Q&A Roundup

I’ve gotten a ton of feedback on the “state of cleantech VC” series – thanks so much to everyone who reached out! I’ve found myself discussing some of the same points with different people more than once, so I figured it would be useful to follow up on them here.

Q: Do you have a PDF of this stuff? No time to read except on a plane.

Sure, why not – here’s the “state of cleantech VC” series in handy-dandy PDF format. I’m also adding it to the newly inaugurated “tools” page of this blog.

Q: You should really use acquisitions for the exit analysis instead of IPOs, because a lot more VC-backed companies get acquired than go public.

I’d love to do this, but I don’t have the data. I was trying to look at “successful outcomes as a percentage of companies invested in,” for both VC-backed companies overall and for cleantech specifically. While the National Venture Capital Association tallies up total VC-backed acquisitions, I don’t know anyone who does this just for cleantech. Further, only a subset of acquisitions count as “successful outcomes;” undesirable fire sales are common. Because acquirers tend to keep their purchase prices secret, we can’t tell the difference without prodigious research.

Q: The post on share price trajectories was interesting. Is there some kind of template out there that I could use to model the impact of raising money at different valuations?

As you can imagine, this one came primarily from first-time entrepreneurs. When I sit down with folks like this to explore a financing, we typically start with a generic Excel template that has all the formulas pre-wired. So go ahead, have at it with my cap table template (also hitting the “tools” page).

Q: Your third post seemed to indicate that raising money at a high valuation is bad for entrepreneurs. How on earth can that be?

Definitely not the point I was trying to get across. Raising money at a higher price than before is a great thing. The problem arises when you raise money at such an extraordinarily high price that any subsequent round is likely to be down – which selectively dilutes common shareholders (i.e. founders and employees). Get it? Higher valuation = great, stratospheric valuation = dangerous (unless, of course, you’re certain that it’s the last money you’ll ever raise). Which leads us to the last topic…

Q: It’s incorrect that down rounds selectively dilute common stockholders. As long as the price at the end is the same, it’s just a question of whether you want to take your dilution now or take it later. It’s the previous investors who get hurt in a down round, not the management or employees.

No! No! Wrong, wrong, wrong!

I heard this from a couple of first-time CEOs who have successfully raised venture money, and I was frankly surprised by it. The missing element is the impact of anti-dilution provisions which are standard terms in nearly every institutional financing.

In the event of a down round, anti-dilution provisions retroactively reset the share price of previous investment rounds to a lower value. This effectively issues new shares out of thin air to the preferred shareholders who invested in those rounds, but not to the founders and employees who own common stock. So while all existing shareholders get diluted once in a down round (by new money being raised at a lower price), only the common shareholders get whacked a second time (by the anti-dilution provisions).

I think entrepreneurs tend to overlook these very standard terms (until they bite!) for two reasons. First of all, the language is obtuse. Here’s an example from a recent term sheet that crossed my desk:

Antidilution Provisions: The conversion price of the Series A Preferred will be subject to a broad-based weighted average adjustment to reduce dilution in the event that the Company issues additional equity securities (other than shares reserved as employee shares described under “Employee Pool” below and other customary exclusions) at a purchase price less than the applicable conversion price.

The second reason is that these provisions are frequently implemented in the form of a “conversion price adjustment” which only manifests itself upon liquidity. In this scenario, no new shares actually get issued at the time of the down round; instead, when the company goes public or gets bought down the road, the anti-diluted preferred shares get converted into a greater number of common shares than originally specified. This delayed impact makes the effect easy to overlook.

Too little is written about this topic, but if you’d like to dig further, this Startup Company Lawyer post works out a case study, and this post by Brad Feld explores how anti-dilution provisions affect company control.

(A final point mentioned by a VC friend: If you’re a senior management team member and you preside over a big down round, your job security may face as much risk as your ownership percentage – perhaps the greatest reason to avoid these events.)

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