The Flawed Terms in VC Deals

My partners and I have given an extensive amount of thought to the contracts we negotiate when investing in start-ups. After about a year of debate back and forth and executing on multiple options, we've become convinced that many terms we used to add to our contracts are basically crap. I also feel that the mentality in the industry of using boiler-plate contracts to begin negotiations is flawed. I do admit that we have a standard contract which we use as a template but basically we put as little in it as possible and add as necessary. Most deals I've seen in the past start the other way around. Take a template from a lawyer which includes everything plus the kitchen sink and then whittle away at it as part of the negotiation. Why did we switch to what we call our contract-lite? Basically to avoid all the bad blood which comes into play when negotiating with a start-up.

It's very difficult to standardize contracts but one thing which I'll focus on as an example is the drag-along clause. It's simply a bullshit term which makes sense to lawyers but not to us or most entrepreneurs. Have we had it in contracts before? Yes, it's made it way into many contracts. Will we never use it again? We'll try to avoid it but it's inevitably going to show up in certain situations. Why do we see the drag-along as unnecessary?

1.  First of all, the drag-along is one of the clauses we saw really hitting a nerve as part of negotiations. It's actually a really weak term in a contract, especially in Germany, where in hindsight you could have many legal implications by triggering it. 

2.  It psychologically terrifies the entrepreneur because he starts playing out the scenarios where it could be triggered. The reality is far from what he or she often believes is inevitable. We're not out to invest in companies and take them over to optimize our gain, screwing the founder in the process. Unfortunately, a drag-along stinks of this no matter how you dress it up. Further, the dynamics of a deal are totally different at the initial investment in comparison to the exit phase.

3.  It's often, if not always impossible to sell a company without the founder. We invest early in businesses. We also invest predominantly in management/founders and not just concepts. Hence, in all likelihood, when we sell the company, the buyer wants the founders as well. Historically, we've seen that the best exits we've had almost always had the original founders still running the company or in some senior management position. The buyer always wanted them for at least the transition and earn-outs always came into play. Combine a drag-along clause and earn-outs demanded by the buyer and you have a mess on your hands.

4.  You can easily negotiate other clauses to be both beneficial and fair to both the VC and the entrepreneur allowing you to avoid the bad blood which creeps up when fighting over a clause which is so one-sided.

Do we have the perfect solution? No, not yet in my opinion. We still end up having lots of discussions which revolve around the value the founder sees in his business and his role as opposed to our view of this. This post could be ten times as long were I to go into each and every term we've decided to pull out of the initial investment negotiation. The drag-along is just one term which I think clearly shows our thinking on this and it's an ongoing process. Nevertheless, we made the conscious decision to make the contract as "lite" as possible to be able to close the deal quickly and smoothly without lots of back-and-forth. 

Other VC's will have their own view on this. There are probably as many views as there are VC's. Add the lawyers to this equation and you can multiple that number by a factor of N, where N equals the number of lawyers out there. Still, we will continue trying to make our contract as simple and straight-forward as possible. This is necessary to close deals quickly and get to the important execution part on the side of both VC's and entrepreneurs. No matter how good your contract, without execution, it's basically the basis for a pissing contest without winners.

Comments

[Sean Grove]

Hey Paul,

Very interesting write-up. You come highly recommended from some friends I respect, so I thought I might ask a few follow-up questions...

What other significant terms end up in these contracts as a result of a "better-safe-than-sorry" mentality? And which do you (or other VCs) regularly use to change a situation not to your liking?

Would you normally accept the same approach if it came from the entrepreneur's side? Or do you regularly negotiate from a position of power and find you can lay down a broader range of demands while accepting fewer?

Thanks for the interesting article - you have one more subscriber now!

[Chris Grew]

Paul:

As always, I appreciate your willingness to question established investing concepts. Apologies if I am a "factor of N".

I agree that a drag along provision typically "terrifies" an inexperienced (read: European) entrepreneur. I agree that the entrepreneur immediately contemplates a future where he can be forced to sell against his will.

However, in many jurisdictions, a drag along is necessary to achieve the sale of a company in an efficient manner. This is because, in many European jurisdictions, the consent of EVERY single shareholder is required in order to sell a private company (or, at least, for the buyer to be satisfied as to the acquisition of the company).

You are absolutely right: it would be almost impossible to sell a technology company without the founder.

However, you've got to acknowledge that the drag along is not really meant to drag the founder -- it is meant to drag along the small shareholders who either cannot be reached because they have fallen off the map (e.g., the former employee who is travelling the world) or are being difficult in the sale (e.g., the former head of sales who bears a grudge against the founder). I've come across these instances and, without _the threat/ability to invoke a drag along_ (particularly in the instance of the difficult shareholder holding a miniscule number of shares), the company would not have been sold.

Now, having said all of that, in my experience the drag along is rarely invoked -- primarily because the typical time frame involved to execute the drag along mechanism is too long (it can add up to 90 days to the sale process). Instead, it's the fact that the shareholders have the drag in their back pocket, and their ability to invoke it, if necessary, that is important.

Most importantly, let's not forget the threshold established for the drag along to be invoked. It's often the case that the threshhold for the drag is set at a percentage whereby the founder(s) would be in a position to block the drag any way, either on his/her own or through aligning with like-minded shareholders.

Fundamentally, I think what is necessary in the context of negotiating a term sheet is more of the approach favoured by Fred Wilson: sit down with the entrepreneur and explain the terms of the deal. Unfortunately, very few European entrepreneurs have experience in term sheets or in VC transactions.

Please don't misunderstand me: I'm all for simplified negotiations and investment documentation. (After all, I'm typically on a fixed fee for a VC deal so, the less negotiation on the documentation, the less fees I have to write off.) As a result, I'm a big fan of the NVCA model documentation in the US and the BVCA model documentation in the UK. I'm curious: does the DVCA have model documentation?

Personally, I would like you to list the other "flawed terms" that you have decided to pull from your term sheet. I'm all in favour of a simple, straight-forward VC term sheet that is all about the "upside" and not obsessed with the "downside protection" -- provided, of course, the definitive documentation doesn't sneak everything back in!

I look forward to seeing you at Seedcamp Week again and hopefully working with you on a deal some day.

Chris

BTW, you may want to check out the Term Sheet Generator that my colleagues in the US have produced (http://www.orrick.com/practices/corporate/emergingCompanies/startup/index.asp). We will be modifying this for English law and, if there is sufficient demand, German and French law.

[Paul Jozefak]

Chris, thanks for taking the time to write such a long response. Even lawyers have a right to an opinion! ;-)

In all seriousness, you brought up the best point. Inexperienced entrepreneurs, which is more often than not the case in Europe, fear the drag the most. It's simply because they do not have the experience of multiple start-ups behind them to know that it's actually a term which rarely comes into play. We always sit down with the entrepreneurs and explain our terms. We did that before Fred wrote about it. Still, there are simply things inexperienced entrepreneurs inherently fear and we are in Europe. I understand that things are different here and hence I try to adapt. Sometimes, the US approach to things just doesn't need to work for us and that's fine.

Basically, in regards to leaving out the drag and dealing with multiple smaller shareholders, we simply pool them. Again, not always possible, yet we do our best to pool the smaller shareholders and any shareholders who may leave the company (disgruntled employees). If you have them voting as one group, you tend to mitigate the majority of the risk of leaving out the drag. This has always worked for us where we've implemented it. Further, it puts the founders and ourselves on the same side of the table and tends to be the fairest option in our opinion. There is a bit more complexity into how the pooling works but that is a bit too much detail for this response.

Finally, you brought up the point about avoiding complexity. We simply are willing to accept some risk to avoid the complexity of negotiating the drag. It's a matter of weighing our options and from our experience, the downside risk of leaving out the drag is significantly outweighed by the benefit of not having to negotiate it.

As to the other "flawed terms" I've realized it'll have to be part of another post. Stay tuned.

[Paul Jozefak]

Sean, many thanks.

We basically don't have a "better-safe-than-sorry" approach to deals. Our goal is to have a contract which both the entrepreneur and ourselves are happy and more importantly, comfortable with. My experience has always been that deals went sour when you entered them already pissed off about something, especially the terms in the contract.

Further, we never try to "sneak" something into a contract. I am more than happy to discuss each and every term with an entrepreneur in our contracts to make sure that the terms are clear. We usually take the approach of "get anything unnecessary out" of the contract.

We often have a position "of power" yet we don't abuse it. It's a give and take. I've been both on deals where I had the upper hand as well as situations where the entrepreneur was in a much stronger situation. My theory is basically what goes around comes around. I'm more than happy to give something up short term to be considered fair long-term. It's a small industry with few key players. People talk and your reputation usually proceeds you. It's quite short-sighted to screw people if you plan on being around for a while.

[Sean Grove]

Paul, Thanks for the timely reply.

Interesting information. I didn't mean to insinuate you had done or regularly do anything underhanded, and I think the comment about your reputation is a very wise one.

That said, I am still curious what terms besides drag-along are usually leveraged by VCs to bend situations more in their favor than in others.

[Scott Wheeler]

Howdy Chris -- great to see your name pop up again. Even if not something that could be used as a drop-in, I'd find it especially interesting to see how the "standard" terms from there were contrasted between US, English and German law. If you don't mind, when you guys get them updated, and you have a moment, ping me via mail or LinkedIn since I'd love to read over them.

-Scott

[Chris Grew]

Paul:

It's my pleasure to be able to contribute to a substantive discussion.

I honestly believe that the fear of the drag is easily addressed by placing the threshold at a level where the entrepreneur is in the same "boat" as the investor (i.e., they will both be able to block the drag). Once the interests of the entrepreneur and the investor are aligned, I think that it's an easy sell to the entrepreneur.

It is my recollection that voting agreements are common in Germany to enable the pooling of the minority shareholders, but I have not come across that in other jurisdictions.

Regarding other "flawed terms", I'd love to make a few suggestions .... :-))

Chris

[ffd]

From the entrepreneur perspective, my experience with drag-along/tag-along clauses has been positive. Our sale of Minick to Swisscom would have been really difficult without. But you're right, drag-along clauses may have unhealthy implications in the combination with other clauses.

I find the approach you described very encouraging. You certainly do not want the entrepreneur being a lousy negotiator and ignorant of legal issues, so maybe the term negotiations are some sort of good test. Signing such an important contract without clear understanding and digging into it might be a bad sign.

[maxbley]

Hi Paul,
I like the premise of your post and agree that there are a lot of boilerplate terms that could be simplified. But perhaps more importantly, the 'usual' terms could be better explained and used. I find that a lot of US-style venture terms are being applied in Europe by VCs who don't really know what the original intent of those terms was.

Properly used, the drag-along clause allows the investors AND founders to drag the last few small shareholders so that they can deliver the company to the buyer in a sale. It is also used to protect the VC from being dragged by other shareholders. If you set the threshold high -- say 80% -- then it becomes an inclusive term that simplifies the sale for the main parties involved.

Best,
Max