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3.0 Hey, Bijan, forcing a Sale is Easy...
TheFunded.com Open Letter
Posted by Mr. Smith on 2009-07-27
Rumors are circulating that Zappos was forced to sell by venture capitalists. Nervous entrepreneurs asked their VCs about this. So, Bijan Sabet of Spark Capital wrote a piece about how VCs can't 'force a sale' from a purely technical point of view: http://bit.ly/jZGfr. This brought on a flurry of support from other VCs, such a Bill Gurley of Benchmark: http://bit.ly/35XDO.
From a purely technical standpoint, venture capitalists can't easily 'fire founders' either, yet two thirds of founding teams are eliminated. In fact, most investment agreements have more provisions to force a sale than they do to eliminate a founder.
Just so that the venture whitewashing does not win here, let's look at the MANY ways that a VC can force a sale. These don't necessarily apply to Zappos, but they apply to most other startups. Please feel free to add more in the feedback...
1. Redemption Rights: After a certain period of time, ranging from three to ten years, most venture capital investments have a redemption right to sell their preferred stock at either cost plus or fair market value, depending. In the practical world of business, calling a redemption right requiring a company to come up with millions of dollars in short order forces a sale, since there isn't a real market for illiquid private equity with complex protective provisions (yet).
2. Fundraising: Most venture funded companies need multiple rounds of funding to succeed, and, if an original investor does not support the company in subsequent rounds, it's nearly impossible to find new investors. So, existing investors can just threaten to walk away from future funding, and the management is placed in a position where they are forced to sell.
3. Debt: Many companies take convertible debt before raising venture rounds and between raising venture rounds. There are very few standards for convertible debt agreements, which range from a few pages to multiple complex agreements. The threat of calling convertible debt for cash, which is not universally supported in all agreements, will force most startups to sell.
4. Board Control: Most venture investments have elaborate Board control provisions, and the independent Board members often find themselves loyal to the investors by hook or by crook. Boards can (and do) request that management hire advisors and explore 'strategic alternatives,' which is not uncommon while raising a venture round to justify valuations. These strategic odysseys can quickly become a sale process, tricking management into a sale.
5. Share Control: Venture capitalists that have participated in a few different rounds may hold a majority of preferred shares or a majority of common shares on a converted basis, providing them with direct control over the company, making it easy to force a sale.
The above five are the easy ways that investors can force a sale. Of course, not everything is always easy, so here are some of the more devious methods used...
6. Blocking Rights: Nearly every debt and preferred investment agreement contain a set of extensive protective provisions that require investor approval for everything from hiring to licensing, from purchasing to borrowing. Most of these are badly drafted without 'in the course of ordinary business' carveouts, allowing investors the right to block many day-to-day management activities to run the business, forcing the management to sell.
7. Harassment: Nearly every preferred investment agreement has extensive information rights, including monthly board meetings, board committee meetings, monthly financial statements, annual budgets, annual audits, and more. Investors can harass startups with a landslide of information requests mandated by investment agreements, burying management in a frenzy of busywork. In such situations, investors can agree to reduce the burden in order to force a sale.
8. Disruption: While this is not the last way, investors can disrupt third party partnerships and internal staff dynamics, forcing a company to sell.
I am a little taken aback by how these seasoned venture capitalists can continue to plead 'not guilty' on everything. It seems that the sun is always shining over the VC industry when a VC has anything to say about it. Next thing you know, they'll be writing articles about how they don't fire founders, but founders fire themselves... Yeah, right.
Mr. Smith - I wish all posts were as lucid, thorough and objective as your post. Thank you for taking the time and effort to write this post
If you have not done so, you should expand upon these points in a blog format, or the like, if you care to share more of this information with those who really need to hear it.
Item #2 rings very true to my experiences. First, or early in investors have a lot of power over the direction of the company by how they represent themselves and their level of interest in having additional investors "welcomed" into the company, or treated has trespassers.
I just closed a company last month because of this. First in guys refused to have anything to do with new investors. It was obvious. I still had enough control over the situation and let them know to play nice or I will walk away and close the company.
They decided to call me on this, so I resigned as CEO, then got a majority vote to dissolve the company, closed it and walked away by following the legal rules in our operating agreement to do so.
I have since started a new company and went back to the interested investors, who were not welcomed in the prior company, and have begun raising money. Almost a million dollars in start up capital was lost, but the ego in these guys got the best of them.
Thanks for shedding light on how things really work behind the scenes.
Terrific, thorough post. VC's can absolutely force a sale, and as the post points out, there are multiple tools they design into the term sheet to ensure this.
Excellent rundown of the methods of gaining and exercising control over important decisions such as forcing a sale. I was a senior VC officer for a bank owned venture group. In these cases, our investments often followed bank loans from our parent bank which included security interests in all the assets of the company. While the bank often had views different from ours as equity holders, when they were parallel and big changes needed to be brought about, the bank's leverage over the company was immense through its loan and security documents. In those cases, there was no pretense by the bank about the leverage that was exerted. I managed our VC portfolio averaging about 30 to 40 companies at a time. Of these, about 20% (a guess after all these years) also involved our bank. Of these, I sat through or was directly involved in about 15% of the joint lending/investing deals in which we arranged for buyers of companies or changed managements. That doesn't count the ones we arranged on our own when there was no bank involvement. These experiences eventually led me to leaving the VC industry and becoming an entrepreneur, with the foreknowledge not to let these consequences happen to me. About 20 years later I co-founded a healthcare company. One VC liked us so much they agreed to fund all our needs. Sounded good until we need our next round of capital. They walked us right up to 2 days before a payroll we couldn't make without their funding and they "persuaded" the Board to fire all top management (including yours truly) and accept their new money at dilutive terms such that old shareholders that owned 75% of the company before the financing owned less than 1% after the financing. What goes around from my early career (which didn't seem capricious at the time) came around in later days where the VC's actions seem egregious and capricious. Bruce G. Rossiter, CEO, Zoom Sales and Marketing.
Great post that any entrepreneur should read when engaging with VC.
My personal experience has been that the most unscrupulous of VCs not only use these methods themselves, they often attempt to conspire with other investors or prospective investors to find ways to achieve their goals. In our case they took method #2 to the extreme of sabotaging our efforts to raise the capital we needed to fill $20M in purchase orders we had in hand. The temptation to take control of the company just when it was headed to be a huge success and eliminate the founder was so great that they actually told other VCs not to invest the amount that had been negotiated, put in a minimum amount, get a seat on the Board and help take over. They then offered a “special price” (without Board approval) to the other firm if they would cooperate. To the credit of the other firms, they saw a dysfunctional greedy Board member and ran for the hills. We know all this because they ultimately caused the demise of the company, lost their investment (and everyone else’s) and we are now suing them and have their e-mails to the other firms to prove the breaches of their fiduciary duty. In my present company, I would close the doors before I would let VCs get close to a controlling position.
This one simple rule applies.
If you take VC money, it is all about the VC and his "needs".
They are always in first place.
And there is nothing and no one in second, third, fourth or fifth place. If you are lucky, you might be in sixth.
Great post and very informative comments. As new to the site, I am learning a lot with your experiences. Thanks a lot. Looks like a game of sharks this VC game. I would bet for having a good shark in my team :) to be prepared and have a good defense.
To Adelante:
I am not sure that you have it right. There is no good defense against sharks.
Once in the shark pool, you are shark bait. A shark only knows three things (From "Jaws") It swims, it makes little sharks and .... It seeks shark bait in order to eat.
There is no point to jumping into the shark pool in order to defend yourself from being eaten. You cannot accomplish anything else since the shark is only capable of eating you.
The only viable choice to make is the first choice you must make.
Do I jump into that pool or not. If you are not in the pool, you don' t have to worry about sharks.
Let me abandon the metaphor.
Since the odds of getting VC funding are 1 in 3,000, why bother.
Spend the time that you would spend in 2,999 worthless, boring, frustrating meetings ... dealing with people who are not interested in you or your project ... spend that time on making your project work.
The best defense against the sharks is to ignore them. Find ways to do everything you need to get done within the resource net you have at hand.
Waste not one penny of your money and not one second of your time, chasing that ice castle.
I know, I know, I know.
Wouldn't it be nice to win the lottery, get 5 million of VC funding, get a 6 million dollar earmark and just not have to struggle, struggle and struggle some more on mundane stuff like paying rent.
When you face the truth ... that you seek that "5 million dollar lapshot" because you just want it easier for a while, not because your project can't work without it,.... you can buckle down, finish your project (you can always find a way) far sooner.
Interesting post. Definitely an eyeopener and confirms the Golden Rule--He who has the gold, makes the rules!
I think that carlwimm's response is particularly poignant. We've been struggling with whether we should attempt to dive into the "pool of sharks" or just get our heads down and make what we are doing work.
We are two years into a business that has been funded by the founders to date, and without the 08 Q4 meltdown would have been on the road to profitability. As a result things are tighter than we'd like. Bringing in outside money will make things easier and probably speed up our growth, expansion and acquisition goals. But the resources (our time building the product and sales) diverted to find that money and the strings that will come attached to it as outlined above make VC funding a not so attractive option.
Mr. Smith, I've done an analysis of the distribution of Amazon proceeds to Zappos shareholders, based on information in the Amazon SEC filing, coupled with details on liquidation preferences for each Zappos series of preferred that are contained in Zappos' articles, on file with the CA Sec. of State. These are at http://wac6.com. Basically, I found that Sequoia is going to do better on the Amazon sale than it would have without its liquidation preferences (which were 4x in the penultimate round, but both of its investments were designed to target a value of $24/share, in Zappos currency, before the preference went away). No redemption rights in the articles, however.
TO SPLEVY
There are actually 4 golden rules, not just one. The one you quoted is number 3.
The most interesting thing about all four rules is that you can judge a man and his intentions by which of the 4 he lives by.
Rule 1 - the Biblical rule
"Do unto others as you would have them do unto you."
pretty simple, pretty straightforward and a good guide for life.
Rule 2 - The Wall Street Rule (and the Washington rule)
"Do unto others BEFORE they do unto you."
Again simple and straighforward, but ..... yuck .... what a way to live.
Rule 3 - The VC rule
"He who has the gold makes the rules".
Basically it is an attempt to fix the poker game by making the game nly about who has the money.
Great technology, great project, great idea, .... who cares, ....
I have the money - please fall down on your knees and worship me.
Rule 4 - the CarlWimm rule
"He who makes the rules, gets the gold".
You either control the tendrils of life or they control you.
Your call. Best of luck to all of you in whatever you choose.