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Exit Timing, M&A Misperception

How VCs Block Exits

by Basil Peters on August 28, 2010 · 1 comment

Most entrepreneurs don’t even know that a VC is likely to block an  exit when they accept the VC’s money. I didn’t when I started out —and neither did my friend who I describe in “Why VCs Block Good Exits“.

In my first company it wasn’t until the final extraordinary general meeting, when the shareholders were voting to approve the exit transaction, that I actually realized how aggressively a VC will try to block an exit.

VCs design their investment agreements to give them the power to block exits.  VCs worry that after they invest, the entrepreneurs will want to sell the company for something that might give the entrepreneurs a 100x return and the angels a 10x return but only a 3x return for the VCs. This concern was one of the reasons that VCs wouldn’t invest in Brightside.

My previous post, at the link above, has more on why VCs block good exits.

The Legal Mechanisms

VCs usually build in more than one way to block exits:

  1. The most effective way VCs block exits is with the terms in their preferred shares. Like my younger self, most first-time entrepreneurs have no idea how multiple share classes really work. For example, when I was starting out, I did not understand that different classes of shares each have to vote separately to approve important transactions. Usually, the VCs are the only ones with the pref shares, so they effectively have a built-in veto.
  2. VCs can also effectively block exits by dominating the boards of the companies in which they invest. This is usually a contractual commitment of their investment.
  3. They will also have terms and conditions in their investment agreements that allow them to make the decisions about when a company can exit.

Even the Y Combinator Docs Provide an Exit Veto

Paul Graham and Y Combinator are making enormous contributions to the evolution of entrepreneurship and early stage investing. Y Combinator invests very small amounts of money into early stage companies through an innovative, modern incubator model.

I admire Paul Graham for posting their term sheets and financing agreements. Even these simple agreements for very small, first financings contain absolute veto powers on exits:

“So long as any of the Preferred is outstanding,  consent of the holders of at least 50% of the Preferred will be required for  any action that: … or (iii) approves any merger, sale of assets or other  corporate reorganization or acquisition.”

I am not saying this is wrong. In an earlier post on Preferred vs Common Shares I point out that in some situations preferred shares are necessary to be fair to the investors. Even where there is a board in place, there may still be situations where it makes sense for the investors to have veto power on exits. There is, however, no way to solve the fundamental conflict of interest when holders of preferred shares sit on boards. Nor is there a way to repair the fundamental lack of alignment between common and preferred shareholders.

My point is that every entrepreneur and board must fully understand how their exit options will be impacted before accepting any pref share investment.

A Chilling Perspective from a Law Professor

For a fascinating, and chilling, perspective on how venture capitalists view entrepreneurs and exits, read this paper “Control and Exit in Venture Capital Relationships” by Gordon Smith of the University of Wisconsin Law School.

Smith has obviously spent a lot of time working with VCs. Some of his language provides an invaluable perspective into how VCs control  exits:

“In most venture capital contracts, veto rights are designated as “protective provisions”. They are also referred to by lawyers as negative covenants. For present purposes, the most important veto rights are those that prevent the company from forcing an exit decision…

Even if entrepreneurs value control highly, they cannot demand its retention at the time that they are seeking venture financing.

…this paper describes a relationship in which a combination of staged financing, board control, and contractual protections ensures that venture capitalists are able to pursue the most desirable exit options.

In these early stages of the relationship, the outside directors would usually be selected by consensus, as conflicts between the venture capitalists and entrepreneurs have not yet (fully) surfaced.

First, they use negative contractual covenants (often called protective provisions) to limit the ability of the entrepreneur to act opportunistically. These covenants typically prohibit the portfolio company from engaging in fundamental transactions (e.g., mergers) without prior approval of the venture investors, thus cutting off the means by which common stockholders have traditionally taken advantage of preferred stock.

In the early stages of the investment, therefore, venture capitalists are less concerned about initiating exit than they are about protecting against forced exit. As the business matures, new conflicts begin to play a more prominent role.

The tricky part of venture capital contracting stems from the need to make mid-stream adjustments which position the company for one exit strategy or another. The potential for conflict between the venture capitalist and the entrepreneur is most visible at these moments, and the key feature of the relationship is control.

Preferred stock has fallen out of favor with most investors, but venture capitalists rely almost exclusively on convertible preferred stock. Bratton attempts to explain why. Like A&B, Bratton relies on the notion of control. Where venture capitalists have full control – holding a majority of the votes in a corporation and electing a majority of the board of directors – the venture capitalist may block any potential opportunistic actions by the entrepreneur. On the other hand, where venture capitalists do not control the voting shares or the board of directors and rely exclusively on contractual covenants and other provisions for protection, room for entrepreneurial opportunism exists.”

This paper is not easy to read, but I highly recommend it for anyone considering a preferred share investment.

{ 1 comment… read it below or add one }

Basil Peters August 29, 2011 at 11:03 am

Comments from http://www.AngelBlog.net

pete 2 years ago (as of 2011-08-30)
This article is brutal but true. A must read. I was CEO of a very high profile company called Charitableway.com At a very early stage of a merger/acquisition that would have been slightly profitable for the VC and wildly profitable for me I was advised it would not proceed. This when it was becoming obvious that investment money was drying up in 2002. I voluntarily left with nothing within two months. Nobody got any return as a result. All my previous deals liquified properly, but this was the last straw. The alignment of common interest with the preferred is critical. On the surface it appeasrs they are aligned but when you factor projected returns they are clearly not. Even to the point of objectives for VC’s are a function of where you are in the lifecycle of the fund. Now I finance my own deals.

basilpeters 2 years ago (as of 2011-08-30)
Pete – thanks for sharing this “war story’ and for your kind words on my post. The same thing almost happened to me in my first company. I had no idea how aggressively VCs would try to block an exit. I narrowly escaped losing everything after ten years of hard work. Since then, several of my friends and acquaintances have not been so lucky. My goal is to shine a light on this aspect of preferred shares and to stimulate more dialog like this. My hope is that younger entrepreneurs will have better information than I had.

From_Hacker_News 2 years ago
From Paul Graham on Hacker News 20090120:
No YC-funded company should be surprised like he was. We tell them all what they’re signing up for depending on whether they take angel money or VC, and at what valuation.
If you sign up for VC, you’re signing up to take over the world– to at least try to get IPO huge (even though IPOs themselves have currently disappeared). This is ok with founders who were planning to anyway. Founders who aren’t sure, or are sure they aren’t, should only take angel money.
Though nearly all later stage investors want a veto on acquisitions, the point where they’ll exercise it varies a lot. It depends mostly on the valuation. As a rule no investor is happy with less than a 5x return, unless the valuation was huge (e.g. in mezzanine round) or the company is in trouble. Over 5x they may still grumble, but most will let you sell the company if you really want to. Or they’ll arrange for founders to sell some of their shares privately. Over 10x they’ll generally be pretty happy.

From_Hacker_News 2 years ago
From BasilPeters on Hacker News 20090120:
Paul – I agree with you. No VC backed company should be surprised, but in my experience, many are. I believe most entrepreneurs don’t really understand share classes and the practical implications of many terms in their investment agreements. Others may understand the terms but are surprised by how they are applied. I applaud your outstanding work in helping to maket this clear to entrepreneurs everywhere. Keep up the great work!

From_Hacker_News 2 years ago
points by sachinag on Hacker News 20090120
Paul, but the YC sample docs give YC a veto over change of control as well. It’s not just the VCs who want that power. Now, you may never have – and state that you never will – exercise that right, but if so, then why is it in there?

20 points by pg on Hacker News 20090120
The docs he linked to are the Series AA docs we commissioned for YC alumni to use to when raising money from -ater stage investors. They’re not the docs YC itself uses.
In our agreement the clause about change of control is more limited. We only have a veto over selling the company for less than 3x the valuation we invest at. The point of that kind of clause is not to ensure returns (on average, a 3x exit would make us the massive sum of $35k) but to prevent abuse– e.g. someone selling the company to his brother for $1. Any subscription agreement will have at least that kind of restriction in it.

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