New Financial Technology
Joseph W. Bartlett, Founder of VC Experts.com
Herewith a periodic update on selected "new" items of financial technology. To be sure, nothing is new under the sun and so sophisticated readers are allowed to interject: "I saw this before in the following guise ..." However, I think these items are new enough to be of interest.
- Tripp Brower from OffRoad Capital revealed at the Private Equity Roundup OffRoad's method (which they deem proprietary, in a manner of speaking) of deal pricing ... a modified auction, viz: On behalf of an issuer, OffRoad places a Series A, Series B, etc., round with a lead investor (a VC firm) and the round is priced. OffRoad then syndicates the remaining open balance of the round to potential syndicate members, in effect auctioning the balance. The lead pays, say, $7.00/share but hoi polloi may pay $8.00/share. This technique has been picked up by lead investors themselves, as a convenient way (and presumably a tax efficient way), to compensate themselves for their extra effort. The advantage? It's simple.
- Another piece of financial technology surfaced at a Master Class I recently led, courtesy of Burt Alimansky's New York Business Forum, a provision designed to accomplish, roughly, the same objective as the Up-The-Ladder Warrants technique, as follows:
The VCs, in a highly dilutive round, set the liquidation preference of the participating preferred at 3x, 4x or 5x, meaning 3 to 5 times money back before the common or prior preferred get anything. (I first saw this device when Carl Kaplan at Fulbright Jaworski was using it in burn out rounds, but with convertible debt ... no double dip). The new wrinkle contemplates an automatic, negotiated ratchet down in the liquidation preference if various milestones are met - an exit event which, for example, meets or exceeds the hurdle set by the investors in the cram down. Thus, if the investors driving the round would hit an IRR  >30% pre-tax, the preference ratchets down from 5x to 1x.
- Herewith some additions to the "savage deal terms" list, courtesy of Sal Vitiello, Kelley, Drye & Warren LLP.
Greater than Pro-Rata Rights To Follow-On: Under this trend, venture capital investors are gaining a right to invest in subsequent rounds above their pro-rata ownership interests (typically 1 1/2 to 2 times their ownership interest). This right has become popular because it ensures that investors will be able to "load up" on successful portfolio companies in subsequent financings.
The Preferred Stock Option Grant: By granting preferred stock options to executives, management receives the same economic benefits available to the venture capital investors ... and, despite the burnout, is motivated alongside the VCs. The founder, the friends and family, and the angels take gas. The idea is to burn out the superfluous common shareholders, and raise the spirits of management.
Increasing Option Pools included in Pre-Money Valuation: Venture capital investors have typically required a portfolio company to increase its option pool prior to determining the company's valuation. However, where increasing the option pool to handle up to a year of option grants was once sufficient, venture capital investors are requiring that the option pool be increased to handle up to five years of option grants, or the estimated time to liquidity. This approach shifts all dilution associated with the option pool to the founders and prior investors, and reduces the per share price of the preferred stock for the new venture capital investors.
Finally, some VCs are arranging for performance-based dilution protection. See the following example of contract language.
"If the Company does not have Revenues (as defined below) for the fiscal year ended December 31, 2002, of at least $19,000,000 (the "Target") the Conversion Price shall be reduced to a Conversion Price equal to the product obtained by multiplying: (i) in the event that Revenues for such period are less than eighty-five percent (85%) and greater than seventy percent (70%) of the Target (A) the quotient obtained by dividing the Conversion Price then in effect by the Initial Conversion Price, by (B) $3.115; and (ii) in the event that Revenues for such period are equal to or less than seventy percent (70%) of the Target, (A) the quotient obtained by dividing the Conversion Price then in effect by the initial Conversion Price, by (B) $2.566. "Revenue" shall mean revenue of the company (as determined in accordance with generally accepted accounting principles), including revenues on the income statement of the Company for the year ending December 31, 2002 and deferred revenues on the balance sheet of the company as of December 31, 2002."
Note the theme throughout much of the above: Tie equity awards, including founders' shares, to performance whenever possible.
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 Note the backlash in certain quarters against "IRR" benchmarks. The skeptics allege that there is too much room for creativity. They prefer a straight cash on cash calculation, the only variable being the time value of money.