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Aleph Venture Capital, Tel Aviv
  1. When The Stock Market Dives, Your Stock Options May Be Crushed By Terms You Can’t See

    The "terms" that you can't see in your company's financing rounds can impact the value of your stock options much more than the shiny valuation of the last round.

    I am sure any engineer or executive at a Unicorn company or a tech company valued at hundreds of millions of dollars is sitting around asking themselves what does the stock market dive mean for me?

    Startup valuations have always been cyclical at some level. Priceline’s stock trades above $1,000 per share now. I remember when it was $1 per share in 2001. Amazon traded for a while at 1/30th of its current valuation after it was worth a significant multiple of that previously. Tech, and more importantly tech valuations, is a cyclical business like every business.

    Even though Venture Capital is a long term business and private investors should not necessarily watch today’s stock prices, there is inevitably both a psychological and financial impact of the stock market’s downdraft on venture valuations. Mark Suster makes that point very clearly in his posts of the last couple of days. My Benchmark partner Bill Gurley (see this Bloomberg TV interview) has been warning of this for months and noted the causal relationship between stock market selloffs and late stage private valuations coming down in an epic tweetstorm on Thursday (read from the bottom up).

    Screen Shot 2015-08-25 at 10.54.46 PM

    With the stock market dropping almost 10%, odds are that the board of your company is sitting around trying to figure out how to cut expenses and get profitable on the money you have. Just because you get buy on your existing investment, that does not mean the value of your private company has not come down along with the public markets. It merely means that your stock does not trade every day so the reduction in value is not transparent.

    Given the likely retrenchment on valuations, more Unicorns or Unicorn-wannabes will need to get profitable on the money they have but might have a lower exit value. Alternatively, they will need to raise more money in a different, more difficult environment. That next fundraising will be very impacted by the terms of your last fundraising. Ironically, everyone talks about valuations but the most insidious and impactful element in a funding round are the terms that don’t appear in the press release. Therefore, if I was an engineer or executive at a startup that had raised $50MM or more, I would be asking management about the terms of your company’s financings. Here is why:

    When you joined your startup, you were granted Employee Stock Options. This is an option to buy common stock in your company. The Common Stock price is not synonymous with your company’s share price in their most recent round of funding. So if you got options to buy 1% of a company’s stock, and the last round valued your company at $1 Billion, your options are not necessarily worth $10 Million.  Recently, many funding rounds at Unicorns, or companies that have raised tens of millions of dollars, valuing the startup at hundreds of millions or billions of dollars, have included “terms” that help those investors reset their valuations if a new round is not raised at a higher price (sometimes a significantly higher price).  This is often referred to as a ratchet and we are seeing many of them at Israeli companies, especially later stage ones. If your company has a ratchet then your individual percentage of the company could be crushed either by the next funding round, or by an acquisition that does not meet the threshold of that investors’ ratchet terms.

    In Israel, we have seen a bunch of companies trade simplicity of terms for a higher valuation. The investors are willing to pay the company’s higher asking price because they know their price will be reset if the market turns down. With these ratchets, the last round valuation was just a press release. The price will really be set when the company goes public or gets acquired and the investor invokes the ratchet if he needs to. While high priced rounds with funky terms looks nice on paper (everyone gets to talk and brag about high valuations), when the markets turn, and there are no buyers or investors for the companies at such high valuations,  it can be debilitating to the cap table and destructive to the value of Employee Options.

    Another term that has popped up more frequently in the last 12 months is a multiple liquidation preference. When some investors agree to
    pay high prices, they justify the valuation by getting a multiple liquidation preference. The multiple liquidation preference means that they get paid a multiple on their investment no matter what, and before anyone else gets paid. As an example, let’s look at an investor who invests $50MM at a $500MM valuation with a 2X preference. If the company is sold for $500 Million (no increase in value), the investor will get paid $100MM (2X * $50MM) and leave $400MM for everyone else. If the company in our example is sold for $300MM, the investor will still get $100MM, leaving only $200MM for everyone else, including early round investors, founders and employees. You can see how the pie shrinks dramatically when liquidation preference terms are accounted for.

    We have seen and heard about numerous term sheets like this in Israel, with some even sporting 3X preferences and a ratchet (See Yael’s post on screwed up Cap Tables). If you really want your head to spin, here is how these ugly terms work. Today an investor puts $50MM into a company at a $500MM valuation post money with a ratchet and 2X liquidation preference. A priori, the investor gets 10%. However, if the market or your sector (see this post)  has come down and the company goes to an IPO at a $300MM valuation. In that case, the same investor who put $50MM into the company actually ends up with 33% of the company and your stake was diluted by 25% more than you thought. They will get 2X for liquidation preference which effectively doubles their investment to $100MM and a reset of the price to $300MM post-money. $100MM/$300MM is 33%. Yes, we have seen term sheets like this as well. The next round investors at these companies generally get the same or better turns creating even more of a obtuse ratcheted preference stack.

    Oftentimes, when VCs are raising new funds, it is useful for them to put the headline valuation number on their portfolio companies, ignoring the potential crush of the liquidation preferences and ratchets. The press is also generally uneducated on this topic. When the market is going up, early stage investors and entrepreneurs get loose with these terms, thinking they will never come back to bite.  But they do. And, more often than not, they bite the employees and engineers a lot harder than they bite others.  These terms also tend to complicate future financings for the company, especially in down markets creating ever more risk to your company. I have seen quite a few cycles as a VC. Trust me, it gets ugly.

    So, if you are an executive or engineer at one of these companies, now is a good time to ask your CEO what the terms of the investment rounds were. How much are you under the preference stack given new valuations? Are there ratchets in place? What are they? How complicated is the cap table?

    When you are an engineer or an executive, your time is your investment. When you stay at a company and vest your stock options, that is an investment that you expect a return on. If your expectations are based on false assumptions, and the ratchets will take down the value of your options, it is better to know that now.

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