Pari Passu or F.U...little guy
|Mike Markkula presenting Steve Jobs with first investment in Apple|
I recently watched an excellent documentary on PBS, Something Ventured: Risk, Reward, and the Original Venture Capitalists. It is the story of the founding of the venture capital industry in Silicon Valley and features many of the iconic companies created including Apple, Intel, Genentech and Cisco. VCs profiled include Arthur Rock, Tom Perkins, Don Valentine, Dick Kramlich, Reid Dennis, Bill Draper and Pitch Johnson (fathers of the industry). Yup, no women, unfortunately, and industry is still male dominated over 40 years later.
The documentary is well worth watching. It is both entertaining and a stark contrast to today's venture climate, that is dominated by sharp elbows and the focus on personal gain and self promotion (or the more acceptable term of creating a "personal brand").
Perhaps, I'm becoming an old curmudgeon, but I like the focus on working together to create something really big. This is the feeling you get from watching the venture capitalists talk about the entrepreneurs and other investors in the film.
Pari Passu is a term that was used quite frequently in the early days of the venture industry and even when I got my feet wet in the late '80s and early '90s. It is a Latin phrase that means "on equal footing" and has been translated to mean "ranking equally", "hand in hand", and "fairly" according to Wikipedia. In investment parlance, it strictly means that new classes of stock have equal rights with prior classes in terms of liquidation preference, voting rights, etc.
However, I view pari passu as a more intrinsic definition that goes beyond simple legal definitions. I'm a strong believer in fairness (although my daughters may not agree) and investors and entrepreneurs working together as a team to create something valuable to all stakeholders (customers, employees, founders, investors). Startup outcomes tend to be very binary. The company either fails and provides little or no return to investors or is a success and returns a multiple to investors. Yes, there are a number of cases in the middle where having a senior or participating preference does make a difference in liquidation proceeds, but I argue that it does very little to overall returns in a diversified portfolio.
I've witnessed a lot of bad behavior by investors recently, along with other examples of greed that stray far from pari passu. I'm all for transparency, but won't be naming names in this post as I don't want to put some entrepreneurs in a difficult position. However, I'm sure some of ProfessorVC's readers will recognize themselves or others in these examples. It's also interesting how a lot of this resembles toddler behavior on the playground from "show me a little more love" to "mine mine mine" and of course, the classic playground bully.
One area I've noticed a lot more recently are angel investors and seed stage funds trying to grab a little bit extra, whether it's warrants for leading the round, advisor shares to go along with the investment, or a common stock stake for just being who they are. Entrepreneurs are put in a difficult position as they are trying to get a round closed, benefit from having certain investors committed, but at the same time can't feel very comfortable having to tell prospective investors they aren't getting the same deal. I always ask the question if other investors have different terms and almost always don't invest on principal in these cases.
Another closely related area is that of variable pricing on convertible debt or equity deals where different investors have different caps. Generally (but not always) it is investors that came on board a little earlier. As regular readers of this blog know, I'm not a fan of convertible deals to begin with, and it is difficult for me to internalize how value in the company has been created in the two weeks a cap goes from $3 million to $5 million. I have turned down several of these types of transactions recently.
Seems like my rant is picking up steam now. I was working closely with an entrepreneur and introduced another angel investor to the company. We considered a joint investment in the company and the entrepreneur decided not to take funding at the time. A year or so later, the entrepreneur did raise a round from a seed stage fund that wanted to have most of the round, but the guy I introduced was able to invest, while I got left on the outside. Company has now raised over $70 million and is growing rapidly. Yes, the entrepreneur could've worked to get me in the round, but not the easiest position when you are a young CEO raising your first round. The other investor could've certainly lobbied to get me an allocation.
Another area where I'm not sure I stand is with some of the more formal referral and syndication programs that are emerging now. Funders Club (which I've written about previously) recently launched a referral program where angels can receive 10% of the carried interest in a deal they refer that ultimately gets investment from an FC fund. Since this only impacts the investors participating in the deal through FC, I don't have a big problem with this, although not something I would participate in. Not sure how much value in just a referral, but also going back to pari passu, I'm just as likely to refer the next opportunity and am happy investing at the same terms on one I refer as one that you refer.
AngelList (which I remain a big fan) also recently launched a syndicate program. In this program, an angel can ask the entrepreneur for an allocation of the round and then syndicate through AngelList. It is assumed that the angel has done diligence and will be working with the company going forward to earn a carried interest from others investing in the syndicate. Effectively, the angel is acting as a VC and works in a similar manner to a pledge fund, where a firm's LPs commit on a deal by deal basis. I could see potentially getting involved in this type of transaction, but am curious if the investor is committing to the full allocation whether she can syndicate or not. If it is contingent, then this could provide some perverse incentives.
Finally, I have to bring up some bad behavior by a name Sand Hill Road firm (SH). An entrepreneur received two Series A term sheets, one lead by an international investor and the other from SH. The seed round had participation from two venture firms that were committed to doing their pro-rata and seed round was done with a very clean term sheet (1x preference, non participating, no anti-dilution). SH wanted a senior preference over the seed investors (full disclosure: I'm one) and we tried to push back that precedent was being set for Series B and whoever comes after them, to demand the same, which will negate the value of their seniority at A. Unfortunately, not everyone follows the KISS principle. Their response was that we should be happy they didn't ask for a participating preference on top of the seniority. Lucky us!!
We went ahead and accepted the term sheet, partially due to the fact that they knew the company well from 3 months of diligence, had expertise in the domain, and promised a quick close in 3 weeks from term sheet signing. Well, those 3 weeks came and went, and they decided they weren't sure about the market and needed to get other partners in the firm on board. That is VC speak, for get ready to bend over...After several meetings with different partners, principals, venture partners and associates, they scheduled a partner meeting for one month after the original close date to decide if they wanted to move ahead. They did get the partners on board on the condition that the term sheet is renegotiated at a lower valuation. Don't know why I'm thinking of Kevin Bacon from Animal House all of a sudden. "Thank you sir, may I have another!"
Just in case you are forgetting at this point, I'm not a pollyanna. It's also not a Rodney King "Can't we all just get along" thing. I'm a capitalist, a CFO and investor. I know it's all about capital and using wealth to create more wealth. However, Wall Street was never an appealing destination for me (unlike the majority of my Wharton classmates) and as much as I snickered, I liked it when VCs started referring to their investments as projects rather than deals. The venture industry has clearly changed and grown since the early days profiled in Something Ventured, but it would be good not to forget all of the lessons shared in the documentary.
About Steve Bennet: The best way to describe my work is probably start-up CFO guy. I spend my days working with cool start-ups in a variety of capacities. I am an active angel investor and on the board of Sand Hill Angels. I take CFO roles in early stage companies and participate on the management team during the early financings and business model development phases. I typically stay anywhere from 6 months to 3 years depending on a number of factors, not the least important being that I do not have the temperament or attention span for a full time gig. I also teach Entrepreneurial Finance at San Jose State. On the personal side, I live in Palo Alto with my wife, two daughters (one who started blogging way before I did and the other who runs faster than I do), dog, and crested gecko. On the 3rd Saturday of the month, you can find me on the links at Half Moon Bay. You can find my blog here.