Home > Finance > Working with Investors > Angels and VCs: Don’t Be Greedy Even if You Can

Angels and VCs: Don’t Be Greedy Even if You Can

By: Dave Berkus

 

Angels and VCs Dont Be Greedy

Sometimes the end game or sale of the company is not a happy event for the early investors, including the entrepreneur or the founders. Especially when outside investors, venture capitalists or angels have put in substantial money, and the sales price is not enough to give them a reasonable return for the time and money invested, these investors can be—in a word—greedy.

Most sophisticated investors will take either a promissory note or preferred stock, both of which come before founder or management stock in a sale or liquidation. Promissory notes come before any equity, and most late equity investments come before early equity investments, even of the same class of security. This makes for some head-rubbing when attempting to calculate the return on investment with a proposed sale. Further, preferred stock holders can be recipient of accrued dividends in a sale or liquidation. A rather common but small dividend rate of six percent becomes a massive amount after seven years, almost half again the value of the original investment. And some preferred investors have participation rights, where they take all of the above amounts, and then also convert their shares into common stock and participate again alongside the founders and option holders.

It is in this combination of possible methods of amassing a return that greed can become a significant factor, so much so that the courts are sometimes stepping in to void some of the most onerous terms of investment agreements when challenged by those locked out of payment in a sale.

Take a situation where the VC investors finally see the chance of a return after ten years, with participating preferred and fifty percent of the ownership after several rounds. A marginal sale at twice their original invested amount could yield a starting value of eighty percent of the sales price to the VCs (fifty percent invested plus accumulated dividends for ten years at six percent which equals thirty percent of the sale price) and then fifty percent of the remaining twenty percent after participation. The result is that the preferred shareholders would receive ninety percent of a sales price that was double their investment, compared to ten percent shared by the founders and all others, including option holder-employees.

No-one complains if the sales price is ten times the investment, since there is plenty to go around. It is in these marginal sales that the formula distorts returns so badly in favor of the investors.

Fortunately, and perhaps because the courts have not looked favorably upon these outcomes, many VCs will voluntarily forgive either accumulated dividends or participation in a marginal sale, especially if the sale is cultivated, planned and carried out by the efforts of the common shareholders including the founders.

Related Article: Stay in Touch with Your Investors

Although many VCs are openly against allocating a “cutout” for management in marginal sales, practically speaking, management must be taken care of in marginal sales, or the sale might not happen at all. In a cutout, some percentage, usually fifteen or twenty percent of the total sale, is allocated to management in order to continue operations through the closing period and help in closing the sale. That further reduces the amount available to founders if not still in the ranks of management.

So this advice is directed to the investors. Don’t be greedy even if you can. You will not be moving your IRR needle enough by grabbing a few extra dollars in a marginal sale, but you will incur the wrath of a number of stakeholders who would be more than willing to spread the word far and wide about your greedy ways. And that reputation will last for a long time in the entrepreneurial community.

Conversely, I have praised and seen others praise VCs who volunteer to eliminate participation clauses even before knowing the ultimate sales price in a deal. It is those who receive the loudest accolades since they have given up a right for the good of the rest of the investor and management community.

Published: October 21, 2015
1165 Views

Source: Berkonomics

Trending Articles

Stay up to date with
Avatar photo

Dave Berkus

Dave Berkus is a noted speaker, author and early stage private equity investor. He is acknowledged as one of the most active angel investors in the country, having made and actively participated in over 87 technology investments during the past decade. He currently manages two angel VC funds (Berkus Technology Ventures, LLC and Kodiak Ventures, L.P.) Dave is past Chairman of the Tech Coast Angels, one of the largest angel networks in the United States. Dave is author of “Basic Berkonomics,” “Berkonomics,” “Advanced Berkonomics,” “Extending the Runway,” and the Small Business Success Collection. Find out more at Berkus.com or contact Dave at dberkus@berkus.com

Related Articles