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The Toxic Term Sheet: Founders beware


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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