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| MARCH 21, 2003 VENTURE CAPITAL By Gabor Garai
Increasingly, the answer is the "restart." Here's how it works: A company may have received $15 million of venture capital several years ago and has gone through all the steps to complete its product development and prepare for marketing. The only problem is that the sales effort hasn't proceeded as quickly as expected, so revenues are behind projections. The venture capitalists who gave the $15 million a few years ago don't want to put more money into the company, and new VCs resist because they don't want to bail out the original VCs. So the new ones propose an alternative. WIPE OUT THE OLD. They'll consider investing -- if the balance sheet is restated. A hypothetical deal could go like this: The company is accorded a "post-money" valuation of $10 million, and all preferred stock is wiped out and turned into common stock. The new venture capitalists propose to put in $5 million and insist that the old investors put in an additional $2 million to show their ongoing commitment, in exchange for 70% of the company -- 50% to the new investors and 20% to the old. Of the remaining equity, 20% goes to management and employees in a new option pool to create an incentive for them to stay on and see things through. The last 10% of the equity is what remains from the previous investments -- both venture capital and the founders' sweat equity. The new investment group will generally insist on receiving "super-preferred stock." Instead of being guaranteed the customary minimum annual rate of return of 6% to 8%, this super-preferred carries a "liquidation preference" of two to three times (an amount negotiated ahead of time) the original investment. This super-preferred stock is given to everyone who put in "new money" -- the new investors who put in $5 million and the original VCs who put in the additional $2 million. "LIQUIDITY EVENT." Also, as a condition of the deal, the holders of the super-preferred require that all of the old investors convert their original investment into common stock -- the lowest rung on the equity totem pole. Thus, they join the founders whose sweat equity is already held in common stock. So, how do investors and management make money? If the super-preferred stock has a guaranteed return of three times the original $7 million received in any "liquidity event" (such as a sale of the company), the first $21 million in proceeds go entirely to the holders of super-preferred stock. The next few million goes to the common shareholders. Where this gets interesting is a situation whereby all those who invested money make more money by converting their super-preferred into common stock and thereby getting more than their liquidation preference. In the example outlined above, this would occur if the company sold for in excess of $30 million. Suppose it sold for truly big money -- say, $100 million. Then the holders of the super-preferred can convert their stock into 70% of the total equity, realizing $70 million from the deal, while leaving $30 million for those who originally owned common stock or options for common stock. SHARED FAITH. The attraction of a restart for all parties is that it's better than the alternative. Management receives a small carrot to keep it in the game. The founders and existing investors avoid the prospect of folding up the tent and get to invest in a business they already know as opposed to scouting out something new. And the new investors gain an attractive valuation and reduced risk by virtue of the "super-preferred stock" and the involvement of the old investors. The key, of course, is a shared faith that the restarted company can make it. A client company of my firm succeeded in negotiating a restart based on the shared sense that it's really close to achieving significant success. With nearly $15 million in venture capital raised three years ago, the company completed the development of its product but found that the recession made most customers resistant to making new capital expenditures, no matter how attractive the product. It hasn't yet been able to achieve breakeven and thus needs additional financing. In the late 1990s, this company would have been a candidate for an initial public offering or a mezzanine financing at a hefty markup over the prior venture rounds. Now, it's in the process of raising up to $8 million in a restart. Investors hope that the economic climate has winnowed the field of competitors and proven the company's own business model. Restarts now account for between one-third and one-half of the activities of the venture firms I deal with. While still risky for venture capitalists, restarts typically are further along in their development than many of the new opportunities the investors evaluate. The research and development is completed, one or more products exist, and the management team and employees are in place. From their point of view, better to choose the devil you know. Gabor Garai is a partner in the Boston office of national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and mid-size companies. He can be reached at ggarai@ebglaw.com |
