the long term. Matt, please…

pwb said:

Is Visto a good proxy for this…or anything really?

Employee#3 said:

I have received offer from some luminary to be employee #3 in his startup. Most founders also end-up in the

Employee#3 said:

I have received offer from some luminary to be employee #3 in his startup. Based on most statistics, most founders end-up owning

GP said:

This is a good thread.

What I see are companies that have raised several rounds of financing at relatively high valuations running out of money.

Management (often founders with common stock) negotiate for a new round of financing.

What gets negotiated, then, is a new series of preferred stock with a 2x liquidation preference at a much lower (and probably fair) valuation. The combination of the lower valuation and the 2x liquidation preference wipes out the value of the prior series of Preferred Stock, as well as the value of the Common Stock. The investors, often some of the VC firms who invested in prior rounds, defend the 2x Liquidation Preference as a reward for higher risk, but more candidly will admit that it is a way to recover money lost in prior rounds. When challenged as to the fairness of the terms, they say “You are welcome to invest too or we can just let the company fail.”

Do the founders bear the pain of having founded a company now worth less than the amount of cash invested? You would think so, but not to the extent they are management.

Management negotiates sweet new equity and cash incentives, so they will profit even in a scenario where non-management common shareholders or Series A and B investors get nothing.

In other words, you have management and the new investors acting without a scintillia of concern for the other shareholders of the company. This may sound cynical, but let me assure you it is true.

How does the law allow this? I’m not sure it does. In this scenario, usually all if not most of the Board of Directors has a conflict of interest and hence the transaction (depending on state law) must meet a “total fairness” standard. Where you have a deal struck that is sweet for the negotiators but not the other shareholders, I would say such transactions are not totally fair.

In practice, however, these “unrepresented at the bargaining table” shareholders probably go along in the face of threats that, if they hold up the deal, the company will fail.

It is a sad state of affairs, indeed. One wishes for managers, law firms, venture capitalists and independent directors who would stand up and make sure a transaction is negotiated taking account managements and the Board’s fiduciary duties to all shareholders. And recognizing that founders have to take a hit to their equity because they company has not performed well. And that a 2x liquidation preference is not supported by sound business analysis, because new money is new money and not supposed to recover prior losses and because 2x liquidation preferences present a host of perverse complications by burying the value of the common stock and related stock options.

100 investor loans said:

This is good stuff! Keep up the good work!