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.

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

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?

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

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.

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.

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.