IF YOUR PRIMARY ADVISORS ARE TRAINED ONLY IN FINANCE, THEY MAY NOT PAY ATTENTION TO THE LEGAL DETAILS ONCE THEY’VE AGREED ON PRICING AND VALUATION TERMS. THIS CAN BE A PRICEY MISTAKE, PARTICULARLY IF THE INVESTMENT OPPORTUNITY SEEMS PARTICULARLY EXCITING AND AS A RESULT THE VALUATION IS HIGH
a high-profile blood testing contract with Walgreens, and in 2015 she was named to Time Magazine’s Most Influential People list. In the same year she became the youngest person ever to win the Horatio Alger Award, among other accolades. Theranos also boasted a high-profile Board of Directors that included Henry Kissinger, George Shultz, Sam Nunn, Bill Frist, Gen. James Mattis, former Wells Fargo CEO William Kovacevich and famed trial lawyer David Boies. With all the excitement and attention, it was obviously easy for investors to succumb to enthusiasm too quickly. Not all prospective investors fell for the Theranos story however. Bill Maris, then at Google Ventures, reportedly looked at Theranos and decided not to invest. “We looked at it a couple times, but there was so much hand-waving — like, ‘Look over here!’— that we couldn’t figure it out,” Maris said in an interview with Business Insider. “So, we just had someone from our life-science investment team go into Walgreens and take the test. And it wasn’t that difficult for anyone to determine that things may not be what they seem here.” Basic technical due diligence and the discipline not to get swept up in the hype probably saved Google Ventures a substantial sum.
of increased dilution to the founders and earlier stage investors. The full ratchet anti-dilution provision is still unusual in comparison to the more typical weighted average approach, but it is becoming more common particularly in high value unicorn transactions (Box is another high profile IPO in which the full ratchet anti-dilution provision was triggered). There are also other elegant ways to give investors heightened protection, such as a blocking right in the case of a lower priced IPO, participating preferred shares, in which the investors receive both (as opposed to either of) their liquidation preference and their as-converted percentage on liquidation, and increased minority protections. These types of discussions are particularly important to consider if the founders have protections of their own such as super-voting stock.
to solve problems and to grow the business. Fourth, you’re smarter than you look!
It can be easy to be intimidated, even subconsciously, by impressive founders, particularly if those founders have impressive technical, political or business backgrounds. Not only was Theranos’s founder being proclaimed by some as the next Steve Jobs, the company hired an impressive technical management team and recruited a Board of DC heavyweights. Bill Maris, however, still reportedly refused to invest without understanding how (or whether) the technology worked. His team’s insistence on validating the company’s claims from a technical perspective (in other words, how did the technology actually work and did it produce correct results?) uncovered the weakness in the company’s presentation. In addition, the media hype surrounding some “disruptive” technologies or industries Third, remember that you’re investing in people, and the founders in particular. seems to provide air cover for business claims In evaluating an investment, it can be tempt- that otherwise would be met with a greater ing to get lost in the details of the financial degree of skepticism. For example, the disanalysis and the legal terms and conditions, tributed ledger/blockchain industry gave rise and to forget that the success or failure of an to some crypto token ICOs that in hindsight investment will in large part depend on the appear to have been at best problematic and at management team’s ability and motivation to worst fraudulent. In certain cases, the published deliver. Founders in particular are often critical disclosures relating to these deals should have components of the development of the product failed to pass the “smell test” of reasonably prufrom a technical perspective, not to mention dent investment professionals. Anecdotally, the the visionaries and the “heart and soul” of the legal cannabis sector also seems to have attractoperation. It is not unusual for savvy found- ed a fair number of individuals peddling farers of exciting companies to bargain for their fetched investment opportunities and schemes. own protections, usually in the form of all or As with investments in non-disruptive indussome combination of a minimum number of tries or technologies, if you don’t confidently guaranteed Board seats, super-voting stock understand how the company makes money or and employment agreements with severance how you make money from the investment, you provisions. Working through these issues can are well advised to learn more or pass on the be tricky, as often the founders’ motivation for opportunity. maintaining control is at least as emotional as it is economic, so a horse-trading approach can To conclude, truly disruptive innovation opens significant opportunities for investors be counter-productive. While often tense, experienced investors to make outsized or asymmetrical returns. will generally find common ground with sav- That said, the hype surrounding disruption vy founders. After all, each needs the other to can often cause prudent investors to make make the deal successful. Investors will often mistakes. Balancing the excitement and enpermit a founder to maintain a high degree of thusiasm of disruption with caution, creative control, and perhaps even longer term control downside protections and an insistence on via super-voting shares, as long as the inves- understanding the business from a technical tors have appropriate Board representation, and financial point of view is the only prumeaningful minority protections in the form dent way to bet on the next big unicorn. end of veto rights over certain major decisions and some form of golden handcuffs (often vesting or re-vesting over some portion of the founders’ 1. This article is for information shares). In a well-crafted venture investment, purposes only and should not the investors and the founders have a balance of be construed as legal advice, investment advice or tax advice. power which motivates them to work together
CSA - Zegzebski
Second, don’t stop negotiating after agreeing on price and valuation.
If your favorite tool is a hammer, you only tend to look for the nails. Similarly if your primary advisors are trained only in finance, they may not pay attention to the legal details once they’ve agreed on pricing and valuation terms. This can be a pricey mistake, particularly if the investment opportunity seems particularly exciting and as a result the valuation is high. Consider the example of Square’s initial public offering and its prior venture capital round. Approximately a year prior to its IPO, Square issued shares of Series E Preferred Stock at $15.46 per share which resulted in an approximately $6 billion valuation. When Square filed to go public, however, it priced its shares significantly less than the $15.46 per share paid by its Series E investors. While this decreased valuation and resulting dilution would ordinarily cause heartburn, Square’s Series E investors were comparably unconcerned. After all, they had included a somewhat unusual “full ratchet” anti-dilution protection provision (rather than the more typical “weighted average” anti-dilution formula) in their investment documents which not only made them completely whole, it even guaranteed them a significant return in comparison to the IPO price, all at the expense
CSQ Q1 2019
Q1 2019 | Innovation & Technology