Once upon a time, in a land not so far away, two dynamic entrepreneurs – Bakra and Bakri got together and started up an amazing e-commerce business to sell sheep wool online!
Within a few months their business was rocking; orders were pouring in from all over the world, page views & comScore numbers were soaring and the servers and the site were happily crashing. This was indeed a great start up.
One day, on a midsummer night, they heard a knock on their cottage door, and when they opened it, a dark skinned man in a black suit, black shoes and black umbrella, with gelled black hair, holding a black satchel greeted them.
‘Hi’ he said, ‘My name is VC, and I am here to fund you’.
Over the next few days, VC patiently explained how he would invest his humongous dollars into Bakra and Bakri’s start up, so as to scale it and make it profitable and ‘Nasdaq’able’.
On the final day, VC didn’t meet them, but sent them a terse mail that read ‘Term Sheet attached. Sign and Return’.
Bakra and Bakri were innocent entrepreneurs and decided to forward the same mail to Rodinhood – the Prince of Entrepreneurs who lived in the Forest of Enterprise.
When Rodinhood read the term sheet, he found the same 3 deadly weapons he had suspected – well concealed and embedded inside the document. These, if not disengaged, could kill or at least severely damage Bakra and Bakri’s economic progress.
This is what he identified:
1. The Shot Gun: The ESOP carve out Clause
In the clause of ‘ESOP’ or employee stock option plan, the term sheet stated that the entrepreneurs (B&B) would carve out 10% of the share of the Company PRIOR to the funding. The weapon was the word PRIOR. It meant that B&B would have to further dilute 10% of their OWN stocks to make way for future employees, (who would work for the Company and actually benefit all the owners).
In his explanation Rodinhood wrote to B&B that the carve out of ESOP’s PRIOR to the funding was unfair on two counts:
a) It should come from the share of every owner of the company’s share and hence POST not PRIOR to the funding since the benefit accrues to all owners as the company grows
b) In case of non-allotment of the complete 10%, the Investors would share the residual shares as well! Hence this was an indirect ploy to get more shares of the promoters under the guise of an ESOP plan.
Rodinhood’s final advise was – Try and negotiate esop dilution after funding and limit the commitment to 5% to begin with, since no one knows at the start of a business what really the esop pool requirement will be.
2. The Samurai Sword – The Liquidation Preference Multiple Clause
The term sheet stated that on liquidation of the Company, the VC would receive 2x of the money invested.
This meant that upon Liquidation (and this interpretation could include an exit), the VC would first take home not just the amount invested in the Business but DOUBLE of the same – so 2x of the investment!
Hence, no matter what the outcome, the VC would enjoy a 100% return on his investment; Bakra and Bakri would be left with what remained if anything at all.
Rodinhood’s comment was that if VC means Venture Capital, it should remain Venture Capital and not Vampire Capital. Hence, the fair multiple was 1x of the principal back and NOT 2x or 3x etc, etc, in favor of the VCs. 1x ensured return of Capital and nothing more if the Company was sold in extraneous circumstances.
3. The Nuclear Bomb – the Preferred and Participating Clause
In this Term Sheet, the clause ‘Preferred and Participating’ made Rodinhood’s Marwari blood boil. This was the classic nuclear bomb aimed at the entrepreneurs.
It meant that in case of a sale, FIRST the VC would take home 2x of his investment. Then, on the remainder, the VC would take his legitimate %.
So, assume that Bakra and Bakri’s Company raised Rs 100 from VC at a 30% dilution.
Also let’s assume that after 4 years, the business would sell at Rs 800.
Logically, VC would take home 30% of Rs 800 or Rs 240? Correct?
Under the preferred and participating this is what would happen:As per the ‘Preferred’ clause, VC would first take home 2*100 (2x liquidation preference) = Rs 200.
As per the ‘Participating’ clause, OF THE MONEY THAT REMAINED – Rs 600, VC would take home 30% or Rs 180.
Hence the total money that the VC would take home would be 200+180 = 380 instead of 240!
In other words, the Equity of VC just became 47.5% rather than the original 30% only because of this Draconian Clause.
Rodinhood sent his comments back to Bakra and Bakri with the above explanations and the final advise – ‘no matter what anyone tells you, including myself – do what’s right for yourself and your business. Just try and remove or disengage these weapons as best as you can. Always remember –when you have a good thing going, capital chases entrepreneurs and you must negotiate justly and hard’.
[Guest article by Alok Kejriwa, Founder of Games2Win. Article reproduced from his blog