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08/17/2005
Preferred To Death
The most common cause of inter-investor conflict is poor
investment performance. If a start-up is
failing to execute on its business plan, investors generally get nervous and
one can almost feel an “every man for himself” attitude start to overtake the
group. Some investors might want to
change management, some might want to change strategies, some might want to
“stay the course” and still others might just want to sell and get the hell
out. While investors no doubt often have
principled disagreements over what’s best for the company in such situations,
more often than not, a particular investor’s preferred path is heavily
influenced by their specific financial position relative to the other
investors.
A similar, though somewhat less common, situation can occur
when a start-up is doing very well. In
this situation, investors may disagree about the best path to maximize the
return on their investment. The typical
catalyst for such a conflict is a buy-out offer from another company. Once again, each investor’s preferred path
is highly influenced by their relative financial position. In a reverse of the downside scenario, in
this scenario it is the early investors who are typically pushing hardest for a
sale, while it is the later investors who are most vested in “staying the
course”. This difference is due to the
fact that the early investors often stand to make a much greater investment
return than the latest investors.
Much of the underlying tension in both scenarios comes from either
overt or implied threats by one investor class or another to exercise the VC
equivalent of the Nuclear Option. Each
class of preferred shares has so-called protective provisions. These provisions essentially give each class
of preferred stock veto-power over a set of company decisions. One common protective provision is that a
majority of investors in a particular class of preferred stock, say the Series
A investors, must vote to approve any merger or sale for it to be valid or must
vote to approve any new round of financing. In this way, any class of preferred investors can essentially veto a
sale or new round of funding. In the
case of the new round of funding, vetoing it can effectively kill off the
company if it is in distress, while in the case of selling the company, vetoing
it (or simply not voting for it) can kill the deal outright.
Investors insist on such “blocks”, as they are often called,
to avoid situations in which they invest in a company at a $100M valuation only
to have the other investors, who invested at a $20M valuation, sell for
$80M. This obviously wouldn’t be fair,
so it’s not like blocks are an inherently unreasonable term.
However, in addition to “blocks”, most investors get
preferences, or the right to get their investment (and sometimes multiples of
their investment) back before the other investors. Theoretically preferences encourage investors
to invest at higher valuations than they might otherwise.
The problem isn’t that blocks or preferences or preferred
stock are inherently bad, but that each new issue of preferred stock builds up
a separate layer of blocks, preferences and other terms. After just a few rounds of preferred stock,
companies are often saddled with so many different terms and provisions across
the various issues of preferred stock that getting simple board consents can be
harder than ratifying the SALT II treaty. Major decisions, such as selling
the company or raising a down round or hiring new management, are almost
pre-ordained to set off World War III.
Having been through what seems like World War III, IV, and V
and few times, I have developed a 5 step method to preferred investor harmony:
- Never have more than three classes of preferred stock outstanding. Roughly speaking, the amount of investor tension and the chance of “going nuclear” is a log function of the number of preferred stock series outstanding. Having any more than three series outstanding is just begging for investor Armageddon. If you find yourself on a board debating the merits of Series G stock, you should immediately stop what you are doing and proceed directly to recap the entire company.
- No Class Blocks For Sales: Allowing an individual class of preferred stock to block a sale of the company is simply a recipe for trouble. You are better off giving a class a higher preference than giving them a block. By all means don’t give them both as there’s no real justification for both. If you must give a sale block to a preferred stock, at least make it conditional in that they can’t object to sale above a certain share price.
- Keep It The Same Stupid: To the extent humanly possible, the terms on each class of preferred stock should be the same as the others. That means the same protective provisions, the same conversion terms, group votes on as much as possible, etc. The more everyone is in the same boat the easier it is to make harmonious decisions.
- Drag Along’s Are Your Friend: Drag-along provisions, provisions that require investors to support certain actions whether they like it or not as long as enough of the other investors vote for them, are a company’s best friend as they preclude all sorts of childish and destructive behavior on the part of a rouge investor. They are somewhat draconian, but you will come to love them when you have to line up consents for a new financing or a sale.
- Manage Expectations: When recruiting additional series of preferred stock it’s important to let them know what the expectations and intentions of the existing investors are. If the existing investors have resolved that they will hit the first M&A bid above $50M, by all means tell new investors that. On the flip side, if a late stage investor plans to not even consider selling before they make a 100% return they should let the company know that before they put their money in.
Inter-Investor
Agreements?
While these suggestions are all ways to keep the peace
within an investor syndicate using existing preferred stock purchase documents
such as the Stock Purchase Agreement, the Investor Rights Agreement, and the
Articles of Incorporation, fact is these documents are really written to
address issues between the investors and the company, not issues between investors.
August 17, 2005 in Venture Capital | Permalink
Legal Disclaimer
The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.
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