VC and Angel Contracts: Why Over-Optimistic Entrepreneurs Lose Control of Their Companies - (Series
"In a sense, venture-capitalist financed firms are much like a marriage, in that the partners come to learn much about each other only after entering into the transaction, and, as in marriage, there is always the possibility that a divorce will ensue."
Imagine, for a moment you are an entrepreneur with an idea for a super computer inexpensive enough to target the average consumer. After years of perfecting the prototype in your garage on a shoestring budget, loaned from family and friends, several venture capital firms want to buy a piece of your company.
After their experts have finished their valuations and a deal has been signed for your company, you receives an influx of 1.5 million dollars over the course of several years through a VC syndicate. In exchange the venture firm took a 60% ownership interest in your company. However, after the years of slower than expected growth, the company has become part of the so-called “living dead.” The venture capital firm, once so supportive, is now desperately searching for a way to divest. But the company cannot be sold because it is too unattractive for any potential acquirers and could never successfully go public. You are relieved of duty as CEO and all the technical knowledge you have, that was once so valuable, is worthless. After you have been terminated a new CEO is able to turn slightly more profits, making the company marketable to potential acquirers. An industry giant decides to make a bid for sixty million for your company; but because of your contract* and a preferred controlled board you are left with nothing and are completely powerless to stop the acquisition.
After the Management Incentive Plan (MIP)** that went to the new CEO and key employees there is literally not a dime left to go to the common shareholders, which means you will not receive any of the proceeds of the sale. The dream to sell your company for millions of dollars turned into a nightmare. The dirty secret of venture capital is that sometimes the venture capitalists make millions in a sale, leaving the founders with nothing. This is an all too real situation that many entrepreneurs find themselves in.
Recent court cases have illustrated how this happens. Preferred shareholders used their contracts and a preferred controlled board to arrange mergers that allowed the venture capitalists to gets back their initial investment and left the entrepreneur with nothing. Many cases are never brought against venture capitalist or are unsuccessful because the contracts that the parties have entered into preclude the claims.
One-sided contracts, that favor the investor, stem from:
(1) the superior bargaining power of venture capitalist and angel investors during contract negotiation
(2) initial over optimism by entrepreneurs
This series is intended to close the gap between investors and entrepreneurs when contemplating a new venture in order to ultimately make the venture capital industry more sustainable. While no system is perfect, the need to increase transparency and fairness in the venture capital market is paramount. As the venture capital industry becomes a cornerstone of US economic growth, it is of the upmost importance to make sure that this industry is sustainable.
In the next post I will be discussing the differences between common and preferred shares and why preferred shares have become the almost exclusive vehicle through which VCs and Angels invest.
Click here if you want to read about the history of entrepreneurialism and venture capital in the United States and the reasons the US has such a vibrant venture capital market.
This article was written by Curtis Roberts, the founder of The Founder's Attorney.
If you have any questions or suggestions he can be reached at curtis@foundersattorney.com. You can check out his LinkedIn page here.
This is a weekly blog series that details the applicable documents when a deal is signed and how venture capitalist maintain board control of a new venture.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
Manuel A. Utset, High-Powered (Mis)incentives and Venture-Capital Contracts, 7 Ohio St. Entrep. Bus. L.J. 45, 45 (2012).
* The contractual sources of venture capitalist control are (1) the preferred stock purchase agreement, (2) the terms of the preferred stock, (3) the stockholders' agreement, and (4) employment agreements.”
** An MIP is a Board approved bonus paid to key management if a sale or merger is successful even if the transaction yields nothing for the common stock.