Sea Change

Joseph W. Bartlett, Founder of VC

It's ugly out there. The collapse of high-tech stocks in the public markets has had a ripple effect on private equity. Some professional investors have simply shut down the window on new investments and are focusing entirely on attempting to salvage their walking wounded and/or liquidate hopeless investments. The amount of liquidity in the sector remains enormous by historical standards, and deals are getting done. The money is there but it is very nervous money in the opinion of this observer, and no one wants to be written up in the trade press as the bozo who invested in [ disaster]. There are private asset managers, who have never seen a rainy day, traumatized by the catastrophes in their portfolios. Now, nobody is about to take up collections for the impoverished VCs.

We were speaking recently to the manager of a private banking unit of a major investment bank targeting super rich individuals in the valley, and particularly partners in venture capital funds. We inquired what the minimum net worth of his targets was and he responded $200 million . with plenty of people to call on. So the money is there, for the appropriate opportunity; but there has been a sea change in two significant respects:

As one might imagine, pre money valuations have been slashed. The unscientific estimate from this corner is that valuations for private equity in the Series A round has dropped by as much as two-thirds, measured by what the numbers were in January or February of 2000. My guesstimate is based on anecdotal evidence; hard data of this nature will be available shortly from the VC Experts Round Table . But the drop off is certainly in the 50 to 66.6 percent range.

The second, and related, phenomenon has to do with changes in deal terms. Those of us (like the undersigned) who represent issuers (as well as the VCs) are compelled to push back hard against extremely aggressive term sheets, with some new and some not-so-new wrinkles, all of which are designed to enhance returns and the quantum of control enjoyed by nervous investors.

Thus, for example, participating preferred (versus convertible preferred) is, nowadays, more the rule than the exception. Briefly stated, a convertible preferred entails an election by the investor upon a liquidity event, particularly a sale of the company for cash or stock. The investor can either hold on to the preferred and get its money back plus accrued dividends or, if the price is sufficiently attractive, convert into common and take the agreed-on percentage of the upside pari passu with the common shareholders. Participating preferred eliminates the necessity of an election; the senior investors get their money back first and then participate as if they had converted. If participating preferred is too strong (and it hugely impacts the founders' and angels' rate of return unless the sales price is a home run), there is a form of security we label a super-charged convertible preferred. This still requires an election, either money back or convert into common; but the `money back' election is, say, at two or three times the amount invested, plus accrued dividends, versus conversion.

The next feature has to do with a truth which this columnist repeats to himself in every negotiation: If the three rules of successful investing in real estate are "location, location, location," the three concerns for the common stockholders in a venture financing are "dilution, dilution and dilution." The new reality has to do with calculating the conversion price of the convertible preferred. The conversion price is a way of figuring how many common shares are received when the preferred converts. Usually it is one-to-one relationship; the preferred shareholder pays $100 per share and the conversion price is a $100, meaning that, on conversion, each preferred share obtains one common share . cost divided by conversion price. There are mechanical adjustments to this ratio, as in the case of stock dividends and splits, which are non-controversial. There are potentially ugly adjustments if a subsequent round of financing amounts to a so-called "down round," a lower price than the, say, the Series A investors paid when they bought their preferred .

One such adjustment is called "weighted average" and it takes into account (i) the drop in price between the Series A and the current down round and (ii) the number of shares sold . measuring the overall effect of the dilutive round.

The second is "full ratchet" which focuses only on the drop in price and drags down the conversion price (which results in an increase in the number of shares received by the VCs despite the fact they do not put up any more money). The full impact of full ratchet is felt when only a small number of shares are sold in the so-called down round. Despite the relatively mild dilutive impact of the down round, the conversion price is reduced without regard to that fact, and the maximum amount of new shares, free shares so to speak, are allocated to the preferred shareholders.

Another relatively new wrinkle has to do with the impact of accrued but unpaid dividends. When convertible preferred was first introduced by the financial engineers many years ago as an appropriate security for the VCs, the conventional wisdom was that accrued but unpaid dividends (and dividends are rarely paid on a current basis in the venture capital context) entered into the calculation only if the holder of the preferred elected to stand pat in the face of an exit event . i.e., to receive back the initial cost of the security, rather than converting and participating as a common shareholder.

Given the fact that the holder elects not to convert, the proceeds will obviously be disappointing (otherwise the VCs would convert) and it is deemed only right and proper that a cost of money element be added to the disappointing result. However, under the old rules, if the founder did convert, accrued but unpaid dividends were ignored. Conversion implied a happy result and the idea was that the VCs were being adequately compensated by what necessarily was an attractive upside for the common shareholders, including the converted preferred.

Under the new rules, accrued but unpaid dividends do enter into the calculation upon conversion. This means, in effect, that the preferred shareholders, assuming a result that calls for conversion, are diluting the other shareholders by an amount roughly equal to the dividend rate per year times the percentage that preferred owns in the company. Thus, if on a fully converted basis, preferred shareholders would have received common stock equivalent to 20% of all the common stock without taking into account accrued dividends and the dividend is 10% of the initial cost, and the preferred shareholders will receive an annual increase in their holdings of 10% x 20%, or 2% a year, meaning that the other shareholders are diluted 2% a year despite no declaration of a dividend.

An additional dilutive structure has to do with `warrant coverage.' If the convertible preferred converts into 20% of the Company (let us say 200,000 shares out of 1 million shares to be outstanding after conversion), the convertible preferred may also insist on a warrant for anywhere between, say (i) 50,000 shares (that being 25% warrant coverage, 50 being one quarter of 200) and, say (ii) 200,000, which would be 100% warrant coverage. The exercise price of the warrant is usually the same as the price per share being paid for common stock (looking through the preferred to the conversion stock received on conversion in order to arrive at that price). Therefore, it may appear that the preferred is simply buying more stock in the round at the same pre-money valuation. However, since the security is a warrant and not payment at the closing, the VCs enjoy a call on an additional portion of the upside, without having to put up any money initially. Indeed, they do not have to put up any money at all, if `cashless exercise' is entailed, which it usually is. That means that, upon exercise, the VCs receive shares, or the cash equivalent of shares, which represent the spread between the fair market value of the warrant shares as of the time of warrant exercise and the exercise price. To use a simple example: if the VCs own a warrant on 100 shares of stock exercisable at $10 per share . i.e., a total exercise price of a $1,000 . and the warrant shares on the date of exercise are worth $100 a share, then the spread, or the amount the warrant is `in the money,' is $90 times 100 shares or $9,000. On cashless exercise, the VCs could be paid that amount in cash in order to retire the warrant or be issued that number of shares (valued at $100 per share, which equals in value the spread . or 900 shares. Obviously, warrant coverage has an additional dilutive effect on the common shareholders.