August 18, 2010 by dan.

Having served on more than my share of boards, and often on the comp committee, I am often asked about the following situation:

• A company has taken quite a bit of investment, usually from institutions and angels.
• The deal that was struck has a liquidation preference (if you don’t know what this means, you should educate yourself). Good terms for companies meeting their goals are 1x participating preferred (sometimes capped); bad terms are 2x to 3x and usually granted when a company is in trouble and needs to raise money.
• Acquisition seems like the best alternative, but the offers are for less than the liquidation preference (or not much more than the preference).

In this case, the common stock and options are essentially worthless. The founders, employees, and others who bet on the upside find themselves in the position of having worked for little-to-no upside (or in the case of board members or consultants who took options – nothing!).

What is the board to do?

Here is my perspective:

• Recognize that management did not deliver the value that was promised when the money was taken. It is not fair to give management a great return, while investors lose money.
• On the other hand, it was management’s sweat that got the company to exit. This needs to be rewarded.
• The board should try, as a first priority, to ensure that management gets a good deal from the acquiring company. This is good for the acquirer and allows the proceeds to go to investors.
• If a carve out is necessary, I believe that it should be graduated (like a graduated income tax). In that way, as the investors do better, management increasingly does better. This aligns incentives. For example, if the liquidation preference is $10M and the acquisition will be in the range of $5-15M, the carve out might look like this:
  • 5% of proceeds for the first $5M (which is $250k at $5M)
  • Between 5-10M, $250k plus 7.5% of the amount over $5M, which is $375k at 10M
  • $875k plus 10% (plus the value of their stock, which is now in the money) for any amount over $10M
• This seems to give both aligned incentives and balance the reward for management with the need to get investors their money back.

Of course, all of this looks much better when the company sells for a lot more than was invested!

Posted in Company behavior, Startups, Boards, Investment Terms, Angel Investing | No Comments »

August 18, 2010 by dan.

Over the last several weeks, I have had a series of experiences where boards have not represented the interests of shareholders. Why? Kindly, you would say inexperience or lack of knowledge. Less kindly – incompetence. Or even less kindly – greed.

In one case, the board, without any form of communication about the company’s status or consultation to the vast majority of shareholders, in short order (1) forced a “pay-to-play round” led by two institutional investors; (b) granted the CEO and other senior managers a HUGE carve out (despite several years of missed targets and poor performance); and (c) negotiated a quick sale of the company where the winners were the management (who got the carve out and a bonus from the acquiring company) and the institutions that forced the pay to play. This was done by a board that was incredibly conflicted, but counted on the fact that the angel investors in the deal (there were about 30 of us) wouldn’t take any action. Payout to the angel shareowners - $0. That’s right – nothing. This is egregious, but not uncommon.

Angels need to be willing to take better actions to protect their investments.

1. We must be willing to band together. I am working with several attorneys and the Alliance of Angels to create an LLC that can be used to aggregate our investments in a company. In this way, we will in aggregate be a “major shareholder” in the startup and get rights and privileges commensurate with a VC. This will add a small expense to our investing and require some overhead, but it should be worthwhile. And the company should love this, since this will be one shareholder instead of many.
2. We need to insist on a board seat and assign one of our members with sufficient experience to take that seat.
3. We must insist that our CEOs communicate, communicate, communicate. I get frustrated with a CEO that has bad news and decides not to share it until there is good news. Often the only communication is one from the law firm representing the startup and usually that is really bad news. Funny how the CEO was quite communicative while raising money from us. Boards need to step up and make sure that their CEOs treat their investors with the respect that they have earned by investing in the company.
4. Boards must represent shareholders in holding management accountable. I’m not saying be obnoxious. But, if you hired a contractor to fix your house and they didn’t do the work they contracted for, you wouldn’t pay them the full amount. Why do boards feel it is OK for a team to miss on their execution and then reward them? Boards need to step up.
5. Carve outs need to be measured. I understand that an acquisition can only occur with a willing management team (and a willing board). If there is a large liquidation preference overhang, (as there often is) management’s stock might all be under water. There is a need to take action to make sure that rewards are balanced. Boards need to be proactive in this. I will be posting a separate blog on my assessment of best practices on this.

So.. investors need to insist that board really do represent them and not allow them to take the easy way out, create conflicts of interest, or have investors take it on the chin. Boards – step up!

Posted in Startups, Company behavior, Rip-offs, Boards, Investment Terms, Alliance of Angels, Angel Investing | No Comments »

March 16, 2010 by dan.

In a previous posting/rant, I talked about Angel Groups that gouge entrepreneurs (http://blog.drosenassoc.com/?p=13). Some charge over $10,000 for the right to present and that steams me. However, I have not directed my wrath at another group that gouges entrepreneurs even more – brokers and small investment bankers. Note to entrepreneurs: Do Not Use a Broker (or small investment bank)!

Such firms typically charge an entrepreneur between 5-10% of the amount raised, in addition to expenses, legal fees, and a retainer. No angel I know wants to see the money they invest in a startup flow out the back door in this way. You do not need to pay to find angels and get them to invest in your company. If you have a good idea and a good business, approach us directly. The staff at the Alliance of Angels gives you far better feedback, based on angels who actually invest, than you will get from a broker. And it’s free!

The Northwest Entrepreneur Network (NWEN) and Washington Technology Industry Alliance (WTIA) offer seminars, networking events, and classes on how to raise money. They are low cost and valuable.

But.. no angel I know likes deals where there are brokers involved. We like to meet with and get to know the entrepreneur, help them get their company going, and build to a success. None of want or need someone in the middle.

Posted in Rip-offs, Alliance of Angels, Investment Terms, Angel Investing, Investments | 1 Comment »

March 25, 2008 by dan.

Convertible Note vs. Priced Preferred Round

The form of an investment is an on-going issue for Angel Investors and Startup entrepreneurs.  This post describes the differences between a convertible note and a priced round, the benefits of each, and recommendations for investors, service providers, and entrepreneurs.

A priced round is easy to understand.  Each investor in that round is told the price per share, and is issued shares (generally preferred) at that price.  Legal fees for a priced round are usually in the range of $25,000 to $50,000.  So for a small round, the legal fees can be a significant portion of the round.  Also, many entrepreneurs and investors cannot agree on the valuation of the company to set the price.  I believe that this is the wrong reason to avoid a priced round, because it is indicative of a deeper problem and fundamental disagreement between the investor and the company.  Would you buy a car, where you didn’t know the price till you had driven it a year?

Many lawyers recommend that startups offer investors a convertible note, a form of loan that converts to equity when the next round is closed, usually with some form of discount.  It is both quicker and incurs lower legal fees than a priced round.  In general, these notes are used to “bridge” a company between two funding events, e.g. between a friend/family round and an institutional round.  There are several key parameters in these notes.  They are outlined below (with what I consider average values in Seattle today):

1)      What is the term of the note?  This can range from 3 months to 18 months.  In general, most of the deals I see have a term between 6-12 months, where 6 is more investor friendly and 12 is more entrepreneur friendly.

2)      What is the discount?  This discount can take two forms.  One is a plain discount, where the investor gets a price per share that is less than the next investors.  The second, is the issue of warrants, where the investor gets warrants issued as a discount (e.g. 1 warrant for every 4 shares = 25% discount).  This is to some degree related to the term – the longer the term, the higher the discount.  It is rather common for the discount to increase with the term (e.g. 20% for the first 6 months, then increasing by 5% per month for the next three months).  Currently, the discount is about 20-30%.

3)      What is the interest on the note?  In general this is either prime plus some percent or a fixed percent.  Lately, I have seen 8% annual.

4)      Is there an assumed value?  This takes two flavors in the docs.  First is what happens if the company doesn’t raise its round before the term of the note.  For example, if the company issued a 6 month note, but didn’t raise its round, at what price does the note convert?  Usually, investors will insist on a price that is prevailing for the company at the time the note was issued.  This is often the last round pricing.  For Seattle startups, without a final product or customers, that is typically in the $1.5M to 2.5M range, but there is great variability depending on lots of factors.  The second flavor of the value is what will happen if the company is acquired before raising the round.  For example, if the company takes in a convertible note for $1M, but then sells for $100M before the conversion?  Unless otherwise specified, the investor only gets their principal plus interest (in this case $1M plus 8%), while entrepreneur gets the other $99M.  As an investor, I like to be aligned with the entrepreneur, so would set an assumed value in this case, so that the investor has their choice of either the principal plus interest OR conversion at a fixed value (say $5M) in this case.

5)      Does the investor get any say in the terms of the round? When the company raises their round, it might be at terms that the investor would never have agreed to, but rarely has the right to do anything about it.

So, in conclusion, investors like priced rounds, and usually fight for them.  Entrepreneurs often benefit from convertible notes.  If the note is short term and has reasonable terms, it’s not a bad idea.  However, there has been a trend for longer notes (more than 6 months), at a time when the next financing round is not pending.  In essence, this is the company asking the investor to put up their money to build value in the company so that they will then pay a much higher price per share.  As an investor, not something I’m inclined to do.

Posted in Investment Terms, Angel Investing, Investments | No Comments »