Monday, January 22, 2007

Venture Capital: Negotiating the Ratchet

Anti-dilution, or price protection mechanisms, have become standard provisions in most VC term sheets in Canada and the US. How should you negotiate these terms?

Start by understanding how the proposed provision will work. Price protection terms allow an investor to protect the economic value of its investment in the event that shares are issued in future at a lower price. For example, VC #1 invests at a per share price of $0.50. 18 months later, VC #2 offers to invest at only $0.25 per share. A price protection term would adjust the original investment price paid by VC#1 - so that either the original price is $0.25 (a "full ratchet") or some average of the two prices (a "broad based" or "narrow-based" weighted average) - and VC #1 would receive additional shares to reflect the difference in the number of shares originally purchased and the number of shares that would have been purchased at the adjusted price. A full ratchet is almost unheard of these days. A broad based weighted average formula generally is more favourable to you, since it is takes all reserved and issued securities into account.

Understand the rationale behind the request. In an early stage investment, a VC typically will argue, there is a risk that the VC may overpay for its stake in a company. Traditional methods of valuation (such as discounted cash flow and market comparables) simply don't work when applied to an early stage company, a VC will say; however, in the interest of ensuring that founders keep a meaningful stake in the company, the VC is willing to accept now a valuation that may prove artificially high later, when future investors value the company. A related point some VCs make is that they also need the provision in place to protect them from the risk of a general market decline. Market fluctuations are not a theoretical risk, they will tell you. Look at 2002, when the dot-com bubble burst and valuations plummeted.

Apply the rationale to your company's circumstances. Is your VC trying to hedge against valuation/market risk, or is he really trying to mitigate against the risk that you will fail to execute on your business plan? Or both? If your company is at the "back-of the envelope" stage, then the answer is probably both.

But many of my clients are farther along in development; they have product, some customer validation, and a sales channel strategy. For companies at that stage, you might argue, there's little - if any - valuation risk. Surely the other terms the VC has required (a board seat, a veto over many key operational and strategic decisions) are better protections against poor execution by the company. In fact, you may suggest, you believe the VC should be incented to drive execution by actively using the oversight and control he's bargained for. You don't want the anti-dilution mechanism to act as a safety net.


Suggest a halfway point. You're not going to succeed in removing the term, but you can suggest a few tweaks that may blunt its impact on your share of the Company. For example:

1. Propose a floor price - i.e., if the price falls below a certain point, the anti-dilution mechanism is reduced so that management's stake is not completely wiped out.

2. If the VC is concerned about execution risk, use that to negotiate a term that eliminates the anti-dilution provisions once certain performance milestones are met by the Company.

3. Focus on management compensation, and negotiate for performance-based adjustments to offset any dilution caused by anti-dilution mechanisms.

In all cases, you should argue for a "pay to play" provision. If the VC does not participate in a future round at a lower price, it loses its rights to the protection in all future rounds.

The "C" Factor. It is important for Canadian companies to bear in mind the "C" factor in any of these negotiations. Canada had produced many outstanding tech companies, but only a handful of them qualify as home runs - RIM, Cognos, Nortel. This means that, to a degree, your ability to negotiate is coloured by the track record of our industry. You will be less likely to move management compensation or negotiate a floor price here than in the US, for the most part. Be sure to understnad that sensitivity, and don't overreach. For now.

My two cents.

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