Business implications of venture capital contracts

Liquidation preference paradox

Seasoned VCs such as Draper Fisher Jurvetson appreciate the contribution of entrepreneurs to the success of their enterprises. DFJ’s philosophy according to its web site: “Entrepreneurs are extraordinary individuals possessing unusual intelligence, energy, vision and drive, and should have large stakes in their companies that can generate great wealth for those who make the early sacrifices.”

While VCs may wish to motivate entrepreneurs to succeed, they sometimes motivate them to fail. Paradoxically, liquidation preference can be the culprit. Liquidation preference is defined as the amount of money to which the preferred shareholder is entitled upon sale of a company before distributions to common shareholders, including founders and management.

Dr. Abraham Ortal, a lecturer at the TAU law faculty, says: “VCs instruct their lawyers to protect their interests in case the investment does not perform as expected. However, the contracts that feature protections such as liquidation preference often fail to protect, and can even damage the economic interests of the VC firm. VC firms say ‘if it is so bad for us, we will fix it when the time comes.’ However, that method has significant transaction costs such as risking bankruptcy of the company.”

Dr. Ed Mlavsky, a veteran Israeli venture capitalist, also takes exception to mechanisms such as the liquidation preference except when limited to capital invested plus eight percent per year. He says, “Amateur VCs demand twice their investment. You cannot sustain such draconian terms when a new investor comes. Sensible people do not put them in investment contracts. They know what the world is about. Even participating preferred (liquidation preference plus pro-rata sharing of the remainder) causes some later investors to look askance.”

Some investors deride entrepreneurs unwilling to relinquish control to preferred shareholders calling it “founder’s disease.” Yet fully vested holdings in common shares can be wiped out by a single M&A decision. Risk of this scenario misaligns interests and discourages founders from relinquishing control.

The Napster story

A case in point is Napster, the company that enabled music downloads over the Internet. With Napster, an ill-conceived liquidation preference caused a VC to forfeit its entire investment despite a serious acquisition offer by a strategic partner. Modification of the liquidation preference provision would have allowed, according to insiders, the VC investor to recoup a large share of its investment.

Venture firm Hummer-Winblad acquired 21 percent of Napster as preferred shares with liquidation preference. When Bertelsmann offered $15 million to purchase Napster under a strict deadline, Hummer-Winblad, as a minority shareholder, needed to garner common shareholder support for the transaction. But the interests of the preferred shareholder and the common shareholders were not aligned.

The liquidation preference was close to $15 million. This meant that common shareholders would effectively receive no value for their common shares under terms of the offer. Hummer-Winblad was the primary negotiator. It structured the deal controlling where incremental value went. If the price went from $15 million to $20 million, the increase would go primarily to common holders.

Hummer-Winbald had no motivation to increase the price, but rather sought to shift incremental value to insurance against legal liability for themselves. Had the interests of Hummer-Winblad and the other common shareholders been aligned, Hummer-Winblad could have increased the incremental dollar amount while compromising on insurance. When the common and preferred did not agree quickly enough, the buyer walked away, and everyone lost. The company went bankrupt.

Structuring an initial deal

“When a company does not meet expectations, it is much harder to convince the representatives of the investors to improve the equity position of common shareholders,” according to Dr. Ortal. “It is much easier to agree in advance not to include in the contract conditions which wipe out equity value of common shares in case the investment does not turn out as expected.”

If the liquidation preference had a “carve out” mechanism, for example, limiting it to a maximum of 70 percent of the total pie, then for each incremental dollar, each side gets some-thing.

In a case where some percentage goes to common shareholders and some percentage goes to the preferred shareholders, all sides desire to maximize the price because they participate in each incremental dollar. Legal experts, such as VC lawyer Barry Levenfeld of Yigal Arnon, support including such a carve-out mechanism.

This article is based on Jonathan Stiebel's thesis, being written under supervision of Professor Joseph Gross of Tel Aviv University, Buchmann Faculty of LAW.

This article first appeared in the Israel Venture Capital & Private Equity Journal (IVCJ). IVC Research Center publishes the Israel Venture Capital & Private Equity Journal, a quarterly review of trends and developments in the Israeli-related venture capital industry. IVCJ, distributed worldwide, is dedicated to provide wide-range coverage of Israel's venture capital industry. For more information please visit www.ivc-online.com