Finders Keepers, Founders Weepers

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I have heard that Ray Noorda (Novell fame) used to say, “Finders Keepers, Founders Weepers” to indicate that most of the time inventors and entrepreneurs don’t end up with much. Business savvy investors and later stage business managers can often clean up for themselves, leaving entrepreneurs with nothing but the pride of knowing what they started.

It appears that this has happened yet again, in a fairly high profile case. Gary Rivlin, NY Times writer, discusses how 4 of the 5 founders of Epinions made nothing in the recent IPO of Shopping.com. (Shopping.com was formed last year with the merger of Epinions and DealTime.com).

Rivlin’s article says:

Before the offering, Epinions had two classes of shares: common stock, which was granted to the founders and employees, and preferred shares, which were given to investors. Their preferred shares in Epinions entitled the financiers to be reimbursed the $45 million they had invested before anyone else was compensated.

Today, the Epinions portion of Shopping.com is worth hundreds of millions, but at the time of the DealTime merger, Epinions was valued at roughly $30 million, which rendered all common shares worthless.

“The question we’re asking,” said one former Epinions employee who asked not to be identified and who plans to be part of the lawsuit, “is how this company supposedly worth only $30 million was suddenly worth $300 million only 18 months later.”

When entrepreneurs and employees and early angel investors get common shares, and venture capital firms get preferred shares, there are many scenarios under which the VCs take all–even in the case of a successful outcome like Shopping.com.

The problem is that VCs typically end up controlling the board of directors. This gives them control over the timing of a liquidity event, and whether the company will choose to pursue an initial public offering (IPO) or be acquired.

If preferred shareholders control the board, they therefore have the power to crush the common shareholders by triggering a liquidation event at any time. If the valuation at that point is not higher than the Liquidation Preference, then the common shareholders get nothing.

For any number of reasons, a board of directors may decide to take an action (such as deciding to sell or merge the company) which is considered a liquidation. The valuation of the company at that moment determines whether common shareholders end up with anything at all.

For me, the trouble begins with the word “liquidation.”

Venture capital documents define what qualifies as a liquidation event. According to Term Sheets and Valuations, a typical liquidation clause looks like this:

“a merger, acquisition, or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed to be a liquidation.”

Because Epinions was valued at only $30 million when the DealTime merger occured, and the preferreds held $45 million in preferences, the Epinions preferred shareholders ended up with 100% of the value of Epinions. The common shareholders got nothing.

I bet the preferred shareholders controlled the board of directors when this merger occured.

This terrible outcome for Epinions founders brings back a lot of memories for me. A similar scenario almost occured at MyFamily.com. Fortunately, we barely escaped this fate. Our common shareholders experienced a serious but not a complete devaluation.

Here’s how our story played out.

From 1998 to 2000, MyFamily.com raised funding rounds of $12 million, $30 million, $33 million from venture capital firms at increasing valuations. So we had liquidation preferences equalling $75 million.

Back in the day when our valuations were in the hundreds of millions of dollars, no one seemed too worried about “liquidation preferences.”

I moved to Silicon Valley to open our west coast office and help us move towards an IPO.

The cost of living in the Valley was (and is still) outrageous, and I was running up a serious personal debt. But I had no fear of that debt because of my stake in MyFamily.com. I could always ease my mind about the debt by doing some simple math: “I own X percent of MyFamily.com which will eventually translate into X million dollars–even if the company is only valued at say $100 million.”

Little did I know how wrong that mental math was.

For us, the problem began after the stock market decline of April 2000. By late fall, we were in need of additional cash, but our management didn’t want to do a “down round.” To avoid raising money at a lower valuation than before, our CEO worked out an acquisition of ThirdAge Media, a San Francisco-based company that had some cash and was looking for a business model that worked. (Advertising models were really being hammered back then.)

The merger was quickly approved by our board. Only afterwards did one of our largest common shareholders give me a real education.

He explained to me that ThirdAge carried into the deal another $70 million in liquidation preferences–bringing our total to $145 million.

He explained to me that if the company were sold tomorrow for anything less than $145 million, that the preferreds would take all and the common stock would be worthless.

All of a sudden my mental math (“I own X percent of a company worth at least $100 million”) was meaningless.

For the first time I understood that all the common shares might be worth zero.

As I naive entrepreneur in my first venture-backed company I had always assumed that the term liquidation meant “fire-sale.”

The only time I had seen that term used was in connection to a “going out of business sale” by local mattress and furniture companies. I actually thought liquidation preferences meant that if we went out of business, the VCs would end up with whatever assets the company had to help pay back their investment. That was only fair.

This had never bothered me at all. We were not going to fail. Our core subscription business was always strong, so a liquidation would never occur. I thought we would either be acquired for a huge sum of money or have an IPO, in which case preferred shares would convert to common shares.

A liquidity event, yes; a liquidation event, no way.

I didn’t understand the meaning of the word.

I did not realize then that a merger or sale of the company, even at a decent valuation, could trigger a liquidation event, give the preferred shareholders their investment back, and render common shares completely worthless.

Within six weeks of learning this tough lesson, I moved back to Utah, dramatically cut my cost of living, and did everything I could to help the company raise a final round of funding and get to profitability.

Fortunately, in conjunction with our Series E round of funding, our CEO persuaded the preferred shareholders that to keep the company alive (to retain management and employees and to attract new investment) all preferred shares from earlier rounds needed to convert to common shares. A ratio was negotiated and the conversion occured.

Now, the only preferred shares in the company are from the Series E round.

I relate this story for one reason only: to educate other entrepreneurs about a key clause in venture capital term sheets–liquidation preferences. Never do a deal unless you understand all the terms.

I strongly recommend the excellent book Term Sheets and Valuations, written by a VC to help educate entrepreneurs about clauses in venture deals. You should also talk with legal and financial advisors with recent experience.

I wish VC deals could be more balanced and not so investor favorable. I have only one reason to hope that they will: I recently heard of a venture deal where the venture fund took common shares in a company that is profitable and very promising.

Now that, in my book, is fair. I wish all venture fundings were this fair and balanced.

Now I don’t want to be misunderstood. I am not against venture capital.

I am against entrepreneurs seeking venture capital without understanding the terms and risks–which I think few do.

I also think few entrepreneurs and inventors realize that most of them won’t end up with nearly the payoff that some of the more business savvy investors and late stage business managers achieve.

If you want to mentally prepare yourself for the potential disappointment of building something great and seeing most (if not all) of the financial rewards being taken by others, I suggest you read the concluding chapter of Crossing the Chasm, the classic high-tech marketing book by Geoffrey Moore.

Moore talks about the difference between pioneers and settlers.

Pioneers are entrepreneurs, technologists and salespeople who create a business out of nothing and in a state of early stage chaos build a promising venture. Companies cannot be created and built without pioneers.

But at a certain stage, when high tech companies are trying to “cross the chasm” from an early adopter to a mass market, with all the standardization of processes and all the pragmatism that this entails, the pioneers are no longer needed. In fact, they can become a liability.

What is needed in the “post-chasm” stage are settlers who are willing to systematize the business processes and build a stable and predictably profitable company.

I re-read Moore’s book a couple of years ago after the common share devaluation experience. I felt much better after realizing how critical the settlers are in building a sustainable enterprise (like how Dell CEO Kevin Rollins put so many systems in place at Dell, taking it from a $2 billion to a $50 billion company along the way). I almost felt that Moore was claiming that settlers roles are in fact more valuable than pioneers and that if everyone went into a business understanding this fact, that much disappointment would be avoided down the road.

Perhaps all entrepreneurs should entertain this humbling thought, that you are not the most important person in your company, even if you created it.

You need settlers to take you to the next level. And they should be generously rewarded for doing so.

If you think you’ve been ripped off by investors or settlers, my advice is to get over it, move on with your life. Do you want to end up like the Wright brothers, involved in lawsuit after lawsuit while others are taking your ideas to the next level? Just start over, do it again. After all, you’re a pioneer.

(Note: The Wright brothers won their patent lawsuit in 1914, but it was a hollow victory since Wilbur had died of typhoid fever 2 years earlier and Orville had spent so much time in court that others had leapfroged his invention and taken aeronautics to entirely new heights…pun intended.)

(Thanks to John Richards for sending me the NY Times story.)

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3 Responses

  1. Dear Paul,

    That was a terrific blog on the “liquidation” dangers faced by entrepreneurs. I have a friend who has been TWICE bitten by such clauses.

    But like you I am hoping to see the tide change some in regards to VC monies.

    Scott Klossner

  2. “If you think you’ve been ripped off by investors or settlers, my advice is to get over it…”

    Why not do both? Build your next project and exact justice for the first one.

  3. Finders Keepers, Founders Weepers at No VC Required

    […] discovered a brilliant blog entry by Paul Allen (the other one) on his experience with Liquidation preferences. It uses the excellent case of how […]

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