Start-up's tricky choices on capital

That’s a scene from “The Social Network.” The real story is that Victoria’s Secret was nearly bankrupt at the time of its sale. And The Limited bought the company for $4 million, paying far more than Wexner’s board thought he should pay. It was Wexner’s marketing genius that turned a nearly failed business into a success.

So that scene might not be completely accurate, but it, like other parts of the movie, has a kernel of truth. With start-up companies, entrepreneurs are focused on the business’ life and death. They may make heat-of-the-moment decisions that will affect control and whether they can profit.

In the real-life case of Facebook, Mark Zuckerberg is a rare entrepreneur who has not only maintained a substantial interest in his company, but also control. Many others receive needed money, but lose control of their business. There is a saying that once you accept venture capital, you have sold your company. VC funds require a return on their investments and will need to cash out through a sale or an initial public offering.

A venture fund will negotiate a set of agreements with the founders at the time of its investment with this goal in mind. Not only will the fund negotiate to ensure that an exit occurs, but the VC will insist that it be paid back before the founder.

The key for entrepreneurs in negotiations is to make sure that when they do raise VC money, they have options. If they can get multiple term sheet offers, then they can negotiate to sell the smallest part of their company on the most lenient terms. If you only have one term sheet, you are not going to fare well.

When the company is not performing to expectations, these legal rights negotiated at the beginning of the founder-VC relationship come into play. The venture fund will exercise control of the company primarily through the board. While VC funds will not always appoint a majority of a board’s directors, these investors often require that a board consist of a number of independent directors who can break any dispute between the founders and the venture capitalists. But these directors are often independent in name only. When things go bad, they typically side with the more experienced venture capitalist. Venture firms also invest by buying preferred shares that are more senior to the founder’s common shares. These shares often require that the venture firm be paid back first with interest in any sale or exit.

In addition, there will often be terms negotiated if money is subsequently raised at a lower valuation, a “down round.” These provisions are known as anti-dilution rights, and their strength can vary. The strong form is known as a full ratchet and provides the initial venture capital investor full protection from dilution in any down round, at the expense of the founder. “Drag-along rights” will sometimes be included — they force founders to sell their shares when the venture capitalist does. Most important, a venture capital firm will often provide investment capital for a short, preset period. The VC’s thus control the company by ensuring that the founders will need to return for more capital.

All of these terms can come back to haunt. A founder is often desperate for capital, and there is little negotiating leverage at the beginning of the company’s life. Simply obtaining capital appears enough. But this can change as time passes and the founder may no longer be the right person to run and expand the business. Worse yet, preferred-share provisions that give venture firms shares that are senior to the common shares could leave the founder with nothing.

Venture Capital experts suggests that VC’s negotiate  stronger sale rights, including one that would effectively force a  company to sell itself without a return to the founders. This need for an ultimate cash-out for the VC’s is paramount. Even Zuckerberg will ultimately have to find an exit for his VC’s, most likely in an initial public offering. Wexner did so years ago and now owns only 16.3 per cent of The Limited Brands, the successor holding company to The Limited. Yet he’s still firmly in charge, and Zuckerberg has a good chance of staying as well.

The real lesson from the story told in “The Social Network” is that businesses are not sold too soon or too late, but that they are instead sold when the founders can no longer take them forward.

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