Term Sheet 101: Preference

Too Much Information

Angels or VCs? Or both?

by Charlie Odonnell

I'm pretty sure I'm not allowed to fundraise according to the SEC, so let's just play hypotheticals for the moment... wink wink, nudge nudge.

IF I was a startup looking to raise seed money for development of a project, ooh.... something similar to Path 101 (I think I've settled on having a space there), and raising somewhere between 250-450k, what should the makeup of that round look like?

On one side, not many VCs would even do such a round pre-product, but a few of the would.  There are
some smaller, perhaps more specialized funds that do this sort of thing.  Either way, these are people that are primarily in the business of investing in startups.  To me, the benefit is that they have experience, connections, and they (ideally) have a sense of professionalism around the way they conduct their business.  (i.e. They're not going to show up at your door one night demanding their money back.)

The one thing I don't necessarily believe is that it makes them any more likely to invest in an A round.  Sure, they've gotten a chance to get to know you, but if a VC is interested, they don't need to put in 200K to do that.  They can take you out to a few lunches and hang around the rim enough to see what you're up to.  Plus, if you don't wind up coming out with a compelling product, they're free to just walk away from the deal anyway.  At least with angels, there isn't an expectation that they're going to participate significantly in an A round, so you won't have egg on your face if it doesn't happen.

As for angels, you're likely to need them at this point, so I think the question becomes more of a question of composition.  Friends?  Family? Big names?  Angel groups?  A mix?  How many?

If you can, I think its advisable to avoid friends and family, unless you have friends and family in the business that you're going into, whether its tech or something else.  You'll need their moral and emotional support and you should let them know that's what's important.  You don't want money, or lack of it when the company blows up, getting in the way there.  Plus, unsophisticated investors, even if it's your mom, are probably going to be a little bit of a pain in the butt.  (Although, Jeff Bezos' parents turned out to be good angels...)

I think a mix should probably be in order.... the professional investors that you know best, and also a few "reach" candidates.  If you could get anyone on board--captains of industry, celebrities, etc--who would it be?  For me, I think anyone on the founding teams of Monster, Careerbuilder, or Hotjobs would be perfect.  Published authors of books like "What Color is Your Parachute?" would be ideal, too. 

But I'd like to hear from entrepreneurs.  What's been your angel experience?  Surprises?  Who's been a much better addition than you expected?  Who's been a disappointment?  VCs in angel/seed rounds? 

The credit crunch could help venture capitalists

By Matt Marshall

The Dark Side of Startups: 5 Corrosive Co-Founder Conflicts

by Dharmesh Shah

Most of the startup writing out there (including articles on this blog) addresses issues of strategy, finance, innovation, product development and other "fun" topics. 

For this article (which I hope will become the first in a series), I'd like to take a slightly different angle by looking at some of the not-so-pleasant sides of the startup experience.  What I call the "Dark Side Of Startups". 

The following is a list of the types of co-founder conflicts that I have encountered in my 15 odd years working in and with startups.  Some of them are from my own personal experience, some are from late night conversations with other entrepreneurs dealing with co-founder issues.  If you've kicked off a company and had one or more co-founders/partners in it, chances are some of these might resonate with you -- I'd be very surprised if none of them did.  If you're on the outside, looking in (i.e. thinking about starting a startup), don't let this list dissuade you.  I still think startups are great things, but it's often useful to look at the dark underbelly of exeperiences sometimes to get a fuller understanding of things .

5 Common and Corrosive Co-Founder Conflicts

1.  The "Who Gets What?"  Conflict:  This conflict is likely the most common.  Anything that impacts the amount of money made for the various founders has the potential to generate conflict.  The most obvious example is equity in the company. Who gets how much?  Why?  What happens if one of us leaves?  Another example is the issue of founder compensation.  How much should each founder get paid?  Why?  Who gets to change it?  The good news about economic conflicts (vs. some of the others we'll talk about later) is that the conflict itself is understandable and rational.  Everyone wants to be treated fairly and at some level, there is a natural conflict of interest (i.e. if I get more shares, someone else gets less). 

Under good circumstances, most conflicts in this category can be resolved through discussion, negotiation and perhaps some outside intervention (i.e. an advisor or mediator).  Under bad circumstances, this cannot be reconciled the "easy" way and as such, the legal documents get visited, people hire lawyers and unpleasantness ensues.

2.  The "I Work Harder Than You!" Conflict:  It is mathematically impossible for each founder to work at exactly the same levels in a startup.    It is natural for each co-founder to invest time/energy based on her situation.  This could be influenced by how much time they have available, how passionate they are about the company (yes, you heard it here first, not all co-founders are totally passionate about the company), their own style, their personal obligations, etc.  When founders begin arguing about who is doing how much, this can often be rooted in the "who gets what" conflict.  Example:  I'm working 100 hour weeks and Joe's only working 50 hours weeks, so I should get twice as many shares as Joe!". 

3.  The "Who Gets To Decide?" Conflict:  If you and your co-founders are well matched, chances are your skills and talents are not totally overlapping (i.e. they are good at some things and you are good at others).  This resolves most of the "who gets to decide" issues as lots of decisions fall into the area of expertise of one co-founder or another.  If the founding team is functioning well, most decisions never become issues.  But, there are two areas where issues do arise:  When you both have some background/expertise in an area (or believe you do) and when neither of you has any background -- but both have opinions.  One common example of this is raising capital when all/most of the co-founders are first-time entrepreneurs.  Everyone has opinions on whether or not to raise capital -- and if so, how much and from whom.  Since there are no easy answers to this (even when you have had prior experience), conflicts can occur.  A lof the conflict in this category really comes down to personal goals of the co-founders.  Some want/like control. Some like/want a certain outcome ("We've raised money from a major VC -- woo hoo!") and some just want to build something cool.  When decisions impact the various personal goals of the founders, tensions can arise.  My only advice here is to have conversations about this as early in the process as possible.

4.  The "I Can't Stand Jill, One Of Us Has To Leave!" Conflict:  This is the worst.  If the situation degenerates to the point where two co-founders are so conflicted that one or the other has to leave the company, several bad things can (and likely will) occur.  In some situations, it's not the loss of a co-founder that's the most traumatic for the startup -- but the time leading up to the loss.  If there are other members on the team, their morale is impacted.  If there are other co-founders (besides the two in conflict), they are pushed to "take sides".  Lots and lots of unpleasantness.  Of course, getting to this point is not always a bad thing.  There comes a time in the evolution of a startup that it makes good sense for a co-founder to leave.  Everyone involved discusses the situation, determines what the best path is for the company and parts friends.  It's all rainbows and sunshine. If you find yourself with this situation, congratulations, you're working with some great people.  If not, and you have this conflict, your life is going to suck for a while.  My sympathies are with you.

5.  The "We're Going Down In Burning Flames…" Conflict:  In my experience, most startups have near-fatal experiences regularly.  In my first startup, not a year went by that we didn't he a day where we just thought the company was going to die.  It could be some major product issue.  Could be the potential loss of a significant client.  Could be the draconian activities of an important business partner.  Whatever it was, something really bad was going on and it was easy to come up with all the reasons why the company would just not be able to survive this setback and the "why don't we just cut our losses" type thinking begins.  The conflict arises because not all the co-founders will see the situation in the same way.  Some, because they're natural optimists (like me) and will ignore the evidence.  Others, because they are influenced by having too much, or too little at stake in the game.  Regardless, the conflict arises because one or more co-founders want to just go ahead and call it quits -- and the others do not.  As is usually the case in these situations, there's no clear answer.  Perhaps it is time to call it quits, but nobody really knows for sure In my first startup, we had several of these near-death experiences, but did not decide to call it quits and were reasonably successful.  In another of my startups, we probably should have called it quits sooner, but didn't.  In any case, it's hard to know the right answer and even if you knew, it's sometimes hard to get everyone to agree.

So, what do you think? 

Have you experienced (or are you experiencing) any of the above conflicts now?  How do you deal with them?  When do you bring in outside help?  [Note to self:  Write future article about the difficulty of finding competent, non-conflicted advisors]. 

Have I missed any major types of conflicts?  Leave a comment, and let us know (even if it's just to vent).

Fundraising: No-Shop Agreements

Friedman estimated that it could take four to six months for the current financing log jam to clear up; but then, he said, private equity activity should restart.

Looking ahead, Friedman asserted that the private equity business is by no means over, noting estimates of roughly one-half trillion dollars of capital yet to be called.

But, he said, investors should expect noticeable changes in the industry going forward.

He anticipates the large mega deals that had dominated the market in recent months will become rare and that deal sizes for large firms will average in the $1-10 billion range.

He also expects to see lower prices, lower leverage levels, and ultimately wider spreads. Friedman maintained that, amid all the market uncertainty, the private equity industry remains strong: Owners of private equity firms have had good performance, and continue to have access to a lot of low-cost capital.

At the same time, he cautioned investors to be alert to signs of further deterioration in the broader economy. "There are some obvious industries, such as real estate and autos, where we expect to see weaker results," he said. "So far, the weakness does not seem to have spread. But if we start to see that this credit tightening is having a broader impact, private equity firms will need to examine the companies in their portfolios more closely."

When asked how long it might be before the private equity market resumes its normal pace of activity, Friedman indicated it could take 18 months to two years for banks and investment banks to make the necessary decisions to resolve their backlog of loans.

noted that, interestingly, the problem to be resolved is not really a credit issue, but rather a supply-demand imbalance. As for what might happen to the half-trillion dollars in uncalled capital--that, he said, is too soon to tell.

Few thoughts about selling your company

August 17th, 2007

How To: Make Your Own VC Referrals!

by Alexander Muse

You need a referral to get most VCs to return your call.  If you are trying to raise capital from VCs you will need to talk to them over the phone to a) gauge their interest in your business, b) see if your business philosophies mesh and c) to schedule the ever important face-to-face meeting.  When I was in money raising mode in the late nineties there were over 1,000 venture capital firms across the United States.  I must have talked to more than 100 of them, scheduling meetings with perhaps half of that many.  I could get less than 10% of venture partners to even return my call without a referral.

Today, lots of people call me and ask, "do you know such-and-such at such-and-such venture firm, I need a referral."  In some cases where I know both the entrepreneur and the venture partner I will make a call to grease the wheels.  In other cases I may just say, "you can use my name and explain that I recommended you call."  It all depends on how well I know the entrepreneur or the VC.  Bottom line, in my experience, without a referral you aren't very likely to receive a return call.  With a referral your success rate will be 50/50 based on the quality and type of referral.

For those of you who don't know me and need a referral to a specific VC I recommend a simple way to "Make Your Own VC Referral."

• Step One: Determine which firms you want to talk to.  Based this decision on which firms have previously funded deals in your space.
• Step Two: Figure out which partner at your target firms you want to work with.  Based this decision on which partners managed the deals you used to decide which firm to call. 
• Step Three: Contact the CEOs of the companies the VC partner funded.  Let the CEO know that you are considering working with one of their VCs and suggest that you plan to talk to the partner they work with.  See if he will answer a few questions about his experience with them.  Usually a CEO will return your call very quickly.  Ask him real questions that might help you determine if, in fact, you really want to work with the firm and partner you found on the Internet.  Hint: not every VC is fun to work with.
• Step Four: Contact the VC partner (i.e. leave him a message) and explain that you had a chance to talk to such-and-such CEO of his portfolio company.  Tell him that based on that conversation he sounds like just the sort of investor you are interested in working with.  Ask him if he would be interested in getting together for coffee to discuss your business.  More often than not you will get a return call.

Get it?  By following these simple steps you can create your own referral.  Of course, don't be deceptive, the VC will soon realize that you don't really know his CEO and that is fine.  You are obviously the sort of business person that does his homework.  You are just as concerned about him as he should be in you and your business.

One side note, if you ever see that "submit a plan" button on a VCs website run away. NEVER, EVER submit your business plan blindly to a VC.  You don't want to be 'that guy.'  Always send your plan to a real person, someone you have actually talked to.  It would be like putting a "Submit Termsheet" button on your website.  If you actually got one from someone who obviously knows nothing about you would you take it seriously (assuming you can make payroll next month).  Good Luck!  

Changing tax on VCs

By Jean-Luc

Washington post article on how Carry works

And why the tax on it is unfair.

Interest on the carry is at the 15% cap gains rate, not the 35% for regular income.

So therefore, when the big payday happens and everyone gets money distributed back, right now, the carry is taxed at the 15% for the General Partner, and the Limited Partners.

The outcry is that this is unfair, and that the GPs should be paying 35% on the carry they earn, since it is regular income from services rendered, just like the management fee.

Heck, I’m surprised they’re not going to consider it gambling revenue, but in anycase, the argument is that the revenue to the GP should be at a 35% rate.

And it hits a small enough, population that’s seen to be wealthy enough to afford it, so there’s little political risk, and little chance something won’t be done.

But does this solve the issue?

No.

There are always unintended consequences in every action.

If a special IRS rule comes out saying that the GP interest will be taxed as ordinary income, then an army of lawyers and accountants will find out which structure would be most advantageous, and then move on.But as these general partners move over to different structures, then there will be more unintended consequences and further flack or disruption to current company structures and taxes. 

What can the VC community do to help our energy crisis?

By Ray Rothrock

The trouble with private equity

From The Economist

Private equity has come in for much political criticism, but its more serious problems are financial

FOR the past few years the wild men of private equity have rampaged through the public markets. They have ventured into the drowsy glades of badly managed companies and they have stormed the citadels of multinationals. The wind has been at their backs for so long that it has been hard to imagine how anything could stop them (see article).

This week witnessed the biggest private-equity offer in history, a buy-out of BCE, a Canadian telecoms operator, that would be worth a total of $48.5 billion. Virgin Media, a British cable company, faces a $22 billion bid. The value of takeover deals—plenty of them involving private-equity firms—soared to $2.7 trillion in the first half of the year, almost half as much again as in the last six months of 2006. Optimists will take all that as further evidence of private equity's bright hopes. But it is also possible that the weather is turning and the debt that powers private equity's siege engines is starting—just starting, mind you—to become harder to scrape together. It may not happen this month, perhaps not even this year, but sooner or later the private-equity boom will come to an end. 

This possibility will delight private equity's many critics. Private equity is routinely charged with all sorts of iniquity. It strips companies of assets and flips them for a fast buck. It loads them up with dangerous amounts of debt, to suck out capital for its investors. It pays scant attention to employees and suppliers. Its greedy partners avoid the tax that others have to pay. If the markets turn, the volume of condemnation will only increase. Imagine the derision when funds stop making money even as their partners take home large salaries on the basis of past achievements; when private-equity-owned companies default on debts, leaving insurers and pension funds saddled with the losses; when workers are put on to the street because of desperate cost-cutting or bankruptcies.

Public vices, private virtues

There's some justification for complaints against the tax regime that private equity enjoys. Partners in private-equity firms benefit from a tax break on their earnings. It should be withdrawn. And, because of tax breaks on interest payments (from which all companies, private or public, benefit), the growth of debt finance erodes the tax base. Other charges are mostly groundless. Takeovers, whether by private or public companies, tend to lead to redundancies and cost cuts. In the longer run, private equity makes money from investing in a business, because a thriving company is worth more than an ailing one. Studies in Britain suggest that over time buy-outs add jobs rather than cutting them, and, in America, that buy-outs that rejoin the stockmarket perform better than other new issues.

That would not be surprising, because of the weakness of public markets that private equity has pointed up. Since managers and boards of public companies are spending other people's cash, they sometimes do so wastefully. That is why public-company shareholders put a lot of effort into monitoring managers and boards, who, even then, can be hard to control without resorting to boardroom coups and confrontation.

Sometimes shareholders cause trouble. They often make conflicting demands that managers must struggle to reconcile. Institutional investors tend to insist on instant performance, because their funds are judged on that quarter's returns—which undermines criticism of private equity's short-termism. The threat of shareholder lawsuits and the regulation of the public markets have added to the distracting burden of compliance and to enterprise-sapping bureaucracy. Because private-equity managers answer to a single shareholder, they have clear instructions and can spend more time creating a business with a healthy future.

At the same time as providing a critique of the equity markets, private equity has helped turn illiquid bank-dominated debt markets into highways for delivering cheap credit. It has shown that debt can finance takeovers on an unimagined scale and in industries, including finance and technology, once thought beyond its scope.

A storm is coming

The power of this debt-market transformation looks as if it is about to be tested. Rising long-term interest rates have pushed up the cost of borrowing. Sensing a shift in the economics of the industry, creditors around the world have started questioning the easy money offered to private-equity firms, which feed off risky types of debt. Last week US Foodservice, an American wholesaler being bought by private-equity groups, cancelled a $3.6 billion bond-and-loan deal when lenders balked at the lack of protection they were being offered. In Australia, private-equity firms pulled out at the last minute from the country's biggest takeover, complaining of the high cost of debt. This week the sale of a British retailer fell into confusion, after two private-equity bidders withdrew. The prospect of dwindling returns makes buy-out firms reluctant to club together to buy the big companies they covet; banks, meanwhile, are growing wary of offering their own capital as “bridge” finance. Shares in Blackstone, a private-equity chieftain that listed on the stockmarket last month, have fallen below their offer price—though it is still worth a tidy $32 billion.

That's not to say their bull run is over yet. Following Blackstone's lead, big buy-out firms continue to tap the public markets for fresh capital. There may well be a few more record-breaking takeovers. But if these squalls continue, it is not just private-equity investors who will shiver. Banks have raked in profit from the buy-out industry's appetite for loans and deal-making advice. Stockmarkets have climbed on takeover fever; more than a third of all deals in America so far this year were done by private-equity firms (in 2000, the last such takeover boom, it was a meagre 4%). High share prices make targets more expensive, and private equity is still raising record amounts of money, meaning more competition—and higher prices—for acquisitions, lowering potential returns. Private equity has scaled amazing heights; but its headiest days are probably over.  

Ten Tips On Negotiating The China Deal

Want Sequoia Funding? Submit a Business Plan: Here's How

Raising too much money limits your options

By William Pesek

Portrait of Mao Zedong, former leader of China

It would be fascinating to see what Mao Zedong would make of China's $3 billion investment in Blackstone Group.

Here you have the world's most-watched communist nation investing in perhaps the most capitalist of Wall Street vehicles: a private-equity firm. China is doing so with foreign-exchange reserves, which it uses to ensure employment for its 1.3 billion people.

For Asia's No. 2 economy, "the Blackstone investment represents a supreme business irony," Donald Straszheim, vice chairman of Newport Beach, California-based Roth Capital Partners, told clients in a report yesterday.

China's embrace of the private-equity movement, which the country's regulators have long viewed with suspicion, is about expediency. Officials in Beijing have $1.2 trillion of reserves they want to invest more profitably than in U.S. Treasuries. They lack the expertise to do it themselves and don't want to pay money managers millions in fees.

Enter New York-based Blackstone, an institution with the expertise that Chinese bureaucrats lack: running globally competitive companies. For Blackstone, the deal is a way of improving private equity's image in Beijing.

It's a marriage seemingly made in investment heaven. That is, until you consider it also could be the bonding of the world's most obvious bubbles.

China's Bubbles

China, of course, has at least a couple of bubbles on its hands. One is the equivalent of Spain's annual gross domestic product in reserves. The other is the irrationally exuberant surge in Chinese stocks, which Li Ka-shing, Asia's richest man, says "must be a bubble."

Then there's the private-equity bubble. Banks are helping fund a record pace of mergers this year, with the value of announced leveraged buyouts soaring 40 percent to $188 billion in the first quarter alone. Last week, U.S. Federal Reserve Chairman Ben Bernanke said private-equity financing carries "significant risks" for banks, and the Fed is reviewing the issue.

"It's very important for banks to be quite aware of the risks that are associated with working with private-equity firms," Bernanke said. "We are beginning to look at that."

Bernanke didn't use the word "bubble," yet when it comes to Fedspeak, that's a strong suggestion that the central banker senses one. It's worth noting that New York Fed President Timothy Geithner also said officials are "looking carefully" at the loans that finance leveraged buyouts.

Private-Equity Boom

Geithner will be the guy left picking up the pieces if a private-equity-related meltdown shakes up markets the way the 1998 implosion of hedge fund Long-Term Capital Management did. None of this means the private-equity phenomenon will go bad, though this is a case where regulators are moving too slowly to assess the risks to the global financial system.

The budding relationship between China and private equity dovetails with a report this week from the Organization for Economic Cooperation and Development. It said the boom in buyouts is due to excess liquidity and low yields caused by distortions in the global system -- mainly in China and Japan.

These transactions are facilitated when either borrowing costs or exchange rates are held too low. "Two major prices in the world economy worth noting in this respect are the near-zero interest rates in Japan and the fixed exchange rate for the renminbi," the OECD said.

Distortions

Private-equity firms are forces of change in the global markets and they can create new efficiencies. Yet their activities respond directly to the cost of global credit. At the moment, China's currency policy, together with Japan's ultra-low interest rates, is a key source of the liquidity feeding bubbles.

"We have actually now bubbles everywhere," Marc Faber, who oversees $300 million in assets at Marc Faber Ltd., told Bloomberg News in Zurich on May 21. "We have bubbles in real estate, in equities, in bonds, in commodities, in art prices and totally useless collectibles. So, this bubble is huge and includes just about any asset in the world."

Faber is hardly alone in this view, and perhaps all the liquidity seeping out of China and Japan explains why. If there are bubbles across asset classes, could they really be happening coincidentally? It may be that the side effects of two dynamics thought to be benefiting investors -- Chinese growth and cheap loans from Japan -- are setting the stage for a global swoon.

The linking of China and companies such as Blackstone won't please some U.S. lawmakers. Blackstone aims to raise as much as $7.75 billion selling stock to the public and to China in the biggest share offering by a private-equity firm.

On the one hand, it's a creative way for China to put some reserves in U.S. assets without being accused of manipulating its currency. On the other, it means two issues that lawmakers hope to exploit in next year's elections are becoming more complex.

Mao, who died in 1976, would hardly recognize the China of 2007. Then again, few would have predicted the changes that have taken place in his homeland.

(William Pesek is a Bloomberg News columnist. The opinions expressed are his own.)

VCs and the Naughty Bits

by Randall Lucas

I spotted a piece by Paul Kedrosky today during a blog-feeds-catchup-session where Paul talks about a sort of "(minimum) two degree of separation" rule that VCs maintain between themselves and the sex industry. (Quotes above for my words, not his.) In other words: benefiting from infrastructure, transport, payment mechanisms -- cool. Having fleshy bits linked to from the portfolio companies page -- not cool.

This reminds me of an early experience I had at Voyager. We were looking at a company that was building an online search / social media app. They talked about people using it for various applications -- consumer, enterprise, small business, blah blah blah. We were just about to the end of the pitch, when I asked pretty straightforwardly: "So, what's the sex angle here? Is there an application in dating or porn?"

The room went silent.

I pushed on, oblivious to the mood that had just chilled like a shot of Jaeger down an ice luge. "You know, like VHS, or modems for BBSes, or early adoption of Web marketing tricks like affiliate programs and popups," I articulated despite the intrusion of my foot now rapidly entering my oral cavity. "Is there a strategy for accelerating adoption around that content?"

The founders were visibly uncomfortable. Mercifully, my boss was not pissed, just bemused. "I ... I guess people could use it for other things, too," said one of the founders, finally. Handshakes all around, a quick note on our investment process, and we'll get back to you after next week's partner meeting, ciao for now.

Oops. Back at the office, this is addressed.

"Randall, in the venture business, we have certain things we don't talk about, and certain things we don't invest in, due to a number of reasons."

At the time, I'm thinking: OK, VCs are pillars of the community, have to show up at the Opera, at the charity events, at the B-school reunions, and can't be branded pornographer or such. I filed this away under the "shit not to talk about, Einstein" filter, along with ever admitting to listening to Journey, or denigrating tattoos while speaking to anyone whom you've never seen fully naked.

But now, Paul Kedrosky gives me a flashback and with a key piece of insight. It's a follow the money moment: "... until the venture business is funded by groups other than pension funds, trusts, and endowments (ahem), the likelihood of mainstream VCs ever getting beyond flirtations [[with the sex business]] is vanishingly small." Yep, follow the money. The paymasters here are the Prudent Men, the real stodgy guys, the Trustees and the Chairmen and the Stewards and the Overseers.

And frankly, this is probably a good thing. It's a little like the Senate. You don't want the country entirely run by a bunch of pasty old white dudes, most all millionaires, 60 years old and who won't be fired for 12 years (on average), and who probably still think that Kudzu and the missile gap are our biggest national problems. But you don't want a bunch of whippersnappers on the make driving all your big decisions without recourse to the accumulated wisdom of years past.

The real test will be if one of the trendsetter endowment funds like Harvard or Yale green lights a VC or PE investment that targets the sin sectors. If that ever happens, then the VC business will start to get a lot more (directly) involved in the naughty bits...

Liquidation Preferences: A Response to Leo Dirac

by Randall Lucas

In a recent blog entry, Leo Parker Dirac poses the question of the fairness of liquidation preferences in VC financings of startups. He's going to be delivering a lightning talk based on it tonight at Ignite Seattle.

(To those of you who don't know, liquidation preferences, or prefs, are usually a multiple of invested dollars that a VC gets out first, before anyone else is paid. This is because if you take $10 M from a VC for half your company, then shut down the company one second after depositing the VC's check, he would only have a claim on half of it, thereby snookering him out of $5 M. To avoid this outcome, and due to our general greed, we VCs like to ask for at least a 1.0x preference, meaning that you have no incentive to shut down the company until you've grown it to something more than our investment dollars.)

His conclusion seems to be that liq prefs can be fair if transparently communicated to all parties. Of course, this implies that sometimes, details of prefs are not communicated clearly.

How can this be? I've seen many tens of term sheets, and never once have I seen one that uses invisible ink. Neither have I ever seen a term sheet that has a clause invalidating it if you show it to your lawyer. In short, there is never a case where an entrepreneur isn't reasonably informed about prefs.

Let me construct an example. Say that you're a first-time entrepreneur, and that you don't have anyone on your exec team, nor on your board of directors, nor among your existing investors, who's ever seen a term sheet before. (I was in that spot starting my first company back in 2000, by the way.) And, let's say, you get hold of a term sheet that casually throws out there something like "holders of Series A shall be entitled to an amount per-share equal to two times the per-share price..." and you don't know what it means.

Well, one thing I can absolutely promise you is that no VC is trying to sneak one by you for a shot at 2x his money. A VC investment just takes way too much heartache and worry and effort -- not to mention opportunity-cost of not investing in the billion-dollar blockbuster every VC's looking for -- for a VC to fuck around with taking a chance at cheating you out of a couple million (remember, he has to give all but 20% of that profit to his investors, and split that 20% through some formula of his partnership, so even if he cheats you out of $5 M he's not going to deposit more than a few hundred $k in the bank, and that's at risk of losing his several hundred $k per year sinecure for a GP of a decent-sized fund).

Another thing I can promise you is that no VC ever wants you to sign anything without reading it and having your lawyer read it twice. Think about this one for just a second: I'm about to wire you enough money to buy twenty or thirty Porsches, based on the notion that you're a brilliant businessman who's going to make us both rich. Do I want to give thirty Porsches worth of cold, hard cash to the kind of guy who signs deals without reading the contract??? Seriously: I want you to be the slickest of salesmen, the toughest of negotiators, and the most diligent of dealmakers (not to mention a prodigious engineer, a revered leader, and a master marketer). VCs do not want to give money to sloppy suckers who can't be bothered to read and understand a term sheet -- including seeking savvy legal counsel when appropriate!

Now, having said all this, there are at least two cases where Leo's thinking really does apply to the question of liq prefs. (It shows of Leo that his thinking on the matter of prefs is mostly abstract, that he does not mention either of these two cases.)

The first case is where you are dealing with a fake VC. A real VC is someone who spends full time managing a fund of committed capital from one or more arm's length investors, which capital amounts to at least, say, $10 M per general partner and is entirely meant to be invested in growth companies for the purpose of financial returns primarily via capital appreciation. A fake VC is anyone else who calls himself a VC without pointing out the major differences with the above. And a fake VC has God-knows-what sort of motivation and may well want to swindle you out of a preference multiple.

Your uncle who owns a chain of bagel shops is not a VC. A hedge fund is not a VC. A dude who claims to represent a group of "anonymous Asian industrial families" is not a VC. Anyone who is keeping his day job is not a VC. Real estate guys are not VCs. Note that this doesn't mean they are bad people (unless they pretend to be VCs, in which case they are fake VCs). It just means that the ground rules that you can understand all VCs to play by don't apply.

If you're not dealing with a real VC, read everything three times and have your lawyer read it six.

The second case is in follow-on rounds where the company is in a distressed situation. Everything Leo talks about (and everything I assume in the first part of this post) is about the moment before you take your first VC investment: do I take this capital, with its strings attached, for a shot at building my dream? The alternative there is to simply walk away, and go back to working at Microsoft. But once you're hot and heavy with a company, once you've raised money, promised the moon and the stars to your friends and family, bamboozled the VCs into funding you, alienated all your social contacts and exacerbated your RSI, hired fantastic people and worked them to exhaustion and made them love you enough to drink the Kool-aid, extended commitments based on your word and your honor to customers and suppliers -- only to find that revenues aren't ramping up fast enough and you need cash -- OK, now you are officially up against a wall. And precisely now is when you will be addled from overwork, and adrenalin-high, and blinded with the urgency of your need -- and when the sharks will smell blood.

That is when you will get the predatory term sheet.

If Leo wants to do entrepreneurs (and VCs) a favor, he should take a hard look at what happens then: when you've got a company that still holds promise, but is in a distressed situation and needs capital for its very survival. Exploring those moral complexities is a lot more interesting than the sort of clean-room, game-theoretical chatter about whether one accepts term X on a first round of capital.