The paper concludes that “Non-local investments made by venture capital firms based in the Valley, Boston, and New York outperform their local investments.”

I was on Sand Hill Road a few months ago and the guys at Sequoia explained that my startup was a no brainer to fund, but I would need to relocate to the Bay Area. Maybe I should send them a link to the paper on Scribd. Thanks for the post Ryan.

Fred Wilson has an interesting post suggesting, “IPOs just aren’t what they used to be.” He explains that “First, it is way too expensive to go public. And if you don’t get your offering done, which is not an unusual occurrence, you are left with a huge bill to pay (and no cash to pay it with). And if you get your offering done, your company will likely be valued lower than it would be valued in a late stage private financing.” The best case scenario for most companies looking for an exit is an acquisition.

We got together two weeks later at their offices to meet some of the other partners. Afterward they asked how my conversations with other potential investors/buyers were progressing. I explained that I was letting these other conversations run their course, but I wasn’t in a hurry to do anything. They explained that they would be taking their time as well, but they did want me to let them know if something changed so they could ‘hurry up and engage’. This comment got me thinking, ‘Maybe they aren’t as excited/passionate as I am’.

So many times entrepreneurs (like me) chase investors who aren’t really that passionate about our businesses. I want passion, excitement! I want an investor who is excited enough about my business to fund it regardless of what other investors think. I want an investor who is passionate enough to get a deal done even when no one else is forcing their hand. Am I asking for too much? Perhaps, but the venture capital world is changing – money isn’t necessarily the currency of the realm anymore. More and more startups are VERY capital efficient; however, there has been no such increase in passion-efficiency.

After explaining his plight, the small businessperson asked the capitalist for a loan. The capitalist replied, While I find your concept intriguing, there is too much risk associated with it and I couldn’t possibly lend you the money. If I were to assume this much risk, I would need an equity stake that I could sell in the future.

Well, I would consider selling you some common stock,? responded the aspirant.

“That’s fine for you, but I need some additional consideration, some kind of preference, in the event you hit less than a home run?” observed the moneyman. “After all, I am trying to achieve an appropriate return on my investment, while you are an enterprising young man, an entrepreneur, if I might coin a phrase, trying to change the world.”

“You, sir, are a predatory vulture,” yelped the youngster.

“I prefer to think of it as being venturesome,” countered the investor. “If you want my money, I need to get preferred stock.”

And thus the lexicon of early stage business added entrepreneur, venture capital, and preferred stock to its dictionary.

Overview of preferred stock

The preceding fiction notwithstanding, preferred stock is the coin of the realm of virtually all institutional, and many private, investors. It is materially different than common stock in many important respects. Some of the terms and characteristics of preferred stock have important characteristics.

Liquidation

The conventional definition of liquidation evokes images of going out of business signs and sales at heavy discounts. In the industrial world, one thinks of Chapter 7 bankruptcy. In the world of private equity, the definition is expanded to take in virtually any transaction that is agreed to that is less than the proverbial home run. It is tantamount to the investor throwing in the towel on achieving the originally conceived exit, and seeking to liquidate his investment.

One of the key features of preferred stock is that higher in the pecking order of who gets paid what and when in the event of a liquidation. Payroll and secured creditors, among others, have first rights to the proceeds of liquidation. Preferred stock holders come next, followed by common stock holders.

Liquidation Preference (or Amount)

This is the amount of money the investor in preferred stock has a right to before the common stock shareholders receive any money in liquidation. It is usually phrased in the term sheet something like,  The Preferred Stock Shareholders shall receive all proceeds from the liquidation until they have received 100% of their liquidation preference.

The dollar amount is defined in the term sheet. It often starts with the investment amount plus accrued, but unpaid dividends (often in the range of 6-10%). Then, depending upon financial market conditions and the types of deals that are being done at the time, some sort of adjustment multiple is defined and applied. These multiples can be:

• a single number (1.25  2.00 in todays [circa March 2004] market)
• a time-based increment (1.25, increasing by .25 on each anniversary)
• tied to some threshold event (2.00 until the second anniversary, 3.00 thereafter)
• tied to the dollar amount of the liquidation (some formula if the proceeds are less than some amount, and a different formula above that amount)

Participation

When preferred stock was originally created (see opening paragraph), it was intended to address the differences between the entrepreneur and the financial investor. In essence, if the financial out come was less than had been anticipate, the investor postured that he wanted the opportunity to some minimum return. What resulted was the creation of simple Convertible Preferred Stock.

Simple Convertible Preferred Stock

In its infancy, preferred stock was an either-or proposition for the investor. Calculate the liquidation preference, calculate the value of the common stock if converted, and pick the one that is to the investor’s greater benefit.

The logic is straightforward and the justification appears to be reasonable.

Participating Convertible Preferred Stock

After a period of time, someone came up with the idea of Participating Convertible Preferred Stock. Its key feature was that the investor got the liquidation preference first, AND then participated in the distributions on an as-converted basis. The investors justify this on the basis of locking in as a good a return as possible in a less-than-desirable outcome. Entrepreneurs often take umbrage at this and consider it to be double dipping.

This is a prime example of the Golden Rule: He who has the gold rules. Without negotiating leverage, if the investor seeks participating preferred, then that’s likely to be part of their investment style, and it’s unlikely that they will be willing to negotiate this feature.

Anti-dilution protection

If the company sells shares at some future date at a share price less than what the investor paid, the investor wants anti-dilution protection.

Full-ratchet anti-dilution protection

The harshest form of protection from the entrepreneur’s perspective is full-ratchet. It says that the investor gets rights to that number of shares as if he had paid the lower price. If he paid $2.00 per share, and subsequent shares were sold for $1.00, his number of shares would double to compensate for this transaction.

Weighted-average anti-dilution protection

Weighted-average is less painful. It takes the share base of the company into consideration, they reducing the overall impact. For those of you who are interested, I borrowed the following language from the documents one of the deals with which I was involved.

Adjustment of Conversion Price Upon Issuance of Additional Shares of Common Stock. In the event that at any time or from time to time after the Original Issue Date for any series of Preferred Stock the Corporation shall issue Additional Shares of Common Stock (including, without limitation, Additional Shares of Common Stock deemed to be issued pursuant to Subsection 2(e)(iii)(1) but excluding Additional Shares of Common Stock deemed to be issued pursuant to Subsection 2(e)(iii)(2), which event is dealt with in Subsection 2(e)(vi)(1)), without consideration or for a consideration per share less than the Conversion Price of such series of Preferred Stock in effect on the date of and immediately prior to such issue, then and in such event, such Conversion Price of such series of Preferred Stock shall be reduced, concurrently with such issue, to a price (calculated to the nearest one tenth of one cent) determined in accordance with the following formula:

(P1) (Q1) + (P2) (Q2)

NCP = —‑‑‑‑‑‑‑‑‑‑‑‑‑———‑-

Q1 + Q2

where:

NCP = New Series A Conversion Price or Series B Conversion Price, as applicable

P1 = Series A Conversion Price or Series B Conversion Price, as applicable, in effect immediately prior to new issue;

Q1 = Number of shares of Common Stock outstanding, or deemed to be outstanding as set forth below, immediately prior to such issue;

P2 = Weighted average price per share received by the Corporation upon such issue;

Q2 = Number of shares of Common Stock issued, or deemed to have been issued, in the subject transaction;

provided that for the purpose of this Subsection 2(e)(iv), all shares of Common Stock issuable upon conversion of shares of Preferred Stock outstanding immediately prior to such issue shall be deemed to be outstanding, and immediately after any Additional Shares of Common Stock are deemed issued pursuant to Subsection 2(e)(iii), such Additional Shares of Common Stock shall be deemed to be outstanding.�

Got that?

Control

I often hear entrepreneurs say, I won’t give up control, or I’m willing to consider any deal as long as I retain 51%. For a plain, vanilla company, that makes sense and is meaningful. But a company that brings in sophisticated private equity is no longer simple, at least in a legal sense. To a large degree, control and percentage of ownership become separate issues. Let me cite two examples.

Protective provisions

One of the features of preferred stock will be a series of provisions that require that the preferred stock needs to approve before the company can do certain things. Let me rephrase that, regardless of how much equity the preferred stock shareholders own, they have veto power over certain company actions, typically including, but not limited to, liquidation, alteration of the preferred stock, issuance of any class of preferred stock superior to the existing preferred stock and restrictions on debt that the company can take on.

Board of Directors

Similarly, as part of the Preferred Stock transaction there will be agreement to the structure of the board and a Shareholders Agreement will be crafted whereby all shareholders have to vote for members of the board in the proscribed manner, regardless of relative equity positions.

Once a company goes down this path, the issue of control becomes complicated and not intuitively obvious, particularly to first-time entrepreneurs.

Advice to Entrepreneurs

• If you’re going to play the game, you need to understand the rules.
• Deals are complex. Ignorance is not a defense against unpleasant outcomes.
• Do everything that you can to prevent the investor from invoking the Golden Rule.
• Surround yourself with professionals, mentors, and advisor’s who can help you level the playing field.

By Frank Demmler adjunct professor of entrepreneurship at Carnegie Mellon