Month: January 2008
Fred Wilson thinks the upcoming (or next) downturn will be different and while he agrees with some things in Will Price’s post titled Downturn – Now What? Fred adds his own thoughts in his post This Time Will Be Different. Flight to quality anyone?
Q: What is the the impact of the U.S. economy going into a (possible) recession on venture funding for new startups?
A: (Jason). Somewhere my undergrad economics professors are shuddering as I type this answer. I won’t hold myself up as an professional economist or fortune teller, but there are some takeaways that have have been learned from prior downturns.
The first takeaway is that a lot of the effects of a recession are dependant upon how deep and long the recession is. For instance, a longer recession will certainly lessen companies desire for buy advertising, whereas a shorter one may not. Given advertising’s importance in the revenue models of many vc-backed companies, a protracted downturn will impact their revenue growth and decrease their chances for achieving profitability. If a VC has a lot of companies in its portfolio that rely on advertising revenues, then it is possible that they’ll have difficulty supporting their companies financially if all of them suddenly experience longer roads to cash flow break even.
Furthermore, companies will start to conserve cash to maximize earnings and this usually means a reduction in IT expenditures. Venture companies who rely on enterprise sales will be affected similarly to ones analyzed above.
Along with companies trying to conserve cash, they will tend to acquire less companies and the ones they do will be for lower prices. IPOs will not be possible in the choppy markets that are common during a recession.
All of the above will cause a lot of noise, grumbling and folks on MSNBC talking about how the sky is falling.
Now how does this all affect VC financings? Well, history would tell us that VCs will put less money into funding companies, converse cash and wait until the acquisition and public markets open up a bit. With a lack of good exits, why would a VC want to invest in a company? However, that’s never made much sense to me, especially if we limit investments to early-staged companies. I’ve always thought the best time to invest in young startups is when things are choppy. You usually can invest at lower prices, hire folks for less than you normally would, etc. Also, I’d never expect an investment to exit in the near future (1-3 years, for sure) and therefore the company will be well positioned to exit at the end of the recession. If you wait until the recession is over, you are already paying too much.
So bottom line is "we’ll see." The last go around saw a tremendous drop in venture investing during hard economic times. If i was a betting man, I’d probably still expect the same, but I can see a strong argument for continuing to invest regularly through the cycle.
Q: I work at a startup in the valley, and I’m wondering what happens to unvested shares in the event of acquisition? I.e., should I expect that they are canceled, accelerated, or stay on the same vesting timeline?
A: (Jason) The answer is “all of the above.” Any of these are potential outcomes in an acquisition. It really depends on the negotiating strength of the companies involved.
Most “standard” employee option plans have a provision in it that says if the acquirer does not assume the option plan and does not keep the options on the same vesting schedule and other similar terms, they vest immediately prior to the close of the merger. So in this case, they are accelerated.
However, there are plenty of times that the option plan is simply assumed by the new owner of the business. Rarely, have I seen all of the unvested options be canceled with no payout to employees, as this would lead to the acquirer angering all of its new employees.
Note also, that when exercising options prior to the closing of a merger, one heavily negotiated item is who gets the exercise cash, the acquirer or the target company? Usually, we see this go to the target company unless it’s a distressed deal.
Fred Wilson has a long post up today titled What To Say To A Roomful of CTOs. As with many of Fred’s "think out loud posts" it covers a lot of ground. It’s an interesting complement to a post I wrote last October titled CTO vs. VP Engineering where I assert that after 20 employees, a startup needs a separate CTO and VP Engineering. I’d like to think both are excellent and provocative reads.
Q: Is it customary for an equity investor to have a veto right over future investments that are at parity or senior to that series? Do you see it often? Do you ever see it limited by the percentage ownership (e.g. if the series becomes a less than 10% shareholder, the veto right goes away)?
A: (Jason) It is customary. In fact, most times the previous investor gets a veto right on all equity financings, senior or junior and in some cases even debt issuances. This is one of the “standard” terms that Brad and I blogged about in our term sheet series regarding the protective provisions section of financing documents. As for a limitation, yes, it’s not unusual for the term to go away if X% of the preferred outstanding at the time the provision is adopted remains outstanding. What is X? I’ve seen anywhere from 25-75%. 50% seems to be non-controversial.
Note also that beside the veto right, the prior investors will also have a right of first refusal to participate in whatever financing you are contemplated. Here’s our prior post on the subject. So while they can say “no” to a financing, they can also say “yes” and either participate or not.
None of this is “as bad as it sounds.” Remember, the VCs are going to want money to come into the company, if appropriate. Without it, the company (and their investment) will not be worth much. When it typically gets to be a problem is when a company raises several different rounds of capital and each series of stock has a separate veto right, instead of an aggregate veto right across all preferred. There have been situations where a new / contemplated financing round is good for some of the prior investors and bad for others. In this case, separate veto rights can, indeed, cause a problem.