Street fighters' down round survival guide

Ezra Roizen · February 21, 2009 · Short URL:

If you're an entrepreneur and your back is against the wall, read this

 There's a lot of whacky stuff going on in the private/VC financing world right now.

So, I thought I'd put out a quick note on three things I think entrepreneurs should be considering if they're in the unfortunate position of needing to negotiate a critical round of financing right now, and their hands aren't very strong relative to their investors.

As a preamble, I believe in a healthy degree of equilibrium when it comes to financing.  A healthy financing is one that balances a fair return to the investors and a significant reward for the entrepreneurs.  Most of the hairy terms in a financing round come as a byproduct of entrepreneurs overreaching on their valuation, and the VCs needing mechanisms to cover their downside if the company doesn't achieve its almost invariably overstated short-term projections.

Also, the more you raise the higher your hurdle. It's hard to build a company that's actually worth an exit price of $20 million.  So if you raise $15 million, you're not leaving much on the table. 

In fact, most likely you'd have been better off just staying in your product manager job at Google or Yahoo! or Microsoft or wherever. 

So, find balance. Raise as little as you can, offer a realistic opportunity for a healthy return to your investors, and keep your exit hurdle as low as possible.

With all of that said, if you're an entrepreneur and your back is to the wall, and you're feeling like you don't have any good cards in your hand in your negotiation with your investors, here are a few that might help.

Strategy 1 - Employment Agreement/Transaction Bonus

The high probability outcome for your startup is an acquisition.  Work into your financing a set of employment agreements which carve out some part of a transaction as a bonus for the management team.  The tax on this for you will be ordinary income, which stinks, but it's better than nothing and gives you another vehicle for getting some upside out of the deal. 

Strategy 2 - Rights to Some Amount of The Latest Preferred Stock

If you're looking at a round of new preferred equity that is going to completely change the cap table, and drastically increase your hurdle, try to access some portion of the new class of stock.  I've seen this done a few clever ways (warrants, etc.).  Oddly it rarely crosses most people's mind as a strategy, but it's a great way to move the management team up the liquidation stack. 

Strategy 3 - Performance Bonus/Common Stock Option Pool

Discuss ways of expanding the option pool and agreeing upon clear performance metrics which would trigger additional distributions of options or other perks like accelerated vesting at some future date.

Also, if you're facing a radical change in your cap table, be sure to think about how it's going to change your current equity position.  If you're moving from a position which was largely founders stock you already hold, to a new stock option plan, what are the changes going to be in things like vesting, tax and control?

I believe it's in everyone's best interest to have an alignment of intentions and outcomes.  If the entrepreneurs overreach on valuation they'll end up with nasty terms that will kill them on middle-tier (and likely) outcomes.  If the VCs overreach, they are in fact pushing the entrepreneur into higher growth/higher return/higher risk strategies at a time in the market that I would say that's a pretty dumb thing to do.  Design a capital structure where everyone is happy (in varying degrees) at a range of outcomes.

If you're really stuck, connect with me over Vator email and we can discuss your situation. 

Hang in there.

This post has been updated on Feb 21, 2009 to add the following:

I've been meaning to add a Strategy 4, which is to take a full market salary, but defer a significant portion as a liability on the balance sheet.  If the investors are going to take an oversized portion of the company based on the perception of increased risk, then management should also be able to take a market salary (albeit on a largely deferred basis).

Some combination of these strategies should give you the tools to design a reasonable reward even out of what may have otherwise been a dire situation.  In the end, it's in everyone's best interest to have some sharing of the upside of the venture.

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Ezra Roizen

Advisor-to and commenter-on emerging ventures

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