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Participating or Preferred: Scoble and Segal on VCs

Segal responds to Scoble.  This is worth a read, including all of the comments.  Scoble commented that he had heard a lot of stories where the VC’s and founders made a ton of money on the company, and the employees got nothing.  Segal disputes that assertion, saying that good VCs make sure the employees participate in the upside too.

Certainly, my experience has been that every VC wants to see a cap table with employee stock options part of it.  The size of the option pool varies, but there’s always an option pool.  And, they always want to see that option pool topped-up before every new round of investment to ensure that there’s a budget of stock options to incent employees as well as a budget of money to run the company.

I’m very glad to see that JL Albright seems to be such an enlightened investor. I don’t believe that Rick’s refreshing viewpoint is commonly held by all VCs, though. 

There’s one common way that employees get screwed on exit, and that’s a beast called a "participating preferred share", more commonly known as a double dip.  This feature of many term sheets says that the fund gets paid back their investment before any profits from the sale or IPO are divided among the common share holders. 

A preferred share is a convertible instrument — it’s like an interest bearing note convertible to common shares, but unlike a true debt instrument it votes as a shareholder, and is entitled to dividends.  On liquidation, the holder has to choose interest, or participation as a common shareholder.  Preferred shares are an effective way to ensure, in the case of a small exit, that the VC gets a return on investment.  A participating preferred share is BOTH an interest bearing note, and convertible to common shares.  The VC doesn’t have to make a choice, because the debt comes due, and then the note is converted to common shares. 

Particularly egregious are the multiples — 2x and 3x dips — which some VC firms ask for. This perversion of the participating preferred says that the VC is guaranteed a minimum of 2 or 3 times their investment before the conversion.  What this does is wipe out the common shareholders in a small or even medium sized exit scenario. The firm asking for this will tell you that the impact is minimal if you hit a home run, which is true.  Most exits aren’t home runs, though. They’re singles, and doubles.  My advice: when you encounter a multiple dip, walk.  There’s a very real risk that neither you, nor your employees, will ever see any return.

{ 1 comment… add one }

  • will December 9, 2005, 9:40 pm

    Liquidation Preference + Participating Preferred is even scarier :)

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