When I wrote my first post on the structure and financial components of a typical venture capital investment – where I described Liquidation Preferences – I alluded to the concept of participating preferred as a maligned and typically hotly negotiated issue in many venture capital investments. In this post, I’m going to try to explain the notion of participating preferred (referred to hereafter as PP), how it works, and its financial and emotional impact on a deal. I’m not going to take sides, but rather try to give a broad perspective on it.
First – some history. I first encountered PP when several of the angel investments that I did in 1994 and 1995 matured to the point where they raised a round of institutional venture capital. Since I was living in Boston at the time, most of the VCs looking at my angel deals were east coast firms. In every single case, the initial term sheets each of these companies received included a PP feature – a “double dip” as my east coast lawyer called it. When we pushed back on the PP, we were told that all east coast term sheets had them (our lawyer told us it was negotiable, but that it was definitely an east coast standard request). The PP survived several of term sheet negotiations, but not all of them.
My east coast-centric world changed significantly after I moved to Colorado in 1996 and started doing venture capital. Because of geography and investment focus, I ended up working on more stuff on the west coast. There, I rarely saw a PP feature and was told flatly that PP was “an east coast term.” As the 1990’s marched on and the bubble started to build, I rarely saw a PP – even the east coast guys had dropped it from their standard term sheets.
After the bubble burst in 2001, PP was back – and this time on both coasts. Suddenly every term sheet I saw had a PP feature in it, regardless of the stage of the investment, type of business, or location of investor. It had once again become “a standard feature”, although it was now bi-coastal (or – more accurately – a red-blooded American term.)
So, with this as background, and before we dig into the actual mechanics of a PP, lets first recognize it for what it is – an economic feature in a venture investment. It’s not a standard term, nor is it something that is evil and should never be part of a deal. Unlike a liquidation preference which is rarely negotiable with a VC, a PP is almost always negotiable. There are even cases where it economically disadvantages an early stage investor who insists on it in the deal from the beginning. Importantly, there is not a consensus among investors on when a PP feature is appropriate in a deal and each firm approaches it from their own, unique perspective.
A PP is the right of an investor, as long as they hold preferred stock, to get their money back before anyone else (the “preference” part of PP), and then participate as though they owned common stock in the business (or, more technically, on an “as converted basis” – the “participation” part of PP). It takes a preferred investment, which acts as either debt or equity (where the investor has to make a choice of either getting their money back or converting their preferred shares to common), and turns it into something that acts both as debt and equity (where the investor both gets their money back and participates as if they had converted to common shares).
To illustrate, let’s take a simple case – a $5m Series A investment at $5m pre-money where the company is sold for $20m without any additional investments being made. In this case, the Series A investor owns 50% of the company. If they did not have a PP, they would get 50% of the return, or $10m. With the PP they get their $5m back and then get 50% of the remaining $15m ($7.5m), resulting in $12.5m to the Series A investor and $7.5m to everyone else. In this case, the Series A investor gets the equivalent of 62.5% of the return (rather than the 50% which is equivalent to their ownership stake). The PP results in a re-allocation of 12.5% of the exit value to the Series A investor.
Obviously, this can get much more complicated as you start to have multiple rounds of investments with a PP feature. A simple way to think about how the economics of a PP works is that the total dollar amount of the preference will come off the top of the exit value (and go to the investors); everyone will then convert into common stock and share the balance based on their ownership percentages. For example, assume a company raises $40m over 3 rounds where each round has a PP feature and the investors own 70% of the company. If this company is sold for $200m, the first $40m would go to the investors and the remaining $160m would be split 70% to investors / 30% to everyone else. In this case, the investors would get a total of $152m, ($40m + $112m, or 76% of the proceeds – 6% more then they would have gotten if there was no PP.)
If you sit and ponder the math, you’ll realize that a PP usually has material impact on the economics in low to medium return deals, but quickly becomes immaterial as the return increases (or – more specifically – as the ratio of the exit value to invested capital increases). For example, if a company is sold for $500m, a $10m PP re-allocates a small portion of the deal ($10m of the $500m) to the investors vs. the $40m of $200m or $5m of $20m in the other preceding examples. As a result, a PP usually only matters in a low to medium return situation. If a company is sold for less than paid in capital, the liquidation preference will apply and the participation feature will not come into play. If a company is sold for a huge amount of money, the PP won’t have much economic impact, as the preference feature of the PP becomes a small percentage of the deal total. In addition, in essentially every case, PP’s don’t apply in an IPO where preferred stock (of any flavor) is typically converted into common stock at the time of the offering.
As PP started showing up in more deals, some creative lawyer came out with a perversion on the preferred feature called a “cap on the participate” (also known as a “kick-out feature.”) In this case, the participation feature of the PP goes away once the investor holding the PP reaches a certain multiple return of capital. For example, assume a 3x cap on a PP in a $5m Series A investment. In this case, the investor would benefit from their PP until their proceeds from the deal reached $15m. Once they reached this level, their shares are no longer counted in the cap structure and the other shareholders share the remaining proceeds. Of course, the investor always has the option to convert their shares to common stock and give up their preferred return (but participate fully in the proceeds). Put another way, at a high enough valuation the investor is better off simply converting to common (in the current example at an exit value above $30m).
Participation caps, however, have a fundamental problem – they create a flat spot in most deal economics where the investor gets the same amount across a range of exit values. If we stay with the example above and assume a 50% ownership for the Series A, the PP would apply until the exit value reached $25m, at which point the investor receives $15m in proceeds. Between $25m and $30m, the investor would continue to receive this same $15m (this is the flat spot – it doesn’t matter whether the exit value is $26m or $29m, the investor would get $15m). At exit values above $30m, the investor would convert to common stock and take 50% of the proceeds (i.e., their as-converted share of the proceeds would exceed the $15m cap so they would be better off converting to common and taking this share of the exit value). This is an odd dynamic, since the common shareholders are clearly not indifferent to exit values in this flat spot, but the investor is (and consider a case where this flat spot was much larger than the one in the example above). Any way you cut it there is misalignment, at least for a range of outcomes, between the investor and the rest of the shareholders.
Another perversion is the “multiple participate”. In this case, the investor gets some multiple of his participate off the top of the transaction. For example, a 3x multiple participate on a $40m investment would mean the first $120m would go to the investor (and then the remaining proceeds would be distributed to the investor and the rest of the shareholders). This type of PP only appeared for a short while when investors were doing recapitalizations without actually going through the mechanics of recapitalizing the company (more about this in a future blog post).
Interestingly, there is a case to be made that PP in early financing rounds can actually end up disadvantaging early investors. The math on this gets complicated very quickly, but if you assume that every subsequent investment round has at least as favorable terms as the initial round (i.e., include a PP if the first round does) and that subsequent rounds include new investors there are many cases where the initial investor is actually disadvantaged by the existence of the PP (they would have been better off to have not put it in the initial round and because of that pushed for its exclusion from subsequent rounds). It’s counterintuitive, but it actually works out this way in a number of very common financing scenarios.
So – if PP simply relates to economics, why is it a term that brings out such emotion in entrepreneurs and investors alike? A close friend of mine who is an extremely successful entrepreneur recently told me “I’ve walked on every investment deal for any company that I’ve run that even smelled of multiple dips of participation – and spit back in the direction the term sheet came from!” We debated back and forth a while. For example, I asked him “would you take $5m for 33% of a company with no participate or 25% of a company with full participate?” He responded “I would go find a deal where I gave up 26.5% without a participate” which, while an emotional reaction, ironically reinforced my point that it was just economics. After pondering this term over the years, I’ve concluded that participating preferred is one of those terms that creates real tension between the entrepreneur and the investor – it forces the acknowledgement by the entrepreneur that a moderate return is not a success case for the investor and at the same time forces the investor to acknowledge that in those moderate cases they believe it is fair to receive a greater percentage of the proceeds at the expense of the entrepreneur.
Everyday Matters is a remarkable book. If you live in New York; have a family member who has had a tragic accident or a crippling disease; or are subject to bouts of depression, you must read this book.
I came across the book while I was browsing in my local bookstore in Homer. The cover caught my eye but the excerpt on the back captured my attention. It was a drawing of the eight stages of an apple being eaten with the quote “Two years before I started drawing, my wife was run over by a subway training and nearly killed. Well, this book is about how art and New York City saved my life.”
Danny Gregory has created a beautiful book with his words, drawings, and ideas. Thankfully he has a blog so I can get a dose of him on a regular basis.
I bought the book ‘Your marketing sucks” because of the title. While I didn’t expect much from it, it was worth reading. It’s a quick and easy read that I recommend it to any CEO who thinks marketing isn’t working as well as it could for his company.
I’m the second guy to admit that I don’t really know jack about marketing (Steve Bayle is the first – he’ll readily admit that I don’t have a clue.) I came to this realization in the middle of the Internet bubble. I was sitting at my desk in Colorado one day when I received a giant overnight package from one of my investments that I’ll refer to as YACOTWTF (“Yet Another Company On The Way to Failing”). It was an unusually large overnight package and I wasn’t expecting anything, so I was curious. When I opened the package, inside was a giant picture frame with a note taped to it. The note said “Congrats on the great ad we’ve placed in Red Herring Magazine.” I looked at the picture and it was a giant (poster sized) framed (in glass) replica of the ad. My first thought was “why the fuck did they send this to me?” I read the ad. My second thought was “what a shitty ad – it doesn’t say anything about what YACOTWTF does.” My third thought quickly followed, “What did we pay for this?” You can see where this was going. “Did I approve the marketing budget”, “Who is the VP Marketing again”, “I better call the CEO to fire the guy.”
After this ran its course, I called up my doctor, made an appointment at a special top secret medical facility for entrepreneurs and venture capitalist (there are two separate buildings but the dining hall and gym are shared), and had an operation that replaced the phrase “marketing” with the phrase “demand creation” in my brain. Oh – and the ad campaign – which cost $2 million in total (unfortunately, Red Herring wasn’t the only place a full page ad was run) – generated ONE lead and ZERO customers. The company went out of business about a year later. If YACOTWTF was the only company on the planet that did something as dumb as this it’d be one thing, but they had plenty of company as many of the Internet bubble companies spend grotesquely more than $2m on “marketing” that had zero return.
It should be no surprise to you that I didn’t hang the ad on my wall in my office. Our building is two stories high – glass makes a neat scatter pattern when dropped from that height (although it was a pain in the ass to clean up.)
This book reinforced a lot of messages around using that thing that I refer to as demand creation to generate value in your business. I knew I’d at least enjoy the book (even if it wasn’t good) when the first chapter started out with the rule that “Marketing is not about spending money on such things as advertising, direct mail, and P.R. Those are just tools. Marketing is about growing your business – its revenues, profit, and valuation.” Ok – well – duh – but it’s often overlooked. When the author started the next chapter with “Most companies make salesmanship the last step in the marketing process. Most companies are wrong: Salesmanship should have come first” I was hooked – at least for the hour it took me to read the book.
While the book has all the flaws of today’s typical business book (author platitudes followed up by mediocre and often self-serving examples, desperate need of a better editor, and reader fatigue after about 150 pages), it’s still a worthwhile book for a CEO struggling with demand creation (I mean marketing).
We invested in NewsGator in June and Greg Reinacker and crew have been hard at work building out the next generation of NewsGator for Outlook and NewsGator Online Services (NGOS).
NewsGator is now providing RSS feeds for University Wire (U-WIRE) content as part of NGOS. U-WIRE is a free membership organization for the college press. As many as 300 student-produced stories are gathered and edited every day by U-WIRE’s staff, then made available to nearly 700 college media outlets. Their daily feed is a collection of the best news, opinion, entertainment and sports content produced by the nation’s college newspapers.
This is the second premium content offering NewsGator has announced this month – the other is with Leadership Development Expert Gene Mage. Look for more premium content coming soon.
Newmerix announced today that it had raised $7m in a new financing. Siemens Venture Capital was the new lead investor, joining us and IDG Ventures.
We provided Newmerix’s seed financing – with IDG Ventures – in early 2003. The vision of the founders – Niel Robertson and Ed Roberto – was to create a family of software products that take an entirely new approach to addressing the issues faced by packaged application development teams. As packaged applications – such as Peoplesoft, Oracle, SAP, and Siebel – have become increasingly widespread throughout enterprises, the teams within IT organizations who are responsible for modifying, testing, deploying, and supporting these packaged applications have been hindered by tools that are fundamentally inadequate for the job. Newmerix’s products take a revolutionary new approach to helping these folks who are impacted by the inability to easily implement changes to their packaged application infrastructure.
We funded a first round with IDG in the summer of 2003. I’ve been thrilled with Newmerix’s progress – they launched their first product in February 2004 (less than 12 months after the seed financing – a short time for an IT Management software company) and landed their first reference customer in May.
They’ve had a great summer – both adding customers as well as completing a solid financing that will enable us to focus on growing the company to the next level. We were also able to convince Wendy Lea – a superstar entrepreneur that we’ve worked closely on several companies – to become chairman of the company. Wendy most recently was a senior exec at Siebel running their eBusiness Consulting unit after they acquired Wendy’s last company – OnTarget.
Newmerix’s currently shipping products are for Peoplesoft, so if you know anyone running Peoplesoft that might be interested in Newmerix’s products, please send them our way.
Seth Godin’s ChangeThis project has officially launched. ChangeThis – in their words “is trying to create a new kind of media. A form of media that uses existing tools (like PDF files, blogs and the web) to challenge the way ideas are created and spread.” As one would expect from Seth, the content is stimulating, provocative, and easy to quickly digest.
I’ve agreed to host one of the manifestos on my site – I’ll be putting up a link to How To Be a Boor. It’s a great piece that talks about proper email ettiquite which – as email becomes ubiquitous – is useful to be reminded of.
As a hardcore NewsGator user (and investor), I’ve been a heavy user of several of the NewsGator plug-ins.
As the number of feeds I monitor has increased, I have found that one of the more annoying things with some feeds is that rather than provide all the content of the article, they provide a very short description. For feeds that I skim or watch headlines, this is no big deal. However, for feeds that I read religiously, this is truly annoying. In a lot of cases, the feed publisher could easily change this (for example, Typepad feeds commonly default to 40 word digests, but it’s easy to change it to the entire content) – however, my guess is that many people don’t know this and it’s not obvious in the setup. In some cases, I imagine this is deliberate on the part of the feed publisher to drive traffic to their web site.
Fetchlinks solves this problem. It’s a simple, free plug-in to NewsGator that retrieves the entire web page for the feed. It’s simple to install (takes about two minutes) and can be configured by feed within NewsGator. You turn it on only for the feeds you want to download the full page for – the rest of the feeds remain unchanged.
Technical Note: If you are already a NewsGator User and want to know how this works:
- go to the NewsGator Subscribe Menu
- choose a feed
- click Edit
- click Rendering
- click “Use this stylesheet:”
- click the pull down menu (which probably says “default.xslt”)
- if you’ve installed Fetchlinks, then “fetchlinks.xslt” will be a choice) – select it and you are done
If you aren’t a NewsGator user, try it free for 14 days (shameless promotion acknowledged).
Last week, I was asked to write up my “Top 10 bootstrapping actions” for a book on bootstrapping that should be coming out later this year. Bootstrapping must be in the air as Fred just wrote about how he teaches about it in his course at NYU Stern and Jerry just wrote about it for his Inc. Magazine column Forget VC Money, Fund Yourself. I recognize the potential dissonance about VCs writing about bootstrapping (or – “how to create a business without taking money from VCs”) – I know Fred, Jerry, and I all feel strongly that VCs are only a small part of the entrepreneurial / company creation ecosystem and the vast majority of companies that get created never take VC money (my first business raised $10 – we had 10 shares of stock at $1 each – and – when we sold it – each share made a share of Google seem like a penny stock – although we only had 10 of them.)
I spent some time with the author – Marcus Gibson – and felt his questions and probing style were very good. Following is my Top 10 list and commentary I gave him to work with.
- Figure out how much cash you really have: When someone says to me, “I’m thinking about starting a company” I typically ask them “how much cash do you have.” They usually answer something like “none”, not realizing I am asking them about their personal resources, not the business resources (or investor dollars). I clarify and explain that they are likely going to have to go a period of time with no salary, pay for expenses out of their own pocket, and invest in various things for their new business. I’m not being nosy (and in fact don’t care what their answer is) – I’m trying to make the point that they need to make sure they are cognizant of the potential personal economic toll that starting a business entails. Obviously, some of this is mitigated by an angel or venture investment, but there’s almost always a period of time prior to this investment (and could be forever in the case where no money is ever raised) where the entrepreneur is essentially funding the business, whether it’s through their own lost opportunity cost of not having a job or – more likely – through writing checks or loading up on personal credit card debt to get the business started. It’s critical for a bootstrapper to understand how much financial capacity they actually have.
- Figure out how much time you really have: The cliche “time is money” applies to starting a company. The amount of time one has to get a business going is often directly linked to the answer of how much cash one has to get a business going. Often, entrepreneurs overestimate how much time they really have, either by only partly dedicating themselves to their new business (e.g. working a full time job and trying to start the business on the side) or setting expectations that the business will be up, running, and generating enough revenue and income to pay full salaries within an unrealistic period of time. In almost all cases, an entrepreneur is going to have to invest substantial time in a startup to get it off the ground. Understanding how much time you have before you run out of cash, energy, spousal patience, or market opportunity is important to think about going into the startup phase.
- Pick a domain and go deep: If your answer to “What kind of company are you going to start?” is something like “Well, I have a few different ideas…” stop immediately. You should pick one idea in one domain and go extremely deep on this idea. Optimally, it’d be something you already know a lot about so that you’ll be leveraging your personal experience and presumably one of your passions. Hedging your bets by thinking about and playing around with a variety of different ideas is a huge waste of energy – you need all of your focus on the one thing you are going to do. Early in my life as a VC, I was in a meeting where an experienced VC asserted that one of the most important questions for a venture-backed company to answer is “What do you want to be the best in the world at?” I think this question broadly applies to all entrepreneurial endeavors.
- Surround yourself with experienced people: This is often easier said than done. When I started my first company, I had a very small network which consisted mostly of my father and several of his business friends. Fortunately, I had the advantage of age (or lack thereof) on my side and several of my early clients took me under their wing and acted as mentors for me and my partner. After I sold my first company and shifted my role to be an angel investor in startups, I helped start several companies with young, first time entrepreneurs. I saw first hand how impactful having experienced folks around the first time, inexperienced entrepreneur can be as my new first time entrepreneur friends were perfectly willing to make exactly the same mistakes I had made eight years earlier when I was starting out (hopefully I was able to help them avoid most of them while we made new and exciting mistakes together.)
- Find angels: This is a corollary to surrounding yourself with experienced people. While angels are typically associated with “angel investors”, they can also be part time advisors that will work for equity to help you get your business off the ground. I’ve found that finding people that are willing to help for equity (and no cash) are surprisingly easy to find. The trick is finding “angels” (vs. devils) – folks that can really help you and are on your team, rather than people who have an agenda other than helping you succeed and are willing to make a buck in the future if you are successful.
- Figure out who you want to look like in 5 years: In 1990, I was sitting in an Inc. Magazine / YEO Birthing of Giants retreat which, at the time – was by far the best professional development experience I’d ever had. I got to spend four days with 59 other entrepreneurs who were running companies from my size (10 people, $1m in annual revenue) to much larger ($250m in annual revenue). We sat together all day, listening to lectures from MIT and Harvard business school professors, other entrepreneurs, and each other. We partied at night and got to know each other well. One of the recurring themes that came up over the long weekend was to look out into the future. I took away an idea that I continually use – I pretend that it’s five years later and I define what my world / business / life looks like. I then look backward and write the story that got me to this point. When you are starting your new company, use this tool. Figure out where you want to get to. I can guarantee with almost 100% certainty that it won’t play out the way you initially envision, but at least you’ll have a vision for where you want to get to that you can start with and adjust over time.
- Get customers: Customers can help address almost all the issues that a startup faces. Most importantly, customers generate revenue and cash. But customers also help shape the product, business parameters, validate the ideas, and provide “honest work” for you to do. In the MouseDriver Chronicles, the authors state that business consists of only two things – making and selling. Getting and having customers helps you focus on this. Successful customers will also typically help generate new customers as well as confidence that your business is doing something useful.
- Learn everything you can about what you are about to do: This is the corollary to “pick a domain and go deep.” Great startup entrepreneurs are intellectually insatiable about the thing they are trying to create. Learn everything you can about your product, market, competitors, and customers. If you are starting your first business, make sure you spend time learning about yourself and your motivation; figure out what is important to you and why. Be relentless about learning how other entrepreneurs do things, especially those that have had both great success and great failures. If you can figure out how to build continuous learning into what you are doing – without it being a rationalization for not succeeding (e.g. I can’t stand the phrase “We had a lot of ‘learning’ from that experience” – it’s both poor English and shallow thinking – don’t “have a lot of learning” – dig down deep and get to the essence of what is going on a talk about that) – you’ll both have a better chance of succeeding while having a lot more fun.
- Figure out your fallback plan: You might fail. It happens. A lot. Your initial idea might be stupid. Potential customers might not care. Competition might be more significant than you thought. You might do a lousy job of delivering your product or service. Failure can be terminal to a business, or it can merely be a setback. If you’ve thought about a fallback plan, especially if you have limited financial resources, you’ll have a different mode you can shift into planned in advance. Time is always working against you when you start a company – the more you’ve thought through the different scenarios – the greater your chance of ultimately being successful.
- Figure out what to do if you fail (face your fears before you start):One of my favorite quotes is from Dune – “Fear is the mind killer.” I’ve always believed that fear is one of the most completely useless emotions. “What if I fail” is one of the biggest fears of a startup entrepreneur. Face it – play with it – figure out what happens if you fail. In most cases, failure is not going to be death (although it could be very uncomfortable). Understanding what your fears are and trying to stare them down in advance of actually encountering them will help you enormously in the process of trying to create a new company.
Jeff Nolan’s post Blogs as Early Warning Systems inspired me to try a similar approach with a recent disappointing experience that I had at the Ritz-Carlton in New Orleans.
I love staying at Ritz-Carlton’s and – while it’s often an expensive experience – I’m willing to pay a premium for the service and comfort provided. Before I left for Alaska at the end of June, I went to the annual EDS / NMCI Industry Symposium where I was on a VC panel with Captain Christopher who runs NMCI for the Navy. The conference was at a sold out Marriott so my assistant put me up in the Ritz down the block. In addition to being a magnificent hotel, I ended up in a room on the Club Level (which I’m sure I paid more for) which included a nice concierge service and a bunch of free (and very good) food.
I only stayed one night, but had a very pleasant stay. I went to check out at around noon and everything was going smoothly until I looked at my bill. I was shocked by the total (which is usually all I look at) and quickly looked over the bill. I wasn’t surprised by my room charge (which was actually pretty reasonable), nor did the state tax, city tax, or occupancy charge both me as I’ve become immune to all the extra “taxes” we pay for travel. However, the “phone – long distance charges” totalled up to over $230 which blew my mind.
I asked the person checking me out why the long distance charges were so high. My recollection is that he indicated that Ritz-Carlton policy is to charge $15 for the first five minutes of the call and then $2 / minute thereafter (or something close to this.) I was speechless. My room had FREE high-speed Internet access. The Club Level had FREE gourmet food. But – my long distance phone bill was $230? I’d made a few short calls and had one long conference call – but $230? Maybe $23, but not $230.
Normally I’d have used my cell phone to make all my calls. However, in my room, my cell phone didn’t get a signal (it worked everywhere else in New Orleans, including in the Marriott Hotel.) So – I used the phone in the room. It didn’t even occur to me that there would be long distance charges, but if there were, I figured they’d be nominal since long distance service is now less than $0.05 / minute.
I asked the person checking me out if this was for real. I told him that I accept responsibility for not reading the fine print, but this seemed outrageous. He responded that “this is the policy – if you don’t like it you’ll have to take it up with Ritz-Carlton Corporate.” I asked one last time if he was serious – I’d told him that I’d recently stayed in a Marriott somewhere and had paid $10 for high speed Internet and unlimited long distance service. He responded, “We aren’t the Marriott.”
I paid my bill and left, the entire wonderful experience of the preceeding 24 hours completely obliterated by the last five minutes of my stay. As I stepped out into hot, muggy New Orleans afternoon I was baffled, frustrated, and amazed. I thought of all the stuff I’ve read from Seth Godin in the last few years and how he’d be rolling on the ground laughing at how the Ritz blew it.
So – I’m going to give the Ritz-Carlton a chance to redeem itself. I’m not interested in my money back. However, I am interested in the Ritz-Carlton changing their long distance pricing policy. While I’m not going to be so presumptuous as to suggest what they should charge, I suggest they consider pricing it similar to their high-speed Internet access.
I’ve forwarded this post to Simon Cooper (President and COO) and Debi Howard (Managing Director Customer Relationships) at Ritz Carlton Corporate. I’ll keep you posted on their response.