At the HBS VC Alumni event I was at last week (no – I didn’t go to HBS – I was a panelist) I heard a great line from a wise old VC who has been a VC about as long as I’ve existed on this planet.
“VCs only need three rights: Up, Down, and Know What The Fuck Is Going On”
If you’ve read Venture Deals: How To Be Smarter Than Your Lawyer and Venture Capitalist, you already know that Jason and I agree with this statement. And even though a term sheet might be four to eight pages long and the definitive documents might be 100 pages or more, other than economics, there are really only three things a VC needs in a deal.
Up: Pro-rata rights. When things are going well (up) a VC wants the ability to continue to invest money to maintain their ownership.
Down: Liquidation preference. When things don’t go well (down), a VC wants to get their money out first.
Know What The Fuck Is Going On: Board seat. Beyond demonstrating that older VCs also swear in public, many people believe that with a board seat comes great power and responsibility. In reality it mainly gives one the ability to know what’s actually going on, to the extent that anyone knows what’s actually going on in a fast moving startup.
As I was writing this up, I remembered that Fred Wilson had a post about this a while ago. I searched his blog (using Lijit and the term pro-rata) and quickly found a great post titled The Three Terms You Must Have In A Venture Investment. He attributes this to his first VC mentor, Milt Pappas, and the three terms are the same ones referenced above. It’s a great post – go read it.
Entrepreneurs – don’t get confused by the endless mumbo-jumbo. If you haven’t read Venture Deals: How To Be Smarter Than Your Lawyer and Venture Capitalist grab a copy. Or read blogs. Or do both. And VCs – don’t forget what terms you really care about – focus on making it simple.
On Friday, I saw a tweet from Chris Sacca about super pro-rata rights that said “Seeing a lot of VCs cram super-prorata terms into deals. Feels uncool to me. Any good arguments for why it’s helpful to entrepreneurs?” I quickly responded to Chris on Twitter with “@sacca just say no to super prorata” and then opened up a WordPress window and scribbled some thoughts for a draft post on that that I was planning to put up Monday morning (now).
On Sunday, I saw a phenomenal post from Mark Suster titled Why Super Pro-rata Rights are Not a Good Deal for Entrepreneurs. In it, he covers many of the reasons I was planning to cover. He also does a great job of setting up how pro-rata and super pro-rata rights work. It’s a must read post for any entrepreneur doing a seed or early stage financing.
Mark talks about why super pro-rata rights are suddenly appearing regularly, but I think he’s being too nice about it. He says:
“Often it’s when a larger fund (e.g. non seed / micro VC fund) wants to put in $500k (less than their typical investment) but wants to have a marker on your company if you end up being super hot. In my mind, it’s almost like a dog pissing on its territory. Read: it’s an option for that investor and a super expensive one to you, the entrepreneur.”
This behavior is not limited to large funds. I’ve had two investments over the past year where smaller funds tried to argue for super pro-rata rights in the seed round. In one case they argued that they were going to do more work than the other two investors (which included me); in the other case they stuck with the 20% argument but said “we have to have 20% after the next round in order for us to want to work on this investment.” In both cases the entrepreneurs ultimately decided not to include the firm insisting on super pro-rata rights in the round.
I’ve also starting seeing this ask all over the place with the “new” seed programs that large funds have. This is a subset of the case Mark is referring to, but it’s actually more annoying than Mark makes it out to be. In the last two years, many large established VC firms have created “new” seed programs. These are firms that have historically positioned themselves as early stage investors, but in some cases explicitly stopped doing seed rounds while in others simply drifted away from them. Suddenly, they are back, with seed programs aimed at making high velocity investments in brand new companies.
I applaud these firms, but only if they are doing their seed investing in a way that is consistent with how they position the activity as “entrepreneur friendly.” Specifically, if you are entrepreneur friendly and you do a seed investment, you do not need or even want a super pro-rata right. Instead, you should earn the right to invest above your pro-rata in the next round through early engagement with the company, hard work, and active help for the company. This behavior is “entrepreneur friendly” and is the spirit of how many firms are talking about their seed programs (e.g. we make decisions quickly, we treat you like any other company we invest in, and we help as much as we can.)
Now for firms that insist on super pro-rata rights, they should call it how it is. Which is “we are tossing a tiny amount of money in you now but we want to reserve the option to own a lot more if you are successful.” Mark calls this dynamic out specifically in his post, but doesn’t put it on the VCs. It doesn’t actually bother me that a VC might want to take this approach; I just don’t think an entrepreneur should ever accept it if he has any other choices.
In many cases, I’ve seen the VC request for super pro-rata rights collapse in the context of a hot seed investment. The entrepreneur holds all of the cards in this case and should use them, as it gives the entrepreneur many more options in the next round. If the VC insists on the super pro-rata right, make sure you really understand what is going on, as this negotiating posture (and philosophy) on the part of the VC will likely surface again in the future.
To all my VC friends – take a page from the super angel playbook. If you want to do seed investments, or have a formal seed investment program, model it after the super angels, especially the ones who have raised small VC funds. These guys make small investments, bust their asses for the companies they invest in, and often get opportunities to invest more in the next round. In a lot of cases, they don’t have the capacity to do anywhere near what you could do, but in all cases I’ve been involved in, the entrepreneurs have fought for these seed investors and as someone who doesn’t feel the need to be the first money in a company, I’ve always tried to accomodate the request for more than pro-rata in the context of the new financing I’m leading.
And yes Chris – it’s definitely uncool.