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Perspective: Are VCs shooting themselves in the foot?

Venture capitalist Bob Pavey warns that the economic downturn in high-tech has given venture capital investors exceptional--and dangerous--bargaining power. He explains why tech entrepreneurs--and the computing public--should be concerned.

When we venture capitalists find ourselves at the bottom of a cycle--and this is my third in over 33 years in the business--I don't worry about a shortage of able entrepreneurs, or an absence of technological innovation, and certainly not the permanent collapse of shattered markets.

Instead, I worry that we'll panic and do something to misalign the interests of entrepreneurs, investors and the public at large so badly that we'll impede progress toward the top of the next cycle.

This happened in the 1970s. Then a number of well-intentioned reforms aimed at things like Teamster abuse of pension funds all but killed the fledgling venture capital industry. It took a concerted effort to persuade Congress to pass legislation that correctly realigned interests of all participants in the venture process. That success contributed substantially to making the U.S. entrepreneurial climate the envy of the world as well as a powerful engine for job creation.

Today, two new threats to proper alignment loom. This time the culprits are not just overzealous legislators, but many of my fellow venture capitalists. The threats come, respectively, from (a) possible accounting rule changes that would require the expensing of stock options and from (b) increasingly frequent liquidity preference provisions that require outsized preferential payouts to new investors.

Though completely different in most respects, these twin threats stem from a similar sense of panic. The one attempts to end flagrant abuses of stock options at large companies, while the other attempts to nail down more certain returns and appease restive limited partners.

In my view, these new "solutions" reveal a fundamental misunderstanding of the fragility of the venture process. Moving innovation from concept to commercial reality is hard! Most start-ups fail. Reaching a successful conclusion requires that everyone is rewarded for pulling in the same direction and understands, with utmost clarity, why they are.

Expensing options the right way
Stock options have proven an essential tool for use primarily by smaller growth companies in attaining just such alignments. Requiring the deduction of options from revenue as an expense will impede recruitment of top-to-bottom "A" teams. Few will accept the outsized risks of employment in a new venture without the promise of outsized rewards.

I worry that we'll panic and do something to misalign the interests of entrepreneurs, investors and the public.

However, it is impossible to fairly estimate stock option values for young private companies. What was the value of stock options in an optical components start-up two years ago? One year ago? Today? For large, highly liquid companies like Coca-Cola, investment bankers may arrive at a useful estimate. Not so for small private companies with only a dream of going public someday.

The only realistic time to expense stock options is when their value is realized. The situation is parallel to setting the value for such sales incentives as trips to Hawaii. Neither options nor cash incentives are expensed to the company until the benefit is realized--only then is the value known.

There, however, the parallel ends. The $5,000 for the Hawaiian trip is paid for with cash. By contrast, the $5 million stock option package comes out of equity. In other words, stock options are not cash expenses, but equity expenses. They show up in the dilution of earnings per share that is disclosed in every financial statement.

Far from being the "something from nothing" sleight of hand that critics claim, the equity effect of options is already accounted for. Options represent the equity that investors are willing to share with employees so all can benefit together from building a successful company---and a clear alignment of interests. Penalizing this alignment and making the financial statements of private companies less useful simply to try to reduce excessive use of options by large companies makes no sense.

Alan Greenspan and Warren Buffet, the two most prominent advocates of expensing options, need to find a different way to achieve their objective.

The primary reason venture capitalists should insist on a preferred right to capital in the event of liquidation is, once again, to make sure the interests of management and investors are aligned. Without the first claim on an amount equal to the venture capital investment--also known in the business as "1X"--management might be tempted to sell the company for the same price as the investment and split the returns with the VCs.

Such a deal would leave management significantly better off, but VCs several millions short of their initial capital. A 1X preference, on the other hand, motivates management to create value and share that value creation with the investors.

This time the culprits are not just overzealous legislators, but many of my fellow venture capitalists.
The economic downturn in high-tech, however, has given venture capital investors exceptional bargaining power, which they have often used to obtain liquidity preferences of anywhere from two times to five times. Such demands, in my view, are counterproductive.

Suppose VCs invest $10 million in a first round on condition of a three times preference or the first $30 million. On the face of it, three times might seem reasonable. But the reality is that if first round investors have three-times preferences, investors in subsequent rounds will also insist on three-times preferences. A venture company that requires $40 million to reach liquidity will need to return $120 million before management gets a dime.

Situations get even hairier when a company has already raised $40 million through four previous rounds, but, in today's climate, is still worth only $10 million. Early round investors--especially corporate VC investors who never grasped the concept of alignment in the first place, as well as those VCs relatively new to the industry--often resist relinquishing preferences to newer investors and leaving room for management incentives.

The result is endless negotiations and deals that look like Christmas trees. Financial structures grow so complex that interests are aligned at some valuations and not at others.

Such deals, which litter the current venture landscape, are almost always doomed to fail. It becomes very difficult to recruit "A" management teams and, to the degree you do get good people, they will "shoot for the moon." They have no incentive to cut the burn rate, survive and go for a smaller win, because that's not what the VCs have given them incentive to do.

The solution? Eliminate earlier preferences by converting them to common stock at a much lower value that reflects the new reality. It's Venture Capital 101. The only way to build successful companies on a consistent basis is to align interests so that everyone pulls together in the same direction.