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For some entrepreneurs, venture financings just don’t pay. Take CriticalArc Technologies Inc., a San Francisco supply chain software maker. Investors that returned for the $3 million Series D initial close earlier this month negotiated an eight-times liquidation preference. That means they will get $8 for every $1 invested from a sale or initial public offering before anyone else can draw a dime. While terms for startups desperate for capital are generally not that extreme, lawyers and investors say that such highly dilutive terms, popular last year, have become a disincentive for entrepreneurs, some of whom stand to lose ownership of their companies. As a result, some investors are crafting ways to keep management motivated, such as bonus pools of cash, stock options or recapitalizations to give management a sufficient stake. But it’s not an easy task. Startups such as CriticalArc have taken in venture money across several rounds, and new investors typically clash with old investors, particularly when a lower valuation is fixed. The deals can be worse for management, leaving little if the company is sold. “There are a lot of things being done now to try and overcome what’s been done in the past,” said Jay Goldberg, founding partner of New York’s Hudson Ventures. “There’s always a conflict. The old money doesn’t want to give up its preferences. Management doesn’t want to be sitting behind it. The new investors are conflicted.” Last year, startup valuations were in a state of flux, and to protect themselves, many investors demanded onerous liquidation preferences. Typical preferences of three or four times would outstrip the benefit that even an exit would normally bring, according to Edward Reilly, a partner in the New York office of San Francisco’s Brobeck, Phleger & Harrison. In CriticalArc’s case, the investors — which included Deutsche Banc Alex.Brown and Bank of America Corp. — “were willing to put in a little more money and perhaps get a return which reduces their loss, while hoping that the company can find a buyer,” according to a source familiar with the transaction. The management planned to negotiate some form of bonus incentive, called a management carve-out, at a future date. Nonetheless, CriticalArc president Ira Haber, who declined to confirm the details, said, “We’re happy with the terms — who wouldn’t be in this market?” It could be worse. Joseph Bartlett of the New York office of San Francisco’s Morrison & Foerster recently saw a deal with 12 times liquidation preference, but that’s very rare. Goldberg belongs to the school of thought that finds punitive terms — anything beyond two times liquidation preference — to be counterproductive. “The company has to be sold for so much money before management gets paid that you wind up putting in separate plans to reimburse management,” he said. “That winds up being ordinary income to management, which is not where you want to go.” He was referring to a common ploy by new investors nowadays whereby all previous investors must convert to common stock unless they participate in the new round. The industry typically refers to it as a “wash-out,” “cram-down” or “burn-out” round. In that scenario, Reilly said, if they can eliminate excessive preferred stock to leave value for the common stockholders, they can still give management options on common shares. On the other hand, Reilly said he’s had many cases where the management gets a formula-driven bonus program. One example involves allotting a percentage of the value of a sale to management in stock security as a form of compensation. “It’s justified because the management is creating value and this is a measure of their performance,” Reilly said. This form of compensation gets paid before any junior classes of stock, alongside but not exceeding the amount of preferred stock, he said. “There have been option grants of preferred stock, so that they get the same terms as the new investors,” said Alexander Lynch, an attorney at Palo Alto, Calif.’s Wilson Sonsini Goodrich & Rosati in New York. However, such situations are never cut and dried. Gregory Smith, a partner at New York’s Skadden, Arps, Slate, Meagher & Flom, cited a recent case of an unnamed company’s Series G round. New investors valued the company 20 percent less than its previous round a year earlier and demanded tough terms that disenfranchised prior investors. It also made management fear that they would never be able to reap a benefit from an exit. So, they quit and no new money came forth. Naturally, deals are also getting done that preserve management incentive. SafeRent Inc., a Denver-based provider of online credit and risk management services to the apartment industry, raised a $13.4 million Series C financing led by New York’s Mellon Ventures in June. Although the pre-investment valuation was about 30 percent lower than the prior round, and Mellon’s undisclosed liquidation preference was higher than before, the management and some employees took preferred options and other protections. Another company, Princeton eCom, a Princeton, N.J., supplier of online billing and payment services, recapitalized for a late-stage $13 million round in December to give management and some employees a continuing stake in the company. Several early investors who didn’t participate were washed out. Lawyers say that investors are cautious about resolving the so-called overhang issue amicably. There was a cautionary tale in the case of Alantec Corp., a San Jose, Calif.-based computer networking equipment maker, which was sold to Fore Systems Inc. of Warrendale, Pa., for more than $800 million in 1996. The founders, who by then had already left the company, sued the investors, claiming their equity interests were lost in a series of financings. They won a settlement in 1997. Although lawsuits are still relatively rare, it’s just a matter of time, lawyers said. “When these companies bounce back and there’s real money on the table that’s been lost by some people, you can expect litigation once again,” Smith said. As more VCs become hopeful for a recovery in the foreseeable future, there are increasing signs of more healthy financing gaining momentum. “Three out of four deals that we’ve done recently were at higher valuations,” said Babak Yaghmaie, a Wilson Sonsini partner in New York. But he added, “A lot of pain still has to go through the system.” Copyright (c)2002 TDD, LLC. All rights reserved.

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