Terms of Endearment (Not!)
Jamie Earle
Issue date: 10/15/01 Section: Technology
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“When they’re a-comin’, I’m a runnin’.”
Why not take this old adage to heart and become a market contrarian by making a go of your high-technology startup idea?
True, money isn’t flowing like it once was, but VCs are still funding good ideas. In the second quarter of this year, VCs parted with $8.2 billion and invested in 669 companies, according to Venture One. So, with deals still getting done, isn’t now the perfect time to get ahead of would-be entrepreneurs who might be contemplating the same product?
Maybe not. Assuming you could find funding, here’s why you wouldn’t go the entrepreneurial route: Terms. What you have to give up in order to get those precious dollars to build your idea from scratch into a successful company. VCs today are demanding terms that have been described as downright egregious. That’s because, with every failed deal, they are becoming increasingly risk averse and willing to stop at nothing (even at dis-incentivizing management) to protect their investments.
Organizational Behavior Professor and Negotiations Extraordinaire, Dr. Margaret Neale, says the number one rule of negotiations is to “get a good deal.” Many of the terms venture capitalists are putting forth in exchange for their investment just aren’t what constitute a “good deal.”
In some cases, it’s the equity you have to give up. Venture One reports that venture investment valuations are at a low not seen since the first quarter of 1999. This affects one or both of two areas: cash raised and equity sold. While cash raised has declined of late, equity sold has risen. So, companies are giving up more for less. Later stage deals are the hardest hit, with some experts estimating that more than 80% of financings today are “down rounds” (rounds in which the valuation is less than that of the previous round).
In other cases, VCs are demanding terms such as liquidation preferences (the right to a stated rate of return in the event of company liquidation or sale, before common shareholders get paid on their options) – often to the tune of 3-4x return, participation rights (the right to share in the leftover proceeds, over and above their liquidation preference payout), drag-along rights (in which all shareholders must approve any acquisition the new shareholders choose), and the like.
A June San Francisco Chronicle article entitled “Venture Capitalists Fight Tough Times with Strict Terms” describes a term sheet eleven pages long with some of the most egregious terms ever proposed by a VC. Called the “Frankenstein of term sheets,” this proposal has become legendary in the Valley and has made the rounds as quickly as any steamy sex email.
So it isn’t enough that entrepreneurs aren’t able to find funding or that they have to give up more equity to obtain that funding. They also are subjected to such absurd terms these days that the deal ends up making no sense. It seems the sour market has caused the pendulum to swing so far against the entrepreneur that almost any deal she could strike with a VC would not be in her best interests.
You might think twice before going the entrepreneurial route. You may find yourself in what Professor Neale aptly calls “a bad deal.”
Why not take this old adage to heart and become a market contrarian by making a go of your high-technology startup idea?
True, money isn’t flowing like it once was, but VCs are still funding good ideas. In the second quarter of this year, VCs parted with $8.2 billion and invested in 669 companies, according to Venture One. So, with deals still getting done, isn’t now the perfect time to get ahead of would-be entrepreneurs who might be contemplating the same product?
Maybe not. Assuming you could find funding, here’s why you wouldn’t go the entrepreneurial route: Terms. What you have to give up in order to get those precious dollars to build your idea from scratch into a successful company. VCs today are demanding terms that have been described as downright egregious. That’s because, with every failed deal, they are becoming increasingly risk averse and willing to stop at nothing (even at dis-incentivizing management) to protect their investments.
Organizational Behavior Professor and Negotiations Extraordinaire, Dr. Margaret Neale, says the number one rule of negotiations is to “get a good deal.” Many of the terms venture capitalists are putting forth in exchange for their investment just aren’t what constitute a “good deal.”
In some cases, it’s the equity you have to give up. Venture One reports that venture investment valuations are at a low not seen since the first quarter of 1999. This affects one or both of two areas: cash raised and equity sold. While cash raised has declined of late, equity sold has risen. So, companies are giving up more for less. Later stage deals are the hardest hit, with some experts estimating that more than 80% of financings today are “down rounds” (rounds in which the valuation is less than that of the previous round).
In other cases, VCs are demanding terms such as liquidation preferences (the right to a stated rate of return in the event of company liquidation or sale, before common shareholders get paid on their options) – often to the tune of 3-4x return, participation rights (the right to share in the leftover proceeds, over and above their liquidation preference payout), drag-along rights (in which all shareholders must approve any acquisition the new shareholders choose), and the like.
A June San Francisco Chronicle article entitled “Venture Capitalists Fight Tough Times with Strict Terms” describes a term sheet eleven pages long with some of the most egregious terms ever proposed by a VC. Called the “Frankenstein of term sheets,” this proposal has become legendary in the Valley and has made the rounds as quickly as any steamy sex email.
So it isn’t enough that entrepreneurs aren’t able to find funding or that they have to give up more equity to obtain that funding. They also are subjected to such absurd terms these days that the deal ends up making no sense. It seems the sour market has caused the pendulum to swing so far against the entrepreneur that almost any deal she could strike with a VC would not be in her best interests.
You might think twice before going the entrepreneurial route. You may find yourself in what Professor Neale aptly calls “a bad deal.”