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In a startup funding environment where dollars are drying up, valuations are dropping and deals are fewer, it’s no surprise that venture capitalists demand more favorable terms these days. Peter Rothberg, a partner with Nixon Peabody LLP, a law firm with 500 attorneys and offices in New York, Boston and Washington, D.C., specializes in representing the interests of startup technology companies. As a result, he is familiar with the terms and clauses finding their way into term sheets and VC funding contracts. In a conversation with The Daily Deal‘s Katherine Goncharoff, Rothberg discusses some of the harsh contractual terms becoming commonplace in startup financings and explains why he thinks some of these developments may ultimately backfire on the VCs. Katherine Goncharoff: What are some of the changes you have observed over the past year? Peter Rothberg: It’s become more of a buyer’s market for VCs, and as a result, VCs are often putting in much stronger terms for their own financial benefit. In prior years, I would have told my clients not to accept these terms, but given the fact that the whole marketplace is much shakier now and valuations of startup companies are way down, many entrepreneurs are taking the money and worrying about how unreasonable the terms are later. Q: What are some of the tough terms that VCs are now putting into term sheets and contracts? A: One of them is pre-emptive rights that give investors the ability to maintain their percentage in the company as each funding round comes along. A couple of years ago, we didn’t hear very much about this. However, VCs are always asking for this now not just for the next round but for all rounds — there might be a total of five financings these days — up until the IPO. Another example of what VCs are demanding and getting is pre-emptive rights that extend to the issues of stock or compensation to employees, such as stock options. They are now putting restrictions on these so that only certain employees or only top management or only a strict number of people can participate. They are also putting a strict number on how many shares can be offered to employees. In the old days, VCs didn’t seem to care about how many shares you issued to either employees or top management. This is also affecting deals where companies might want to issue shares to some of their best customers. Q: Are there any changes occurring that relate to the preferred stock that VCs normally request? A: Yes. VCs continue to ask for and get preferred stock that gives them more protection than a regular, common stockholder. What this means is that if the company has to liquidate, the preferred stockholder gets some money out of the company before the common stockholders get it. In the past, there were traditional anti-dilution provisions attached to preferred stock such that, if there was a stock split, the preferred stock also split and there could be an anti-dilution provision formulated on a weighted average formula. What we are seeing now, however, is that VCs are asking for and getting full ratchet down anti-dilution. This is very tough on the existing shareholders and is very dilutive to the company. Ultimately, it may dilute the interests of the employees as well and makes the employees feel that the VC firm is not taking a long-range view of the matter. Finally, VCs are also putting into the terms of their preferred stock the power to review all hiring and firing and compensation issues at a firm or require that the VC who sits on the board of directors also sit on the compensation committee. And they will insist on overseeing all personnel budgets. Basically, they are trying to keep a lid on all expenses. Q: What happens when tough terms like this are implemented? A: In the instance of one technology company where a VC demanded and got full ratchet down conversion, the employees felt that their interests were not being taken into account and all the best tech people at the company left. This is one of the risks that VCs take when they demand tough terms like this. Q: What can entrepreneurs do about this? A: Most of them just have to grin and bear it, or alternatively, assess whether or not they really need additional money from a VC. Can they wait until the market picks up and wait until valuations get better. Another alternative might be going to existing shareholders and try to do a round of financing within the company family rather than from new VCs. VCs, in trying to protect their investments, will try to squeeze too much, and they can ultimately destroy a company with these demands. Q: Are there any other tough terms entrepreneurs should know about? A: Many VCs have changed the terms of their liquidation preferences and are getting supercharged liquidation preferences. In other words, they are not only getting their preferred stock investment back in the event of a liquidation, they are also getting whatever dividends would have accumulated. And so, they are getting 150 percent of the investment back before the common shareholders get anything. We are also seeing VCs demanding that when there is an IPO, they get directed shares that allow them to have a certain percentage of the IPO issued to people they know. They are also asking for longer vesting periods for employees’ options. This is a development that is driving employees nuts. Q: Is there any good news for entrepreneurs who may be seeking funding from VCs these days? A: Some VCs try to soften the blow of some of these tough deals by issuing ladder warrants. We usually see this when VCs start to interject themselves into management issues. In these instances, they might say, we are going to set certain performance targets and if the company meets those targets, then we are going to demand that options or warrants are issued to re-incentivize the management team. What this does is try to restore some of the anti-dilution that they may have taken away in earlier rounds. Copyright (c)2001 TDD, LLC. All rights reserved.

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