Corporate Venturers

Joseph W. Bartlett, Founder of VC

Several commentators (myself included) have pointed out how difficult deal terms are becoming for entrepreneurs in this particular ugly climate for private equity, principally for early stage companies. By and large the discussions have centered on the deal terms presented by the professional venture capital funds, who are styled in the language of the trade as "financial partners." The idea of using that phrase is to distinguish the institutional and individual venture investors from "strategic partners"... the corporations that have established facilities (sometimes affiliated venture funds) for investing in promising startups in recent years. These companies typically have a view to the 'double bottom line,' which means they desire a financial return plus access to technology that may become useful to the principal lines of business of the parent company. Classic strategic partners include the large pharmaceutical companies, which are under sentence of death if they do not continually feed new diagnostics and therapeutics into their inventory of products. This notation deals with one aspect of strategic partner investing, "corporate partnering," which seems to be growing in popularity amongst strategic partners generally, at the expense of the startup firm and the entrepreneur.

To illustrate, assume that Ms. Entrepreneur owns 50 percent of the startup company she founded and angel investors, friends and family own the other 50 percent. The Company is now ready to solicit VC capital for its Series A Round and it has been advised by counsel to get ready for "Savage Deal Terms" from the VCs, including participating preferred, three times liquidation preference off the top, warrant coverage, reverse vesting, full ratchet anti-dilution and other punitive provisions. Coincidentally, Ms. Entrepreneur and the Company are entering into a conversation with BigCo, a multi-national customer that is negotiating a long-term license of the Company's core products. Further assume that BigCo is participating in the Series A Round financing of Ms. Entrepreneur's company.

To the extent a strategic partner puts capital into the Company as an investment, the partner is entitled to the same rights and privileges as any other investor in its class. However, many strategic partners seek to obtain equity for considerations other than capital investment. For example, it is customary these days for customers to insist on equity-flavored instruments (usually warrants) as an accompaniment of their agreement to buy product. The first problem is that this practice has created some significant accounting issues. Thus, Company A may be selling widgets to a major customer and, in the process, issuing warrants to the customer as part of the transaction. The question arises whether the value of the warrants are in fact a rebate to the customer so that Company A should not, in good conscience, take the entire, notional purchase price into revenues. The situation becomes more complicated if the customer is also investing in Company A as if it were a financial partner, with the warrants deemed to be part of the investment contract. Maybe the investment contract itself is a sweetheart transaction, which should reduce the revenues of Company A.

The point of this notation has to do with a different, although allied, issue. Assume it is clear that the warrants (or perhaps cheap stock) have been awarded in connection with something other than a traditional cash investment transaction. The warrant holder is, for example, a customer getting a rebate or a service provider being paid partially in kind for services rendered. Perhaps, to take another typical case, the warrants were awarded in part payment (along with cash) to an investment banker for its services in finding financial partners.

If the accounting is valid, there is nothing illegal or immoral about the use of equity sweeteners. What is of interest in the instant case is that the warrant holders are beginning to act up, at least as measured by traditional standards. Whether an investment bank providing badly needed placement agent services or a customer whose order is central to Company's A future, the warrant holders are insisting that they be treated as if they were investors. This means they are asking that the warrant represent a call on convertible preferred (or participating preferred) versus the traditional common stock, for example. They are asking for registration rights, anti-dilution rights, negative covenants, three times liquidation preference... the whole nine yards, which the VCs are currently extracting.

The issuer's argument, of course, is that the customer and/or investment banker is not a supplier of that most treasured commodity, investment capital, and therefore not entitled to such additional rights. The conventional view has been that the holder of a warrant does not occupy the same position as a shareholder in terms of the board's fiduciary duties. The warrant is in the nature of a contract, not a "security" (for corporate governance purposes at least), and its terms are set forth in the contract itself, without reference to fiduciary duty overlays.

The service provider (or customer) turns around, however, and argues that whatever it is providing is equally as hard to find these days as cash capital. And, therefore, the provider should not be discriminated against.

There is no one right answer to these controversies; it all depends on the parties' relative leverage. I simply note that this is a discussion occurring with increasing frequency and often at a high decibel level.