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The Toxic Term Sheet: Founders beware

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By John Backus, New Atlantic Ventures

Its official. The unicorn has jumped the shark. The Wall Street Journal and Dow Jones Venturesource established The Billion Dollar Startup Club this year. The special feature on unicorns comes with an interactive infographic, which tracks private, venture-backed companies valued at more than $1 billion.

Companies like Uber, Airbnb, Palantir, SpaceX and Pinterest remain in the top 10 right now. There are also a few more recognizable names on the list. And then there is a collection of supposed billion-dollar companies as recognizable as the characters in the bar scene of “Star Wars”.

Enter the Toxic Term Sheet

In real estate, there’s a saying that goes something like this: “You set the price and I will set the terms.” If you want to sell your million-dollar house for $5 million, fine. I will pay you $4,167 a month for 100 years.”

That very same dynamic is playing out today, right before our eyes, in the world of private investing. Naïve entrepreneurs who want to join the unicorn club, who want a billion-dollar valuation, are setting the price.

But savvy investors are setting the terms. They are using “Toxic Term Sheets.” This usually means some combination of preferred stock, a senior liquidation preference, cumulative dividends, heavy anti-dilution protection (down-round protection) or guaranteed returns. In other words, these savvy late-stage investors have almost no downside—unless the company is a total bust.

Try selling your common stock at a billion-dollar value in this scenario. Good luck with that. In many of these cases, the REAL value of the company is closer to the value of the investor’s preference stack.

If you just raised $100 million at a $1 billion value, via a Toxic Term Sheet, and your company ultimately sells for $200 million, the investors will be just fine. They will get their $100 million. And then some more. The prior investors may also be fine (so long as they invested less than $100 million). The founders? They are toast in this scenario.

The Faustian bargain

Heidi Roizen did a good job explaining the dark side of unicorns, in her blog post. In short, if the performance of your business does not grow into that unicorn valuation, then when your business is ultimately sold, you, as the founder, along with your employees, may see nothing. Just add up the costs of the preference stack and guaranteed returns you offered to your investors in exchange for that mirage of a unicorn crown.

There are actually some really good reasons entrepreneurs want unicorn-status. It helps recruit top talent. Customers believe in you. You’re sought after by journalists. You crowd out your competitors because they will have a more difficult time convincing other VCs to back them. And you get to be on that Billion Dollar Startup Club list.

But entrepreneurs can make a painful, costly, rookie mistake by seeking that $1 billion prize at any cost.

VCs aren’t without blame here either. Unicorns give them bragging rights, as well. It may help them raise their next fund. It can even lead to a spot for the VC partner on the Forbes Midas List. Some VCs are even “buying” unicorn logos so that they can put them on their website, and brag to the world about how many unicorns they backed, even though unicorn logo shopping trend does not serve the VC’s investors, their limited partners. And that is what I call the Faustian bargain.

Rewarding investors for dragons

We should reward angels, seed investors, microVCs, early-stage VCs and expansion-stage VCs for finding, backing and helping entrepreneurs build unicorns over the long haul. Investing in unicorns is easy, because as the VC, you write the term sheet and often set the price. But as I’ve suggested previously, the yardstick that institutional investors should measure VCs by is not the number of unicorns they invested in, but how many unicorns, and other companies turned out to be Dragons for their funds. A Dragon is a company that returns the entire underlying venture fund, as I explained earlier this year on CNBC.

Should we be worried about all of these unicorns? Not really. In the long run, the private capital market is efficient (even though it does not correct in real time as the public stock market does.). Private companies with unicorn valuations will either grow in to those valuations, or, their valuations will adjust downwards—to match the true value of the business—the next time that business raises money.

The rise of the private IPO

Like I said in the Los Angeles Times, “the rise of unicorns and other startups represents a fundamental shift in the way companies are funded.” Venture-backed companies are raising late-stage money privately with increasing speed and ease, and will continue to rely on private market financing for longer in their lives.

In Q2 of 2015, there were 26 companies that raised late-stage funding rounds of $100 million or more, according to the MoneyTree Report published in July by PwC and the NVCA. I call these “private IPOs.” As a former entrepreneur who took a company public myself in 1995, I can see why smart founders might say: “Why raise money in the public markets if you can receive the same valuation, with much less hassle, in the private markets?”

But there is a silver lining here. Today’s unicorns are very different from the accidental IPOs of the late 1990s. Most of today’s unicorns are real businesses, with real metrics, and real scale. And most of their investors are sophisticated institutions. When these companies do go public—and many eventually will—they will be much safer investments for retail investors. Less upside perhaps, but also much less downside.

And for institutional investors in VC funds, there is a gold lining. Longer holding periods and private IPOs result in more value creation while the company is private, accruing directly those institutional investors.

But we should be worried that entrepreneurs are hurting themselves with the stampede to join the Unicorn Club.

The Toxic Term Sheet is a great tool for sophisticated investors to take advantage of naive entrepreneurs. For them, it is “Heads I win. Tails you lose.”

Don’t fall for it!

So if you want to be the next unicorn, fine. Set your price. But be careful of the terms you accept as part of your Faustian bargain.

John Backus is a venture capital investor at NAV. He can be reached by email at backus@nav.vc or you can follow him on twitter @jcbackus.

This guest column first appeared in affiliate magazine Venture Capital Journal, which is published by Buyouts Insider. Subscribers can read the full story by clicking here. To subscribe to VCJ, click here for the Marketplace.

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HuffPost Social Reading  by John Backus Managing Partner, New Atlantic Ventures 

Reclaiming Your Online Privacy Posted

Face it. Everything you do online is visible to someone and can be used without your approval or agreement. You leave details of your online activity in your browser, on your desktop, in your smartphone. All the while, companies, your employer, advertisers and the government are picking up those traces, and piecing them together to make a more perfect profile of – you!

If you aren’t scared now about what organizations know about you, you should be.

Companies have a voracious appetite for your information. The more they know about you, the more they can charge advertisers to micro-target you. The most recent and worrisome real world example is happening as you read this — Google! They just changed their privacy policy, under the faux auspices of “simplicity across sites” to be able to track the content of the emails you write and receive in Gmail, what you search for on Google, what you watch on YouTube, and where you are looking to go on Google Maps. And that goldmine of data wasn’t enough for them. In addition, they specifically and intentionally bypassed Safari’s private browsing mode on your iPhone and iPad to learn more about you.

And, Apple let application developers exploit a flaw in iOS to see all of the contacts in your address book.

Facebook settled with the FTC last fall over its own questionable privacy policies and is now rumored (though they deny it) to be tracking the contents of your text messages from their smart phone app. “Like” something on a website? Facebook knows exactly what you were looking at. Think of every “Like” button on a web page as a Facebook cookie. And remind your friends that “Like” is simply a sneaky way for you to give more personal, valuable information to Facebook.

Your employer knows everything you do at work. They archive your emails – and the court has ruled that company emails are company property — not personal property — and that employees should not have an expectation of privacy when using company resources. Employers also know every website you visit, what pages you see, and how long you spend on each site. You have no privacy when you are working in the office, out of the office but online on your company’s VPN, or doing anything on your company-provided smartphone, tablet or laptop. What you say and where you go belongs to your employer.

Advertisers have an insatiable appetite for user-specific information. Let me share my personal story (and you can try this yourself) Using Firefox, I went to preferences, privacy, and clicked on the underlined text that says “remove individual cookies.” I was taken to a box that showed all of the cookies on my machine. I had over 1000 cookies, most advertiser-related. AND, I use Adblockplus, Betterprivacy, and had checked the privacy box titled “Tell websites I do not want to be tracked.” The same thing happens with Internet Explorer, Chrome, and Safari. Scary. With much fanfare last month, the Government announced the “Do Not Track” browser button, which 400 companies have agreed to honor. Don’t be fooled. This provides limited privacy at best — and only from specific types of advertising, and only certain advertisers have agreed to use it.

Governments want to know more about you as well. The Electronic Frontier Foundation released a report entitled Patterns of Misconduct, which outlined the FBI’s ongoing violation of our Fourth Amendment rights. If not for an aggressive, last-minute online campaign by an unofficial coalition of Internet freedom fighters, Congress was about to pass the SOPA legislation (Stop Online Privacy Act), which would have allowed (and perhaps in some cases required) the government and ISPs to inspect the contents of every packet of information sent across their networks. And Europe isn’t far behind with SOPA’s ugly cousin, ACTA, (Anti-Counterfeiting Trade Agreement) which entrepreneurs in the EU have just started fighting against.

What can you do to reclaim your privacy? There is only one thing to do:

Go invisible. That’s why our venture firm invested in Spotflux. Started by two Internet freedom fighters that have more than a decade of experience solving large-scale security challenges, Spotflux is a free privacy application for consumers, which works by encrypting your Web connection. It downloads in less than a minute on any Windows or Mac computer, anywhere in the world. Spotflux ran a beta test and in less than a year, attracted 100,000 users in 121 countries. It launches globally today.

Spotflux encrypts everything that leaves your desktop, pushes the data through their privacy-scrubbing service, and sends it along. To a website, you are not you — you are Spotflux. And you are invisible unless you choose to login to a website, like your bank, Google, Twitter or Facebook. Even then, companies only know what you do on their site. When you log out, they don’t see where you are on other sites. Better yet, Spotflux’s HTTPS security means no one can eavesdrop on your conversation over a public Wi-Fi connection. And you can surf just as freely overseas as you do in the U.S. Want more? Spotflux also strips out annoying ads and injects real-time malware detection into your browser. Consumers, policy makers and activists are fighting the privacy issue hard but they often face a daunting and cumbersome process. It shouldn’t have to be this way, which is why we think Spotflux is on to something.

Weigh in here with your own privacy horror stories and what you think can be done to reclaim our lost privacy online. Follow John Backus on Twitter:

http://www.twitter.com/jcbackus

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