There is a terrific article on venture capital deals by Steven Davidoff in yesterday’s New York Times’ Deal Book titled In Venture Capital Deals, Not Every Founder Will Be a Zuckerberg. Davidoff examines a case recently litigated in Delaware courts where a company, Bloodhound Technologies, was sold for $82.5 million eleven years after its first funding round. The five founders of the company only received $36,000 in the sale, whereas the management team at the time of the sale received $15 million and the VCs received virtually all of the rest (~$66 million).
How does this happen? The terms venture capitalists negotiate when they make investments can, over time and successive investments, give the investors the power to push the founders out of management and gain control of the company. Moreover, the “liquidation preference” in preferred stock allows investors to get their money back before anyone else gets anything, and they will often then “participate” in the remaining proceeds. In some circumstances investors negotiate preferences that are even more than what they put in, or can, as they did in the case of Bloodhound, negotiate a “cumulative dividend” that grows over time (cumulative dividends are rare, but preferences and terms that give investors control leverage are not).
Davidoff also notes that although good data is difficult to come by, this situation is more common than one might think. That certainly confirms my experience in buy-side M&A: often the founders did not see a cent from some substantial M&A exits.
Is this just a matter of greedy investors? Yes and no. Venture capital is a business, and venture capitalists take a lot of risk in providing the capital required to build and scale businesses. They negotiate terms that give them downside protection and provide upside when an investment pays off. They have an obligation to do so for the sake of their own investors. These terms are part of the “cost of capital” for founders.
How can founders protect themselves from this outcome? By getting as much negotiating leverage as possible and negotiating the best possible deal with investors. This is particularly important in the first round, as first round terms set a standard for later rounds.
How do you gain leverage in your negotiation? Ahhh… the multi-million dollar question. If you have a deal that’s “hot” and a number of investors are bidding to get into or lead your round, you are going to get the best possible terms. Being in that situation is a combination of (i) execution on your business plan and (ii) fundraising prowess. If you have a great business and are executing well on your metrics, you have leverage. And if you have worked hard at communicating your story to as many investors as possible and have drummed up a lot of interest, you have leverage. Ultimately, it’s all about your execution on both fronts.
But that’s not it. I’ve seen lots of founders with a hot deal take bad terms because they don’t understand what they are agreeing to, just want to get the deal closed, are poor negotiators, or are swooning over the investors’ promises. Even when you have great leverage, a founder/CEO should have an acute understanding of venture capital deal investment terms, and of course have an experienced startup attorney advising. A good place to start learning about venture capital deals and transaction terms is Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld and Jason Mendelson (a VC and his lawyer!)
Most importantly, approach venture capital deals the same way you approach other major business transactions: strategically, cautiously, and with an eye to get the best deal possible for your business and yourself.