I’m on a roll this weekend. 😉 Mario Rivera, a friend and an entrepreneur who I hope some day to do business with, commented my last post saying that there were instruments to address the valuation matter that was discussed in my last post. Truth is… He was right on! I had tried to simplify the discussion but did so overlooking instruments that the industry took ages to create in the US.
Particularly, he pointed that a preferred stock with liquidation preference would address the issue. To a large extent, he is right. Especially from the VC’s point of view.
A preferred stock is a different type of stock, which has different (often more) rights than a common stock. It is a version of the Brazilian PN/ ON system on steroids.
One of these additional rights, could be liquidation preferences. Normally that clause will state that the first that there is a minimum return for the Investor in case of sale/liquidation.
Lets go back to my previous example. You are raising $3M at $15M valuation but the VC puts a 6x (rather high) liquidation preference.
If you sell the company, this is what happens: At $100M sale, you’d get $80, the VC would get $20 and everyone would be happy.
However, if the sale is for less than 6x, the VC will get a disproportionate share of the proceedings. Say you are selling for $50. The VC has a guarantee of 6x, therefore is taking $18M (36%) and the founder, $32M. This becomes more extreme as the exit value goes down. If you get to the point where the exit is at $18M or lower, only the VC is taking money out.
In situations like that, another problem arises, why will the entrepreneur even work for a sale? The entrepreneur will either make the company unsellable, in the expectation that it will eventually become more valuable in the future, or he will simply abandon the company. Either way, serious misalignment of interests which has to be solved through other clauses.
Despite the specific discussion, I realized that the reason we don’t use many of these clauses is that the average entrepreneur in Brazil has little familiarity with them.
To address that, Fernando Okumura, amazing entrepreneur leading Kekanto, has sent me a paper done by LAVCA (Latin American Venture Capital Association) and Pinheiro Neto, detailing a wide variety of clauses and explaining them.
Another great source of information is the just released book Venture Deals, written by Brad Feld, from Foundry Group, which goes over all the aspects of raising VC, the process and the terms.
Both of these sources are great ways of educating yourself.
Thanks for the help Mario and Fernando!