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The “VC Bargain”

With the recently announced acquisition of our portfolio company MakerBot, the conversation invariably turns to “was this the best time for the company to sell?”

It’s a question that is asked every time a company sells and it usually creates a lot of noise by people whose opinions are usually misinformed and even more so, irrelevant.  The question is asked over and over and over again:  “When is the correct time for a startup to sell itself?”

The answer is simple:  “When the founders want to sell.”

Period.

Unfortunately, many investors do not feel this way.  Clearly, a VC can be very helpful in advising the founders about past experiences, the current state of the M&A market and their thoughts around valuations, but when the founders want to sell, it’s time to sell the company.  Who are we to tell the founders that they aren’t allowed to fulfill their dreams and create an event that will change their lives?

Brad and I have written a lot about venture term sheets.  (Plug:  buy our book!).  One thing we haven’t written about, however, is what we call “The VC Bargain.”

We believe this “bargain” is inherently created when VCs invest in a company.  And no, this isn’t in the legal documents, but should be part of a mutual understanding by both parties.  (Note, however, we’ve seen some VCs and many late stage funds actually try to draft into the documents at what valuations founders may sell at and we find this practice distasteful).

If a VC is playing for a longer / bigger outcome, then it is the responsibility of the investor to create some financial liquidity for the founders and employees that makes them feel secure.  The situation we hate is one where the founders and employees receive nothing except the message “no, you can’t sell, keep running the business.”

But this isn’t solely as one-way bargain.  If you take venture money, you have a duty as well.  You have a duty to actually work toward a liquidity event.

From time to time, we’ve encountered entrepreneurs who really aren’t interested in selling their company.  This has been expressed both explicitly “I have no intentions of ever selling my company” to more implicitly whereby an entrepreneur continually finds fault with potential buyers (“I hate their culture,” “I don’t like big companies,” etc.).

Few companies can expect to go public.  Therefore, the acquisition market is the only way for investors to create proceeds to return to their limited partners.  And everyone should know that our job is to take our investors money, invest it and return a lot more money to them.   Without acquisitions, we can not do this.

It amazes us, but we find that some entrepreneurs don’t actually realize (or respect) this when they take on investment.  Yeah, we know you don’t normally gravitate working for big companies (otherwise, why start your own?), but at some point, if things go well, BigCo may be correct path of the company.

Bottom line is that this VC Bargain is an important one in the startup ecosystem, but one that is not well understood by some.

June 25th, 2013     Categories: Entrepreneurship, Financings, Venture Capital    
  • jusben1369

    Great post. Makes a lot of sense. I’m struggling with the title though. I think you’re trying to get across “Hey, this is a two way street. VC’s shouldn’t lean on founders to sell unnaturally but founders need to understand that we as VC’s do need an event to keep doing what we’re doing” The title made me think that a VC was getting a really cheap deal on something.

    • Jack Holt

      “Covenant”?

    • http://www.feld.com bfeld

      How about “The Pact a VC and an Entrepreneur Make When The Entrepreneur Takes Financing From a VC.”

      Recently, our government has been talking about “Grand Bargains.” http://www.nytimes.com/2013/01/01/us/politics/grand-bargains-give-way-to-legislative-quick-fixes.html?_r=0

      I think Jason is building off of that language / construct. Think of it as the “grand bargain” between a VC and an entrepreneur. The VC sells when the entrepreneur wants to. The entrepreneur knows that the VC ultimately needs a path to liquidity.

      • Dan Farfan

        While there is economy to “VC Bargain” it doesn’t quite work because “bargain for VC’s” is not what’s intended.

        “VC Calculus” works better in my opinion in part because besides the points raised in this terrific post, there are many, many others.. as you all know. :-)

        (anyone reflexively afraid of math words, should be afraid of VC’s, Angels, and heck… for-profit startups! lol )

        • http://www.feld.com bfeld

          Hah! I like “VC Calculus.” I also like “The Implicit Agreement You and a VC Make When You Take VC Financing.”

          • http://gawk.it/ falicon

            The give and take of VC funding…or maybe…the implicit agreement when you’re VC funded.

  • http://www.semilshah.com/ Semil Shah

    This is a great post because it articulates what many don’t have the courage to say upfront and publicly. Thanks for writing it.

  • Chris Yeh

    Here’s where I think relationships are key. As an entrepreneur, I’ve always wanted to deliver a good outcome for my investors because many of them were personal friends or people I respected for trusting me with their money.

  • Richard J Keck

    Thanks for the candor, and the public acknowledgement that some liquidity is a reasonable aspiration for an entrepreneur. In my view, great entrepreneurs will be even more productive when they know they have amassed a little security. In my view, entrepreneurs don’t start businesses to build a little security — we start businesses to create enormous security. So, sharing an appetizer with your entrepreneurs is probably just a warm up for the main course they will share with their investors.

    • http://www.feld.com bfeld

      It used to be the case that investors said “you can’t get out until I do.” My biggest failure was a company called Interliant. We created a company with a $3b market cap in the public markets that went bankrupt a few years after the Internet bubble burst.

      The founders stock was directly linked to the investors stock (I was a co-founder). We couldn’t sell anything until the lead investor sold. They never sold.

      My entire view on the idea around exits for the entrepreneur changed on this after that company.

  • Saul_Lieberman

    Are you saying that your deals don’t include a “protective provision” which requires your consent to an exit? Isn’t that designed to ensure that you ultimately get to make the decision? And that you will be entitled to make that decision as shareholder, without the constraints of your duties as director?

    • http://www.feld.com bfeld

      We do have protective provisions, but I don’t think we’ve ever exercised them to block a deal. I know VCs who do. We won’t. It’s not how we approach it.

      The shareholder vs. director duties diverge in many cases. That’s one of the biggest challenges for a VC investor who is also on the board of a company. I have been in many board rooms where a VC says “I’m taking off my director hat now and putting on my investor hat.”

      I’ve started telling those VCs to resign from the board if that is what they are going to do. If they want to blend these responsibilities, they have to be able to use their judgement, and have their judgement rooted in a point of view about what they are trying to accomplish.

      I (and I know Jason does also) takes his fiduciary duties as a board member very seriously. We also take our fiduciary duty to our LPs very seriously. But they aren’t abstract constructs we can hide behind (e.g. “we have a fiduciary duty to …”) It’s a total cop out in a very dynamic situation to do this – both in the upside and the downside case.

      Remember, Jason was once a lawyer. Part of his brilliance is that he has extraordinary business judgement. And a consistent philosophy that lines up with it.

      • Saul_Lieberman

        “Who are we to tell the founders that they aren’t allowed to fulfill their dreams and create an event that will change their lives?” Well, the protective provision is structured to be able to tell the founders they can’t sell. And putting it at the shareholder level allows you to make that decision without being concerned about a fiduciary duty.

        You can get to the “right” result by choosing when to exercise your protective right. I am not suggesting that you don’t in fact get to the right result. Still, I find some dissonance between your “Who are we” statement and your standard protective provision (which you shouldn’t need or should only be exercised at the director level).

        • http://www.feld.com bfeld

          Fair point from a technical perspective, but not from a functional perspective. I don’t believe, in the history of all the companies I (or Jason) have been involved in, that we’ve ever used a protective provision to block a sale.

          I can imagine one situation where we would. An entrepreneur wants to sell the company to another entity that is 100% owned by him as a way to eliminate the investors from the cap table. If the consideration is appropriate, then we’d support this. If the consideration wasn’t (say it was for a dollar) but the entrepreneur has majority control of the company, we wouldn’t support this.

          • Saul_Lieberman

            I think we agree on the technical and functional perspectives.
            Your imagined abusive situation (which could happen) could be extended to every aspect of a startup’s life — we usually rely on the usual corporate governance and law to address that kind of abuse.

          • http://www.justanentrepreneur.com Philip Sugar

            This is the conundrum of writing deals. One person is saying trust me we won’t do something bad (block a great exit) but at the same time saying I don’t trust you (sell to eliminate investors)

            So I see your point. But I take just the entrepreneurs point of view.

            Look at the balance of power. If I sell to myself you are going to have lawyers kill me every which way and you have much deeper pockets. If you block a sale and it is your right even if it is a dirty deal I just get to eat your shit sandwich.

            We know which way the deal gets written because of the balance of power, you have the money the entrepreneur doesn’t. I call it the prenump deal. The only thing i ask is don’t hide behind the I have a “fiduciary duty” line. Woman up and say sorry that’s the way this is dude, we write this shit if things go bad, and if they do understand you are on the bottom.

          • http://www.feld.com bfeld

            I think your comment (to woman up) is the whole point of Jason’s post. He’s saying “if you take VC money, make sure you understand the bargain your are making.

            I get the entrepreneurs point of view completely. I can’t remember the last time I used the words “fiduciary duty” except to make fun of other people.

          • http://www.justanentrepreneur.com Philip Sugar

            We agree. My only point is that just realize you put the term in because you can. I love that you use fiduciary duty to make fun of people.

          • http://www.feld.com bfeld

            Yup.

  • Dan Farfan

    “Few companies can expect to go public. Therefore, the acquisition market is the only way for investors to create proceeds to return to their limited partners. ”

    I know it may seem old-fashioned, but what about profit sharing or even revenue sharing? Is positive cash flow so rare for a tech company these days that it’s not even considered a realistic future position? Pre-revenue grand slams (ala instagram) are still considered too rare to really plan or even hope for, right?

    Perhaps more spreadsheet time noodling a business model more creative than lets-trick-millions-into-being-users-then-punish-them-with-ads would help a lot.

    @DanFarfan

    • http://www.feld.com bfeld

      The kinds of companies we invest in rarely lend themselves to profit sharing. While this is something that comes up every now and then, and may come up more in the future, the dynamics of a VC fund (10 year life) and the types of companies funded (heavy losses in the early years as you try to achieve real scale) tend not to fit this model.

      And – when they do – they usually go public given their growth rates – where they will be valued as growth companies.

      Recognize that you can increase growth by investing your profits back in the business. Which increases scale, which increases value!

  • @scalingwalls

    What is the best way for an entrepreneur to discover which VCs operate with a different mindset? (ie. those that habitually block deals)? AngelList? Word of mouth? A better way?

    • http://www.feld.com bfeld

      Word of mouth is by far the best. Talk to other entrepreneurs – both in upside and downside cases – who have worked with the VC. And focus on both firm level and individual partner level references.

      • @scalingwalls

        Good highlight of the importance of reverse diligence. I wonder how much entrepreneurs actually focus on this? Thank you -

        • http://www.feld.com bfeld

          Not enough.

          • Jack Holt

            Speaking of which, what kind of info can an entrepreneur expect to get from the VC?

          • http://www.feld.com bfeld

            The best info is going to come from other entrepreneurs who have worked with the VC and VC firm.

  • Jim Patterson

    With my first company, we had an offer on the table that would have resulted in a 4x return (< 2 yrs). I had some wise counsel that said to me "Know thy multiple." I did not sell to them, but instead sold a few months later at a higher multiple (+ an earnout). I would advise folks when they sell to BigCo to be more concerned about the ability to cleanly leave BigCo with minimum of competitive restrictions (and no claw backs) than a maximized price.

    • http://datasystemics.com/ Joseph Weaver

      Yes. It’s a wonder how BigCo sometimes operates under the assumption that keeping people leashed that do not want to be leashed is actually good for business. OtherBigCo that is an amazing place for an entrepreneur to work would not have to worry about this, right? OtherBigCo would be more successful because of this, right?

      • Jim Patterson

        Joseph, to be fair, BigCo is paying for an asset and they want to protect the value of the asset. Sometimes that includes people, other times that is customers, other times intellectual property, and other assets.

        My comment above is not that BigCo is bad or evil, but, just as entrepreneurs can become enamored with their first pre-money valuation, the strings attached with an exit can have a materially different effect on the founder than on the VC (they do not have the same competitive restrictions). The VC is not party to this part of the “exit bargain”

  • http://www.pointsandfigures.com/ pointsnfigures

    what about a situation where there is a buyout opportunity, the founder really doesn’t want to sell-but in your analysis you think it’s best for the business to sell, and for your LP’s to exit the investment?

    should add-it’s been a difficult relationship with the founder and there is no continuous game-you won’t do business again together.

    I think you alluded to it at the end-but do you force the issue as a board member?

    • jasonmendelson

      I would never force this as an issue. You can have deep discussions and opinions, but it is ultimately the founder / CEOs call.

  • http://datasystemics.com/ Joseph Weaver

    Thanks to Brad for the link to your blog in a recent post; I’ll likely start frequenting it now. Thinking holistically, selling only when the Founders want to sell is best in any scenario; it’s just that some investors may fail to fully realize (or care about) the dynamics of aftermath. Kudos to you guys for sticking to the theme of “What’s great for great people is great for me”. Of course it’s not always possible to ensure a Founder will react rationally in these circumstances.

  • Jill Spruiell

    Thank you for the insight.

  • http://www.feld.com bfeld

    There is a new grand bargain to discuss.

    • jasonmendelson

      Then let us discuss!

  • Pascal Levensohn

    A very interesting topic- I would modify the bargain a bit. If the founder wants out and you, the investor, don’t, is it because you believe it is not the right time for the company to be sold? In that case you should buy out the founder at a price they will accept and then play on without them. We did this with a particularly promising company where the founder became completely risk averse. The result: when we sold several years later, the remaining management team and investors made 10X more than the founder who insisted on selling prematurely.

    • jasonmendelson

      I don’t disagree with this approach assuming that you can replace the founder and still have a strong management team. Many times the founder and the company aren’t separable.