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Another Way VCs Outnegotiate Entrepreneurs

Jeff Bussgang from Flybridge has today’s great VC post titled In VC deals, Price Doesn’t Matter – But The "Promote" DoesWhile I personally dislike the phrase “promote” to describe the concept Jeff is describing (I think “founders post-deal ownership value” – or FPDOV – is a much better phrase, although I realize “promote” is catchier.)

If you are an entrepreneur negotiating a VC financing, you should read this post carefully.  Jeff does an excellent job explaining one of the key ways that VCs outnegotiate entrepreneurs while making the entrepreneur feel good about the outcome.

July 18th, 2009 by     Categories: Term Sheets    
  • http://bothsidesofthetable.com Mark Suster

    It's true that some VCs use outsized stock options as a way of getting to a lower “true” pre-money valuation and I remember seeing the math outlined on Venture Hacks ( ” target=”_blank”>http://www.venturehacks.com) so worth your readers going there and searching for that. Entrepreneurs should also know that sometimes VCs will legitimately be asking for stock option pools based on the norms of stage and the amount of hires remaining.

    More importantly entrepreneurs need to learn how various “liquidation preference” schemes affect valuation as well. These are much more weighted toward lower-valuation exits (e.g. the majority of cases). This can be particularly punishing when they involved 2-3x liquidation preference and even more so if they are “participating.” I have seen VCs use these instruments to deliver a higher “nominal” pre-money valuation while delivering a significantly lower “real” pre-money valuation. My guess is that this topic is probably covered also on Venture Hacks and probably in your archives at ” target=”_blank”>http://www.feld.com

    • http://www.feld.com Brad Feld

      Yup

  • http://www.dynamicsynergy.com Mark Landay

    Agreed. This is key for entrepreneures, get good council. Your lawyer can help explain this and it is significant.

  • http://www.chicagolawblogger.com Clint Costa

    I always sit down with clients, break out the calculator and go through the numbers. It's really the only way for them to understand what's going on.

  • Dave

    Either lawyers should prepare, or clients should prepare and ask their lawyers to review, a liquidation preference model showing allocation of proceeds at various a sale prices. Clients that really want to understand should build (or pay to have built) a spreadsheet showing similar liquidation preference/sale alternatives if you carried similar terms through to multiple rounds of financing. I was always amazed at how few people wanted to actually pay attention and assumed they understood what would happen. The results are often not intuitive as you fold various nuance terms together. Sometimes even the VC's don't understand the impact of the terms (really, I've represented VC's who had no clue of the impact of some terms they insisted on).

    If your VC financing lawyers cannot do Excel, then you need new lawyers.

    • http://bothsidesofthetable.com Mark Suster

      Dave, unfortunately it is often the case that lawyers aren't great at doing the waterfall spreadsheets necessary to understand liquidation preferences and I'm always surprised that even the brightest of entreprenerus I meet don't really properly understand the waterfalls (including the effect of dividends over time). Entrepreneurs really need to bone up on this math – can't emphasize it enough.

      • http://www.feld.com Brad Feld

        I completely agree.

        • Dave

          Brad and Mark–I agree it is the entrepreneurs' responsibility. My point was that if your lawyers are not putting the spreadsheet together, or vetting the entrepreneur's spreadsheet (because there are a lot of things people get wrong the first time through), an entrepreneur hired the wrong lawyers. I have no idea what value the hourly rates bring, if not to help understand the economic impacts.

          From a legal perspective, VC financings are cookie cutter and easy. The average VC lawyer, particularly one who survived the last nuclear winter, should have seen enough financings and strange permutations to do the documents in their sleep. I'm pretty sure I could actually write many of the documents from memory, and I can tell whose forms (WSGR, Gundo, etc.) someone originally started from without knowing who is counsel, which is pathetic but true…

          If the lawyers are not helping their clients understand the math, the lawyers are failing in their jobs. Hiring good counsel is one key way the entrepreneur equalizes the experience difference with VC's. We all know there are no bankers in VC financings, so someone experienced should help with the math problem. Even with good lawyers, I have always been shocked at how few entrepreneurs really listen…

          • http://www.chicagolawblogger.com Clint Costa

            Speaking as a lawyer, I couldn't agree more, Dave. The documents are easy and basically boiler-plate. Understanding what all the legalese actually means in terms of numbers is what the lawyers (or possibly trusted accountant/management consultant) should be doing. This is the ultimate value-add.

  • Devaun

    You can also get good startup reviews or VC news from specialty sites. Take this for an example: http://www.vcgate.com/Startup_Companies_Reviews.h