Towering over the crowd
Towards recapitalization:
WHY THE MARKET FINANCING "UNICORNS" BECAME JUST DANGEROUS ... FOR ALL INVOLVED IN IT.
Last February, Fortune authors Erin Griffith and Dan Primack proclaimed 2015 the “era of unicorns”, stating that “Fortune has more than 80 startups, each of which is valued by venture investors at more than $ 1 billion.” By January 2016, their number soared to 229. One of the determining reasons for this growth of the “unicorns” population was the remarkable ease of mobilizing capital to create such a beast: state the new valuation of the company much higher than the last, come up with a representative headline, ask for proposals - and watch the flow from hundreds of millions of dollars in your bank account. After twelve or eighteen months, you "push off" and do it again - amazingly simple!
Although not visible on the surface, a fundamental transformation has taken place in the investment community, which has made increasing investments in “unicorns” a much more dangerous and complex practice. All participants of the "unicorns" - the founders, employees of the company, venture capital investors and their contributing partners (LP) - see their fortunes threatened from the very nature of the "unicorn" phenomenon. The pressure created by extremely high paper cost estimates, a significant burning rate (and the subsequent need for more money) and unprecedented low IPOs and M & A levels created a difficult and unique situation in which many defining unicorns' managers and investors are poorly oriented .
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Many people point out that the total stock price of shares, created by all such startups, far exceeds the losses from their inevitably ruining brethren. This seemingly commonplace is based on the clear success of the qualitatively new companies of this generation (AirBNB, Slack, Snapchat, Uber, etc.). While this circumstance might give some sense of comfort, most of these startups are not represented in the “unicorns” basket, and there is no indication that they can be bought. To some extent, the majority of participants in such an economic system can affect the specific efficiency of a company and are responsible for this, which explains precisely why it is important to understand the changing landscape.
Perhaps a notable event for the "collapse of bubbles" was an investigation into the Theranos company, conducted by John Carreyro and published in the Wall Street Journal. John was the first to show that the company's ability to raise money from a handful of investors at a very high price does not mean that (i) everything in the company is normal, or that (ii) the value of its shares constantly remains at the value of the last round. Ironically, Carreiroou does not specialize in Silicon Valley affairs, and the success of his publication served as a call to action for other journalists who may have been struck by the "unicorn fever." The next was a deep analysis of Rolf Winkler, “Startup Zenefits with high market valuation is random.” Similar materials can be expected in the near future.
At the end of 2015, many public information technology companies saw a significant decrease in the price of their shares, primarily as a result of lower valuation ratios. A high-performance, fast-growing SAAS-company, which previously was estimated at more than 10 annual revenues, suddenly began to cost 4-7. The same thing happened with many Internet companies. This massive reduction in the ratio naturally contributed to the fact that investors are willing to pay for more established private companies.
The end of 2015 also brought a "lower price for the mutual fund." Many "unicorns" took private attracted dollars from mutual funds. These mutual funds daily revalue securities based on current quotes, and fund managers periodically receive compensation on this basis. As a result, many firms have independent internal groups that periodically analyze company valuations. When the public securities markets went down, these groups began to lower the value estimates of the unicorns. Once again, fantasies began to fall apart. The last round does not mean a fixed price, and being private does not mean that you will get some sort of concessions with careful consideration.
At the same time, we also began to see an increase in problems with startups. In addition to such high-profile companies like Fab.com, Quirky, Homejoy and Secret, numerous companies based on venture capital investments began to hide behind. There were so many of them that CB Insights began to maintain the list. Suspension of activity has also become more common. Mixpanel, Jawbone, Twitter, HotelTonight and many others made the difficult decision to reduce the total number of employees in an attempt to reduce costs (and, apparently, the rate of combustion). Many modern entrepreneurs have limited the impact of the concept of a malfunction or suspension of activity, because this has long been common in industry.
In the first quarter of 2016, the late stages financial market changed significantly. Investors were nervous and were no longer willing to hesitate to invest new funds in unicorns. Moreover, previously ambitious startups began to fight for fundraising. On the boards of directors of Silicon Valley companies, where "growth at any cost" was a mantra for many years, people began to paint a world for themselves, where the cost of capital could grow substantially and profits would again become commonplace. Anxiety began to slowly enter everyone’s world.
Around this time, journalists specializing in the venture capital industry noticed something fundamentally important. In 1999, record cost estimates coexisted with record IPOs and shareholder liquidity. The year 2015 was exactly the opposite. Record estimates of private "unicorns" were offset by a decreasing number of IPOs. In 1999, the bubble was “wet” (well liquid), whereas in 2015 it was very “dry”. All were successful on paper, but from the position of net income there was little to show. In the 1st quarter of 2016, there were no technological IPOs with venture capital at all. Less than a year after the proclamation of the coming year, “the era of unicorns,” Fortune magazine returned with a grim warning: “The Silicon Valley problem of 585 billion dollars: the end of take-off.”
When we move forward, it is important for all players in the economic system to realize that the game has changed. It is also important that each player understands how the new rules apply to him. We will begin by first considering several psychological factors that may irrationally influence the overall decision-making process. Then we look at a new player in the economic system who is ready to take advantage of these aforementioned changes and developing factors. Finally, we will consider each player in the economic system, and what they must take into account when they enter this “brave new world,” as the English writer Aldous Huxley expressed in his anti-utopian novel in 1932.
When theoretical scholars study markets, it is initially assumed that market participants act rationally. But what if the participants are in a state that pushes them to non-optimal and potentially irrational behavior? Many factors contribute to the irrationality of the unicorn financing environment.
1. Founder / CEO. Many of the founders of unicorns and their CEOs have never experienced difficulties with financing - they knew only success. Therefore, they have a firm belief that any sign of weakness (such as, for example, a lowering round) will have a catastrophic effect on the internal situation in the company (company culture), on the process of hiring employees and on the ability to retain them. The leader’s own perception is also a working factor; he has a concern - does the lowering round seem to be a weakness of the leader to others? It is possible that it is difficult for us to imagine the level of fear and anxiety that may arise from a previously confident leader at such a transitional moment.
2. Investors. A typical representative of a venture investment company in 2016 is also exposed to psychological factors. Investors are likely to peer at staggering, paper-based profits that have already been recorded as success by their own investors — contributing partners (LP). Anything that suggests a decrease in investment (the downward round) immediately raises questions about the success rates that have already been “capitalized”. In addition, many such price cuts could hinder their ability to attract further investment. Thus, anxious investors may have many incentives to defend illusions - to do everything they can to prevent a decline in investment (downward rounds).
3. Anyone who has already “credited” the return of their investments. Whether you are a founder, manager, business angel, venture company, or a late stage investor, it is likely that you took the cost estimate from the last round, multiplied by your ownership share and told yourself that you are now! - cost so much! It’s just in human nature that by doing such a mental exercise and convincing yourself of the result, you’ll have difficulty rationalizing the decline in investment.
4. Chasing exit situations. As soon as the fear of a downward trend is asserted, some players in the economic system try to quickly and desperately seize instant liquidity, guided primarily by their own interests. This happens in every transitional situation on the market and can create quite strong tensions between the various participants in each company. We have already seen examples of founders and managers who received liquid assets before investors. And there are also modern examples of investors who drove out the founders and employees from companies. Obviously, providing simultaneous liquidity is the most appropriate option, but the fear of lower prices, as well as an increase in the duration of the conversion of assets into money, can make both parties choose the “I am first” course.
What does a shark mean here? These are sophisticated and unprincipled investors who instinctively understand the effect of the above factors on the participants, know exactly how to handle the investments, and can take advantage of the situation. They are waiting for such situations, licked at the thought of the opportunity to profit.
Transaction agreements containing “dirty” or “structured” terms are those proposed investments where the bulk of the economic profit for the investor comes not from the announced valuation, but rather through a series of “dirty” conditions hidden deep in the document. This allows the shark to meet the "question" of an entrepreneur and a member of the VC board about the valuation, all the while knowing that excellent profits will be obtained even with exits that are much lower than the coverage estimate.
Examples of “dirty” conditions are guaranteed IPO profits, a racket (or, otherwise, “ratchet”), PIK dividends, series-based M & A vetoes, and exclusive preferences (privileges) or liquidity rights. A typical agreement on the basic terms of the Silicon Valley transaction does not contain such conditions. The reason that these conditions can be profitable in and of themselves is that they lay the foundation for restructuring the capitalization table at some point in the future. Therefore, the founder and members of the board of directors of a venture company can continue to think for a long time that everything is going fine. The adjustment will not occur now, it will be made sometime later.
Bargain agreements containing “dirty” terms are a serious problem for two reasons. One is that they are “unpacked” or “exploded” at some point in the future. You can no longer just look at the capitalization table and evaluate your profit. After the “dirty” offer is accepted, the payment in each potential future value estimate requires a complex analysis, where the “shark” profit is calculated first and then the remainder is divided among all the others. The second reason why they pose a serious problem is that their complexity makes future financial investments almost impossible.
Any investor, who will be asked to follow the “dirty” offer, will look at its complexity and, most likely, will refuse. This greatly increases the risk or loss of money, or full recapitalization, which will destroy the previous shareholders (equally all - the founders, employees, investors). Thus, while such a maneuver may seem safe and crucial to your short-term psychological difficulties and problems, you can put your entire company in a much more dangerous position without even realizing it.
Some late stage investors themselves may be tempted to become “sharks” and will begin to include structured terms in their own agreements on the basic terms of the transaction. Successful adherence to such a strategy will lead to the fact that these investors will indeed become “sharks”. It will be convenient for them to know that their interests are in conflict with the interests of the founders, employees, and other investors in the capitalization table and conflict with them. And they will be pleased to know that they will win, while others will lose. This situation is not for the faint of heart and, of course, completely different from the typical investor behavior in the past few years.
Now let's take a closer look at what this new investment attraction environment means for each participant in the economic system.
Today's entrepreneur, working with a unicorn, got his experience in an environment that may be radically different from what awaits him ahead. Take a look at the process history. Money comes easy. The market prefers growth, not profit. Competitors also have access to capital. Therefore, in order to win, it is necessary to grow as quickly as possible in size and be super-ambitious. It is necessary to capture the maximum possible market share.
Never in the history of venture capital, start-ups at an early stage did not have access to such a large amount of capital. In 1999, if the company reached $ 30 million before an IPO, then it was considered a great historical success. Now private companies exceed this value ten or more times. And, accordingly, the rate of combustion increased tenfold compared with what was then. All this creates a monstrously hungry unicorn. He needs capital again and again (if he intends to stay on the current trajectory).
Perhaps for the first time in their lives, these entrepreneurs may be faced with a situation where they will not be able to keep net increasing financing at the proper level in order to ensure the growth of investments. This is uncharted territory. There are several alternatives here:
1. The first possibility that many unicorns have is a deal agreement containing “dirty” terms. As discussed above, these conditions can cleverly fool an inexperienced player, because they are able to "meet the question" regarding coverage assessment; the founder accepting these conditions simply does not understand what kind of “slaughter” awaits him in the near future. The only reason for which such an agreement could be accepted is to support the illusion of valuation, which, however, simply does not matter. Accepting an agreement with such conditions is like launching a clock on a time bomb. Your only salvation will be to go through the IPO window as quickly as possible (note: the Box and Square companies were able to slip through this eye of the needle), otherwise the accepted conditions will eat you alive. The main problem is that after this you will never again be able to make investments, since no new investor wants to sit on the volcano. And you will get bogged down in negotiations with a lender who has already proved that he is smarter than you.
2. Carry out a cleaning round (capitalization tables) at a lower cost estimate. For many modern entrepreneurs, this seems to be a serious failure, but they must quickly change their views. Reed Hastings at Netflix raised money in a resonant downward round as a public CEO. Every public CEO had days when the stock price fell - this is a common and common phenomenon. The only thing you defend is your image and self-love, but ultimately they have no meaning. You should be more concerned about the long-term assessment of your stock and minimizing the likelihood of losing everything. And it is precisely the above-mentioned conditions that are the Godzilla who should be seriously afraid. A downward round is nonsense. We must go through it and move on. It is clear that possibility number 2 is significantly better than number 1.
3. Get to work and do everything so that the cash flow along with the funds in the account become positive. This may seem like the most inappropriate choice of the situation, as your board of directors advised you to do the exact opposite for the past four years. You have been told that you need to be “bold” and “ambitious” and that now is the best time to capture a significant market share. Despite this, the only way to keep your own destiny under control is to eliminate the need for additional capital growth altogether. Achieving profitability is the most liberating action a startup can take. Now you can make your own decisions. It also minimizes future dilution. Gavin Baker, a top-notch investment manager at Fidelity, spoke for the CEOs of unicorns: “Create free cash flow for $ 1 and then you can invest everything else in growth, staying on that $ 1 in free cash flow for many years. I understand that you want to grow, and I want you to grow, but let us internally finance such growth from dollars of gross profit, and not from dollars for new dilutive shares.
Ultimately, internally financed growth is the only way to control your own destiny, and not be dominated by capital markets. ”
4. Become public. Ultimately, the best way for founders to take care of their property, as well as about their employees, is to enter the IPO. Prior to an IPO, ordinary shares are listed as preferred. Many preferred shares have different types of management functions, and most of them have serious privileges in relation to ordinary shares. If you really want to release your own ordinary shares and shares of your employees, then you should convert the preferred shares into ordinary shares and remove the privileges, both in management and in liquidation of your shares. To many founders, various misguided consultants have repeatedly said that an IPO is bad and that the road to success is to “remain private for as long as possible.” However, an IPO is not only better for your company (see Mark Zuckerberg and Mark Benioff on this topic), but is also the best way to ensure the long-term value of your shares (and your employees ’shares).
The stock price fluctuates. There is not a single high-class public (open) joint-stock company that did not have periods of time when their shares showed poor results. Amazon Stock Company has gone from 106 to 6 dollars per share. The company “Salesforce” went down from 16 to 6 dollars and for many months stood below 10 dollars. Netflix went from $ 38 to $ 8 per share in some six months. Do you remember Facebook in the first six months of its existence as a public company?
If you cannot handle the depreciation, then you should seriously consider giving up the position of CEO. Being a true leader means being able to lead you in both good and bad times. Accepting a “dirty” agreement endangers the future of your company solely because you are afraid to lead through difficult new times.
The exact situation with the capital structure of a company is usually hidden from the average employee. You know that you work for this unicorn and that you have a certain number of ordinary shares. Perhaps you know your share of the property. And, unfortunately, you can assume that the result of your assessment of the value of a unicorn and of your share of property is all that you are worth. Of course, in order to be accurate in this assessment, it is necessary to achieve a liquidity event (IPO or M & A) in estimating a value equal to or higher than that obtained in the last round, without increasing dissolution from new rounds. But think about it: M & A gives obviously scarce money (no large company wants to pay these prices or take on this burning rate), and many founders have been told more than once that an IPO is bad. So how do you implement your "liquidity"?
For the most part, employees are in the same position as the founders (see above), except that they do not participate in the decision making, outlined in paragraphs. 1-4. But even so, they have to ask the same questions related to management: Can we get to the break-even point on the money we have? Do we need to continue to collect money? If “yes”, can we do it on “clean” conditions (not on “dirty” ones)? Employees, in fact, would like to know whether the founder and / or CEO are going to enter into an agreement with “dirty” terms (or maybe already entered into it), because the owners of ordinary shares are most at risk in this situation . You also need to know if your leader is an IPO opponent. If your CEO / founder enters a round with “dirty” conditions and is also an opponent of an IPO, then the chance that you will ever be able to get something even remotely close to what you think they are worth now will be very, very low. You will probably be better off moving to another company.
Explanation: It should be noted that the author of the article and his investment company belong to this category.
In most cases, early investors in unicorns are in the same position as the founders and employees. This is because companies after early investors have attracted so much capital that the early investor is no longer a significant part of the holders of voting rights or liquidation privileges. As a result, most of their interests coincide with the interests of holders of ordinary shares, and the desired key decisions on reimbursement and liquidity are the same as those of the founders. Such an investor will also be wary of a deal agreement containing “dirty” terms that have the ability to take control over the entire company. Such an investor will also have a rather strong fear due to the difference between paper and real incomes and due to the lack of total liquidity in the market. Or at least all of this must be present.
The exception is a late investor or a wealthy investor who may represent a substantial portion of all the money raised. This particular type of investor may have defended his property through active proportional or over-proportional investing. They may even have encouraged an aggressive forward-to-win aggressive mentality, knowing that they can continue to write checks. And they act as an irresponsible gambler at the poker table.
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Against this difficult background, many firms offer their companion contributors (LP) to take on new early investment commitments to their next fund at the very moment when evaluation is most difficult and concern about the situation may be at the peak of the cycle. In fact, deep down, most of the contributing partners (LP) know that the venture capital sector is anti-cyclical in relation to the amount of money raised by venture capital companies. With over-financing of the industry, total profitability falls. Huge investments in overblown multibillion-dollar venture capital funds can easily exacerbate problems that already exist.
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2. Brokers and third-class investment banks offering for sale secondary shares in unicorn companies. If you ask any large family capital management company, they will tell you that they are just bombarded with calls and emails offering secondary positions in unicorn companies. Often there are such baits as "a discount of 20-40% of the price of the last round."
3. The rising round of the unicorn. You may also be asked to simply add capital to a standard unicorn round. Being with many investors "at the planned level" because of the already accumulated amount of capital, some companies are looking "under every stone," where else would take the dollars.
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A few weeks ago, on March 31, 2016, the chairman of the Securities and Exchange Commission (SEC) visited Silicon Valley and made a speech at an event at the Law Faculty of Stanford University. For those who are involved in investing unicorns, or for those who are considering investing in them, it would be useful to read it completely (see here ). Interpretation of this presentation by Bloomberg is set out in the article " Silicon Valley must drive its unicorns into the paddock ."
The Chairperson, Ms. White, seems to be fully aware of the problems and impacts that could disrupt the process of financing unicorns:
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WHY THE MARKET FINANCING "UNICORNS" BECAME JUST DANGEROUS ... FOR ALL INVOLVED IN IT.
April 21, 2016
Last February, Fortune authors Erin Griffith and Dan Primack proclaimed 2015 the “era of unicorns”, stating that “Fortune has more than 80 startups, each of which is valued by venture investors at more than $ 1 billion.” By January 2016, their number soared to 229. One of the determining reasons for this growth of the “unicorns” population was the remarkable ease of mobilizing capital to create such a beast: state the new valuation of the company much higher than the last, come up with a representative headline, ask for proposals - and watch the flow from hundreds of millions of dollars in your bank account. After twelve or eighteen months, you "push off" and do it again - amazingly simple!
Although not visible on the surface, a fundamental transformation has taken place in the investment community, which has made increasing investments in “unicorns” a much more dangerous and complex practice. All participants of the "unicorns" - the founders, employees of the company, venture capital investors and their contributing partners (LP) - see their fortunes threatened from the very nature of the "unicorn" phenomenon. The pressure created by extremely high paper cost estimates, a significant burning rate (and the subsequent need for more money) and unprecedented low IPOs and M & A levels created a difficult and unique situation in which many defining unicorns' managers and investors are poorly oriented .
')
Many people point out that the total stock price of shares, created by all such startups, far exceeds the losses from their inevitably ruining brethren. This seemingly commonplace is based on the clear success of the qualitatively new companies of this generation (AirBNB, Slack, Snapchat, Uber, etc.). While this circumstance might give some sense of comfort, most of these startups are not represented in the “unicorns” basket, and there is no indication that they can be bought. To some extent, the majority of participants in such an economic system can affect the specific efficiency of a company and are responsible for this, which explains precisely why it is important to understand the changing landscape.
Perhaps a notable event for the "collapse of bubbles" was an investigation into the Theranos company, conducted by John Carreyro and published in the Wall Street Journal. John was the first to show that the company's ability to raise money from a handful of investors at a very high price does not mean that (i) everything in the company is normal, or that (ii) the value of its shares constantly remains at the value of the last round. Ironically, Carreiroou does not specialize in Silicon Valley affairs, and the success of his publication served as a call to action for other journalists who may have been struck by the "unicorn fever." The next was a deep analysis of Rolf Winkler, “Startup Zenefits with high market valuation is random.” Similar materials can be expected in the near future.
At the end of 2015, many public information technology companies saw a significant decrease in the price of their shares, primarily as a result of lower valuation ratios. A high-performance, fast-growing SAAS-company, which previously was estimated at more than 10 annual revenues, suddenly began to cost 4-7. The same thing happened with many Internet companies. This massive reduction in the ratio naturally contributed to the fact that investors are willing to pay for more established private companies.
The end of 2015 also brought a "lower price for the mutual fund." Many "unicorns" took private attracted dollars from mutual funds. These mutual funds daily revalue securities based on current quotes, and fund managers periodically receive compensation on this basis. As a result, many firms have independent internal groups that periodically analyze company valuations. When the public securities markets went down, these groups began to lower the value estimates of the unicorns. Once again, fantasies began to fall apart. The last round does not mean a fixed price, and being private does not mean that you will get some sort of concessions with careful consideration.
At the same time, we also began to see an increase in problems with startups. In addition to such high-profile companies like Fab.com, Quirky, Homejoy and Secret, numerous companies based on venture capital investments began to hide behind. There were so many of them that CB Insights began to maintain the list. Suspension of activity has also become more common. Mixpanel, Jawbone, Twitter, HotelTonight and many others made the difficult decision to reduce the total number of employees in an attempt to reduce costs (and, apparently, the rate of combustion). Many modern entrepreneurs have limited the impact of the concept of a malfunction or suspension of activity, because this has long been common in industry.
In the first quarter of 2016, the late stages financial market changed significantly. Investors were nervous and were no longer willing to hesitate to invest new funds in unicorns. Moreover, previously ambitious startups began to fight for fundraising. On the boards of directors of Silicon Valley companies, where "growth at any cost" was a mantra for many years, people began to paint a world for themselves, where the cost of capital could grow substantially and profits would again become commonplace. Anxiety began to slowly enter everyone’s world.
Around this time, journalists specializing in the venture capital industry noticed something fundamentally important. In 1999, record cost estimates coexisted with record IPOs and shareholder liquidity. The year 2015 was exactly the opposite. Record estimates of private "unicorns" were offset by a decreasing number of IPOs. In 1999, the bubble was “wet” (well liquid), whereas in 2015 it was very “dry”. All were successful on paper, but from the position of net income there was little to show. In the 1st quarter of 2016, there were no technological IPOs with venture capital at all. Less than a year after the proclamation of the coming year, “the era of unicorns,” Fortune magazine returned with a grim warning: “The Silicon Valley problem of 585 billion dollars: the end of take-off.”
When we move forward, it is important for all players in the economic system to realize that the game has changed. It is also important that each player understands how the new rules apply to him. We will begin by first considering several psychological factors that may irrationally influence the overall decision-making process. Then we look at a new player in the economic system who is ready to take advantage of these aforementioned changes and developing factors. Finally, we will consider each player in the economic system, and what they must take into account when they enter this “brave new world,” as the English writer Aldous Huxley expressed in his anti-utopian novel in 1932.
PSYCHOLOGICAL FACTORS
When theoretical scholars study markets, it is initially assumed that market participants act rationally. But what if the participants are in a state that pushes them to non-optimal and potentially irrational behavior? Many factors contribute to the irrationality of the unicorn financing environment.
1. Founder / CEO. Many of the founders of unicorns and their CEOs have never experienced difficulties with financing - they knew only success. Therefore, they have a firm belief that any sign of weakness (such as, for example, a lowering round) will have a catastrophic effect on the internal situation in the company (company culture), on the process of hiring employees and on the ability to retain them. The leader’s own perception is also a working factor; he has a concern - does the lowering round seem to be a weakness of the leader to others? It is possible that it is difficult for us to imagine the level of fear and anxiety that may arise from a previously confident leader at such a transitional moment.
2. Investors. A typical representative of a venture investment company in 2016 is also exposed to psychological factors. Investors are likely to peer at staggering, paper-based profits that have already been recorded as success by their own investors — contributing partners (LP). Anything that suggests a decrease in investment (the downward round) immediately raises questions about the success rates that have already been “capitalized”. In addition, many such price cuts could hinder their ability to attract further investment. Thus, anxious investors may have many incentives to defend illusions - to do everything they can to prevent a decline in investment (downward rounds).
3. Anyone who has already “credited” the return of their investments. Whether you are a founder, manager, business angel, venture company, or a late stage investor, it is likely that you took the cost estimate from the last round, multiplied by your ownership share and told yourself that you are now! - cost so much! It’s just in human nature that by doing such a mental exercise and convincing yourself of the result, you’ll have difficulty rationalizing the decline in investment.
4. Chasing exit situations. As soon as the fear of a downward trend is asserted, some players in the economic system try to quickly and desperately seize instant liquidity, guided primarily by their own interests. This happens in every transitional situation on the market and can create quite strong tensions between the various participants in each company. We have already seen examples of founders and managers who received liquid assets before investors. And there are also modern examples of investors who drove out the founders and employees from companies. Obviously, providing simultaneous liquidity is the most appropriate option, but the fear of lower prices, as well as an increase in the duration of the conversion of assets into money, can make both parties choose the “I am first” course.
SHARKS APPEAL WITH DEAL AGREEMENTS CONTAINING "DIRTY" CONDITIONS
What does a shark mean here? These are sophisticated and unprincipled investors who instinctively understand the effect of the above factors on the participants, know exactly how to handle the investments, and can take advantage of the situation. They are waiting for such situations, licked at the thought of the opportunity to profit.
Transaction agreements containing “dirty” or “structured” terms are those proposed investments where the bulk of the economic profit for the investor comes not from the announced valuation, but rather through a series of “dirty” conditions hidden deep in the document. This allows the shark to meet the "question" of an entrepreneur and a member of the VC board about the valuation, all the while knowing that excellent profits will be obtained even with exits that are much lower than the coverage estimate.
Examples of “dirty” conditions are guaranteed IPO profits, a racket (or, otherwise, “ratchet”), PIK dividends, series-based M & A vetoes, and exclusive preferences (privileges) or liquidity rights. A typical agreement on the basic terms of the Silicon Valley transaction does not contain such conditions. The reason that these conditions can be profitable in and of themselves is that they lay the foundation for restructuring the capitalization table at some point in the future. Therefore, the founder and members of the board of directors of a venture company can continue to think for a long time that everything is going fine. The adjustment will not occur now, it will be made sometime later.
Bargain agreements containing “dirty” terms are a serious problem for two reasons. One is that they are “unpacked” or “exploded” at some point in the future. You can no longer just look at the capitalization table and evaluate your profit. After the “dirty” offer is accepted, the payment in each potential future value estimate requires a complex analysis, where the “shark” profit is calculated first and then the remainder is divided among all the others. The second reason why they pose a serious problem is that their complexity makes future financial investments almost impossible.
Any investor, who will be asked to follow the “dirty” offer, will look at its complexity and, most likely, will refuse. This greatly increases the risk or loss of money, or full recapitalization, which will destroy the previous shareholders (equally all - the founders, employees, investors). Thus, while such a maneuver may seem safe and crucial to your short-term psychological difficulties and problems, you can put your entire company in a much more dangerous position without even realizing it.
Some late stage investors themselves may be tempted to become “sharks” and will begin to include structured terms in their own agreements on the basic terms of the transaction. Successful adherence to such a strategy will lead to the fact that these investors will indeed become “sharks”. It will be convenient for them to know that their interests are in conflict with the interests of the founders, employees, and other investors in the capitalization table and conflict with them. And they will be pleased to know that they will win, while others will lose. This situation is not for the faint of heart and, of course, completely different from the typical investor behavior in the past few years.
Now let's take a closer look at what this new investment attraction environment means for each participant in the economic system.
ENTREPRENEURS / FOUNDERS / GENERAL DIRECTORS
Today's entrepreneur, working with a unicorn, got his experience in an environment that may be radically different from what awaits him ahead. Take a look at the process history. Money comes easy. The market prefers growth, not profit. Competitors also have access to capital. Therefore, in order to win, it is necessary to grow as quickly as possible in size and be super-ambitious. It is necessary to capture the maximum possible market share.
Never in the history of venture capital, start-ups at an early stage did not have access to such a large amount of capital. In 1999, if the company reached $ 30 million before an IPO, then it was considered a great historical success. Now private companies exceed this value ten or more times. And, accordingly, the rate of combustion increased tenfold compared with what was then. All this creates a monstrously hungry unicorn. He needs capital again and again (if he intends to stay on the current trajectory).
Perhaps for the first time in their lives, these entrepreneurs may be faced with a situation where they will not be able to keep net increasing financing at the proper level in order to ensure the growth of investments. This is uncharted territory. There are several alternatives here:
1. The first possibility that many unicorns have is a deal agreement containing “dirty” terms. As discussed above, these conditions can cleverly fool an inexperienced player, because they are able to "meet the question" regarding coverage assessment; the founder accepting these conditions simply does not understand what kind of “slaughter” awaits him in the near future. The only reason for which such an agreement could be accepted is to support the illusion of valuation, which, however, simply does not matter. Accepting an agreement with such conditions is like launching a clock on a time bomb. Your only salvation will be to go through the IPO window as quickly as possible (note: the Box and Square companies were able to slip through this eye of the needle), otherwise the accepted conditions will eat you alive. The main problem is that after this you will never again be able to make investments, since no new investor wants to sit on the volcano. And you will get bogged down in negotiations with a lender who has already proved that he is smarter than you.
2. Carry out a cleaning round (capitalization tables) at a lower cost estimate. For many modern entrepreneurs, this seems to be a serious failure, but they must quickly change their views. Reed Hastings at Netflix raised money in a resonant downward round as a public CEO. Every public CEO had days when the stock price fell - this is a common and common phenomenon. The only thing you defend is your image and self-love, but ultimately they have no meaning. You should be more concerned about the long-term assessment of your stock and minimizing the likelihood of losing everything. And it is precisely the above-mentioned conditions that are the Godzilla who should be seriously afraid. A downward round is nonsense. We must go through it and move on. It is clear that possibility number 2 is significantly better than number 1.
3. Get to work and do everything so that the cash flow along with the funds in the account become positive. This may seem like the most inappropriate choice of the situation, as your board of directors advised you to do the exact opposite for the past four years. You have been told that you need to be “bold” and “ambitious” and that now is the best time to capture a significant market share. Despite this, the only way to keep your own destiny under control is to eliminate the need for additional capital growth altogether. Achieving profitability is the most liberating action a startup can take. Now you can make your own decisions. It also minimizes future dilution. Gavin Baker, a top-notch investment manager at Fidelity, spoke for the CEOs of unicorns: “Create free cash flow for $ 1 and then you can invest everything else in growth, staying on that $ 1 in free cash flow for many years. I understand that you want to grow, and I want you to grow, but let us internally finance such growth from dollars of gross profit, and not from dollars for new dilutive shares.
Ultimately, internally financed growth is the only way to control your own destiny, and not be dominated by capital markets. ”
4. Become public. Ultimately, the best way for founders to take care of their property, as well as about their employees, is to enter the IPO. Prior to an IPO, ordinary shares are listed as preferred. Many preferred shares have different types of management functions, and most of them have serious privileges in relation to ordinary shares. If you really want to release your own ordinary shares and shares of your employees, then you should convert the preferred shares into ordinary shares and remove the privileges, both in management and in liquidation of your shares. To many founders, various misguided consultants have repeatedly said that an IPO is bad and that the road to success is to “remain private for as long as possible.” However, an IPO is not only better for your company (see Mark Zuckerberg and Mark Benioff on this topic), but is also the best way to ensure the long-term value of your shares (and your employees ’shares).
The stock price fluctuates. There is not a single high-class public (open) joint-stock company that did not have periods of time when their shares showed poor results. Amazon Stock Company has gone from 106 to 6 dollars per share. The company “Salesforce” went down from 16 to 6 dollars and for many months stood below 10 dollars. Netflix went from $ 38 to $ 8 per share in some six months. Do you remember Facebook in the first six months of its existence as a public company?
If you cannot handle the depreciation, then you should seriously consider giving up the position of CEO. Being a true leader means being able to lead you in both good and bad times. Accepting a “dirty” agreement endangers the future of your company solely because you are afraid to lead through difficult new times.
EMPLOYEES
The exact situation with the capital structure of a company is usually hidden from the average employee. You know that you work for this unicorn and that you have a certain number of ordinary shares. Perhaps you know your share of the property. And, unfortunately, you can assume that the result of your assessment of the value of a unicorn and of your share of property is all that you are worth. Of course, in order to be accurate in this assessment, it is necessary to achieve a liquidity event (IPO or M & A) in estimating a value equal to or higher than that obtained in the last round, without increasing dissolution from new rounds. But think about it: M & A gives obviously scarce money (no large company wants to pay these prices or take on this burning rate), and many founders have been told more than once that an IPO is bad. So how do you implement your "liquidity"?
For the most part, employees are in the same position as the founders (see above), except that they do not participate in the decision making, outlined in paragraphs. 1-4. But even so, they have to ask the same questions related to management: Can we get to the break-even point on the money we have? Do we need to continue to collect money? If “yes”, can we do it on “clean” conditions (not on “dirty” ones)? Employees, in fact, would like to know whether the founder and / or CEO are going to enter into an agreement with “dirty” terms (or maybe already entered into it), because the owners of ordinary shares are most at risk in this situation . You also need to know if your leader is an IPO opponent. If your CEO / founder enters a round with “dirty” conditions and is also an opponent of an IPO, then the chance that you will ever be able to get something even remotely close to what you think they are worth now will be very, very low. You will probably be better off moving to another company.
INVESTORS
Explanation: It should be noted that the author of the article and his investment company belong to this category.
In most cases, early investors in unicorns are in the same position as the founders and employees. This is because companies after early investors have attracted so much capital that the early investor is no longer a significant part of the holders of voting rights or liquidation privileges. As a result, most of their interests coincide with the interests of holders of ordinary shares, and the desired key decisions on reimbursement and liquidity are the same as those of the founders. Such an investor will also be wary of a deal agreement containing “dirty” terms that have the ability to take control over the entire company. Such an investor will also have a rather strong fear due to the difference between paper and real incomes and due to the lack of total liquidity in the market. Or at least all of this must be present.
The exception is a late investor or a wealthy investor who may represent a substantial portion of all the money raised. This particular type of investor may have defended his property through active proportional or over-proportional investing. They may even have encouraged an aggressive forward-to-win aggressive mentality, knowing that they can continue to write checks. And they act as an irresponsible gambler at the poker table.
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Against this difficult background, many firms offer their companion contributors (LP) to take on new early investment commitments to their next fund at the very moment when evaluation is most difficult and concern about the situation may be at the peak of the cycle. In fact, deep down, most of the contributing partners (LP) know that the venture capital sector is anti-cyclical in relation to the amount of money raised by venture capital companies. With over-financing of the industry, total profitability falls. Huge investments in overblown multibillion-dollar venture capital funds can easily exacerbate problems that already exist.
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2. Brokers and third-class investment banks offering for sale secondary shares in unicorn companies. If you ask any large family capital management company, they will tell you that they are just bombarded with calls and emails offering secondary positions in unicorn companies. Often there are such baits as "a discount of 20-40% of the price of the last round."
3. The rising round of the unicorn. You may also be asked to simply add capital to a standard unicorn round. Being with many investors "at the planned level" because of the already accumulated amount of capital, some companies are looking "under every stone," where else would take the dollars.
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A few weeks ago, on March 31, 2016, the chairman of the Securities and Exchange Commission (SEC) visited Silicon Valley and made a speech at an event at the Law Faculty of Stanford University. For those who are involved in investing unicorns, or for those who are considering investing in them, it would be useful to read it completely (see here ). Interpretation of this presentation by Bloomberg is set out in the article " Silicon Valley must drive its unicorns into the paddock ."
The Chairperson, Ms. White, seems to be fully aware of the problems and impacts that could disrupt the process of financing unicorns:
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Source: https://habr.com/ru/post/300648/
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