The quality of a blog is reflected and supported by the quality of comments. VentureBeat (Matt Marshall) has by far the best blog in the industry (judged by the comments) because of the reader he attracts as active contributors to the community. Intead of the usual - “Great post, I love to kiss your ass” comments, there is actually a lot of knowledge/experience shared on almost any post.

Today’s post on Visto was thought provoking not only because of the post itself but because of the comments. Given that only 1/10 venture funded startups achieve liquidity, it is more likely than not that an entrepreneur will encounter a “down round” and/or “carve outs” during his time than an IPO. Thus the information on this thread is more important than learning how to price an IPO or put together a roadshow. Instead of learning from experiences, comments like these can save lots of heart aches down the road.

Here are the cast of characters . ..

JB - sounds like a ex-VC returning from the dark side

Sometimes these “pay to play” financings are forced (coerced) by investors that smell an opportunity to increase their ownership stake and restructure clauses and preferences in favor of those that can continue to pony up money, money that they insist they have and on unconscionable terms. Management, typically new and hired guns, is unsurprisingly compliant. Why? They get what is called “carve outs” which is a guaranteed minimum payout (for the CEO and his favored executives), before any other common shareholder (or for that matter, prior investor) gets a penny.

So with carve-outs, restructures, etc. what hope can the common shareholder have? In the absence of a multi-hundred million dollar acquisition or IPO, the answer is: zilch, nada, zippo. Better for them to try their luck elsewhere. To Martin’s point about .5% or 1% or for that matter, 10%, I ask: does it matter when there is little left after the VCs take their cut (and liq prefs) and the execs their carve-outs which leaves (if anything) a measly amount to be split amongst the common shareholders.

Brian McConnell , a entrepreneur holding “perhaps” worthless common stock due to a (regrettable?) exit to Visto

Visto is a special case, and is likely to be Exhibit A for everything that is bad about venture backed private companies, from bloated and mediocre management, to insider deals that wipe out other shareholders. . . .

I am quite sure the average employee, who knew nothing about venture financing, was completely clueless about the actual value of his/her options, etc. It might as well have been a random number.

This is why I think private companies should be required to publish their financials, at least internally, with the same criminal penalties for fraud and misrepresentation. At present, common shareholders and employees are often treated as second class shareholders, with little or no access to accurate information, and little recourse if they wake up to discover that their shares are worthless.

A “Concerned LPs” (a frequent commenter) who should just step into principle investing

There is simply no way founders can structure a deal to protect against carve-outs and other malpractices which are typically engineered by VCs and compliant (new) management (brought in to wipe out everyone else).

The case that is most pertinent is Alantec vs Mayfield (and other VCs) of the mid 1990s. The company was doing ok but not great; VCs engineered a crisis with compliant management to oust the founders and under pretext of financial necessities, recapped the company on terms highly preferential to the “new” investors (all of whom were already investors; no new investor stepped in knowing they were treading on thin ice). Company later flipped at a great profit to those “new” investors. Lawsuit filed by founders and the VCs lost in trial and had to pay up to the founders and common shareholders who were left out earlier. Since then the VCs have not attempted to go the legal path and simply settle (Nishan, Epinions, Rapt, …)

Yann who sounds like he has a degree in economics . . .

Very good thread of discussion! This is an agency problem seen in many asset classes that can only be addressed by transparency and close watch to conflicts of interests.

When you have bloated seriesA valuations, cyclical markets, general uncertainty of a technology or market, even a sound business will have up and downs. Google struggled along for a while before finding the right business formula. So in general, the concept of value going up and down is normal, and common shareholders should not be penalized for that.

If management is forced to be open and explicit about the terms and financial consequences, they will tread carefully. The need to be fair to employees and other common will force management to be fair in these.

So let’s push for transparency and accountability.

Ty Pike who offers some preventive medicine for all involved . ..

c) stay away from venture firms and partners with little operational experience, esp as entrepreneurs. If they haven’t started companies they are unlikely to empathize with entrepreneurs and employees. This worsens if the partner has a financial background.
d) Watch out for “stories” explaining why new money is needed, new management is brought in, etc. Ask if the new managers have the same clauses as all other common shareholders or if some animals are more equal than others. Watch for scapegoating of the previous team (or founders), as it is a timeworn tactic to disguise the greed of those new on board.