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I'm sympathetic towards regular people people being legally scammed by nasty contracts, but how did that happen here? This was not a clueless Joe being forced

by 21 8y ago

I'm sympathetic towards regular people people being legally scammed by nasty contracts, but how did that happen here? This was not a clueless Joe being forced to sign a non-negotiable contract with a giant company. Presumably those clauses and investment contracts were negotiated between lawyers of both parties. Why did they accept such clauses?

JumpCrisscross 8y ago
> Why did they accept such clauses? They're super standard and for the most part make sense. Liquidation preferences say if your firm is worth $90 million, and I invest $10 million, I get my $10 million back before you (i.e. the common stock holder) get anything. If the firm sells for $200 million, I get $20 million and doubled my investment. If the firm sells for $20 million, I get $10 million back and the common splits the remaining $10 million. If the firm sells for $9 million, I get it all. This makes sense because management (a) owns lots of common stock and (b) manages the company. As a risk-sharing measure, it makes sense for the people closest to the operations (and extracting a cash salary) to bear more downside risk. Drag-along rights are the corporate equivalent of collective action clauses [1]. They exist to prevent a person who holds two percent of the company from preventing shareholders who own 60% from selling. (Approving mergers requires supermajorities in most jurisdictions.) [1] https://en.wikipedia.org/wiki/Collective_action_clause https://en.wikipedia.org/wiki/Collective_action_clause Disclaimer: I am not a lawyer. This is not legal advice. Consult with a lawyer before negotiating fundraising terms.
- x0x0 8y ago
  These clauses generally don't cause any grief if the outcome is a win or a complete failure. It's only when it's a partial failure and people are dividing up what there is -- typically less than was put in -- that these cause major differences in outcomes.
- paulsutter 8y ago
  You're describing participating preferred (that is, investors get paid out once as preferred and again after conversion to common). A liquidation preference is more common than participating, where the preferred investors get paid out (for example) at least 2X their investment (can be any multiplier, the highest I ever heard was 5X). Most investments in Silicon Valley are clean deals, with a liquidation preference of 1X and nonparticipating preferred. Companies without a clean deal usually were too thirsty for unicorn status ($1B valuation) or had difficulty raising money.
  - JumpCrisscross 8y ago
    > You're describing participating preferred I'm describing non-participating preferred, which as you point out is far more common. Here's how it would go with participating preferred. As before, I invest $10 million at a $90 million pre-money valuation. If the firm sells for $200 million, first I get back my $10 million. Then I convert to common and get 10% of the remaining $190 million, or $19 million. Before I got $20 million (10% of $200 million). Now I get $29 million. (In the down round scenario, the outcome is the same.) Participating preferred is--nowadays--increasingly confined to distressed finance. TL; DR Participating preferred gets to have its cake and eat it too. Non-participating preferred must choose between (a) its preference or (b) converting to common.
    - paulsutter 8y ago
      I misread your comment, thanks These terms are by no means confined to distressed finance. Many unicorns got their “billion dollar” number using adverse terms such as these Which explains this outcome, Fanduel was a “unicorn”: https://seekingalpha.com/article/4010443-fanduel-unicorn-back-fast-track https://seekingalpha.com/article/4010443-fanduel-unicorn-bac...
barbegal 8y ago
If you're a minority shareholder sometimes you have no option but to accept. Changes to the articles of association of a company only have to be approved by a majority of the shareholders. This is the price you pay for raising equity capital. There is nothing particularly scammy going on here, the majority shareholders are protecting their interests and the interests of the company to the extent permitted by the law.
gnicholas 8y ago
I had the same reaction about these both being sophisticated parties with legal representation. Probably the founders were either more optimistic about the likely outcome (so there would have been cash leftover for them) or they were under pressure when the deal was being struck. I don’t have any inside information about what happened — this is just generic speculation about what might have led to this outcome.

by 21 8y ago

JumpCrisscross 8y ago

> Why did they accept such clauses? They're super standard and for the most part make sense. Liquidation preferences say if your firm is worth $90 million, and I invest $10 million, I get my $10 million back before you (i.e. the common stock holder) get anything. If the firm sells for $200 million, I get $20 million and doubled my investment. If the firm sells for $20 million, I get $10 million back and the common splits the remaining $10 million. If the firm sells for $9 million, I get it all. This makes sense because management (a) owns lots of common stock and (b) manages the company. As a risk-sharing measure, it makes sense for the people closest to the operations (and extracting a cash salary) to bear more downside risk. Drag-along rights are the corporate equivalent of collective action clauses [1]. They exist to prevent a person who holds two percent of the company from preventing shareholders who own 60% from selling. (Approving mergers requires supermajorities in most jurisdictions.) [1] https://en.wikipedia.org/wiki/Collective_action_clause https://en.wikipedia.org/wiki/Collective_action_clause Disclaimer: I am not a lawyer. This is not legal advice. Consult with a lawyer before negotiating fundraising terms.

x0x0 8y ago
These clauses generally don't cause any grief if the outcome is a win or a complete failure. It's only when it's a partial failure and people are dividing up what there is -- typically less than was put in -- that these cause major differences in outcomes.
paulsutter 8y ago
You're describing participating preferred (that is, investors get paid out once as preferred and again after conversion to common). A liquidation preference is more common than participating, where the preferred investors get paid out (for example) at least 2X their investment (can be any multiplier, the highest I ever heard was 5X). Most investments in Silicon Valley are clean deals, with a liquidation preference of 1X and nonparticipating preferred. Companies without a clean deal usually were too thirsty for unicorn status ($1B valuation) or had difficulty raising money.
- JumpCrisscross 8y ago
  > You're describing participating preferred I'm describing non-participating preferred, which as you point out is far more common. Here's how it would go with participating preferred. As before, I invest $10 million at a $90 million pre-money valuation. If the firm sells for $200 million, first I get back my $10 million. Then I convert to common and get 10% of the remaining $190 million, or $19 million. Before I got $20 million (10% of $200 million). Now I get $29 million. (In the down round scenario, the outcome is the same.) Participating preferred is--nowadays--increasingly confined to distressed finance. TL; DR Participating preferred gets to have its cake and eat it too. Non-participating preferred must choose between (a) its preference or (b) converting to common.
  - paulsutter 8y ago
    I misread your comment, thanks These terms are by no means confined to distressed finance. Many unicorns got their “billion dollar” number using adverse terms such as these Which explains this outcome, Fanduel was a “unicorn”: https://seekingalpha.com/article/4010443-fanduel-unicorn-back-fast-track https://seekingalpha.com/article/4010443-fanduel-unicorn-bac...

barbegal 8y ago

If you're a minority shareholder sometimes you have no option but to accept. Changes to the articles of association of a company only have to be approved by a majority of the shareholders. This is the price you pay for raising equity capital. There is nothing particularly scammy going on here, the majority shareholders are protecting their interests and the interests of the company to the extent permitted by the law.

gnicholas 8y ago

I had the same reaction about these both being sophisticated parties with legal representation. Probably the founders were either more optimistic about the likely outcome (so there would have been cash leftover for them) or they were under pressure when the deal was being struck. I don’t have any inside information about what happened — this is just generic speculation about what might have led to this outcome.