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The Double Dip
Brad Feld does an excellent job with his post on the "double dip" otherwise known as the Participating Preferred.
His post is relatively long but absolutely essential reading for any entrepreneur that has never seen a Participating Preferred before.
While Brad didn't take sides, I will.
I insist on participating preferreds and get them in almost all of my deals eventually. Maybe its my "east coast" heritage. But I believe that the risk capital has the right to get its cost back and then share in the profits with the other shareholders who do not have capital at risk.
That's how we do it with our investors, called LPs. And it works fine for us. And I think the same should apply to the entrepreneurs.
I also believe in caps. I think double dips are too generous if the investment works out very well. And so I generally always agree to cap them. When and how depends on the deal.
I generally don't like the "multiple participate" as Brad calls it. There are some cases where its needed to structure around certain valuation and ownership issues that crop up. But its not a good way to align interests among shareholders and causes a lot more problems than it solves. I try to avoid it as much as I can.
That's my view of the double dip.
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Posted August 24, 2004 in Venture Capital and TechnologyComments
"But I believe that the risk capital has the right to get its cost back and then share in the profits with the other shareholders who do not have capital at risk."
The risk capital in this situation gets its cost back and then gets to profit with a zero cost basis along with other shareholders who have a large cost basis. How could this possibly be equitable?
Even if an entrepreneur has not contributed significant financial capital to a business, typically they contribute years of industry experience, specialized expertise in a field, lost wages, extensive time, etc.... All of these are contributed to the enterprise with a substantial risk of loss. Your logic gives these contributions a dollar value of zero.
Posted by: Peter Waldschmidt | Aug 25, 2004 8:58:41 AM
That's a good observation Peter, but I don't think it's correct. The entrepreneur gets a common interest in the value that is created over the cost basis of the risk capital in return for everything that they are contributing. That's all negotiated in the equity split. I think participating preferreds result in higher valuations for the entrepreneur meaning higher equity splits once the cost basis is returned.
And this is how we do it with our investors. We are contributing a lot to the venture partnership but yet we only get a share of the gains after we return the cost basis.
Posted by: fred wilson | Aug 25, 2004 9:18:19 AM
I see your point about how a participating preferred could allow for higher valuations for the entrepreneur. It also lowers the VC's risk substantially while increasing the entrepreneur's risk. (i.e. the entrepreneur has a higher risk of getting reduced post-money value if the company grows moderately or worse). It makes evaluating a potential VC deal that much more strenuous for an entrepreneur.
Posted by: Peter Waldschmidt | Aug 25, 2004 11:14:01 AM
Peter,
You get what you pay for. As somebody once said "them's the terms". Nobody said it would be easy.
Posted by: jackson | Aug 25, 2004 1:53:47 PM
Peter,
You get what you pay for. As somebody once said "them's the terms". Nobody said it would be easy.
Posted by: jackson | Aug 25, 2004 1:53:50 PM
Since I've filled up the comments on Brad's blog, I thought I'd comment here too.
As I said there, comments like "risk capital has the right to get its cost back..." are just posturing. It's just a negotiation, and whatever terms the parties agree to (assuming they are legal) are "fair" since they agreed to them. If the investor has more leverage, then they get more of what they want.
Investors should focus on WHY they have a participate: because they're not really in the game for moderate returns, and they don't want to incent the entrepreneurs to aim for that.
Many entrepreneurs have a risk/return profile that is in conflict with that of the investors. For a VC, a 2x return is not interesting, at least not *before* the money goes in. But in a typical venture deal, a 2x return for the VC could easily put $1 million in the entrepreneur's pocket. Many first-time entrepreneurs would view this as a huge success (to quote Office Space, "What would you do if you had a million dollars?"), when in the VC's eyes it is a ho-hum sideways deal.
I think this disconnect is rarely addressed up-front. I'm not even sure most VCs are aware of it, and I know the entrepreneurs aren't.
Finally, I want to point out that your analogy with carried interest in the limited partnership works for early stage investments, but not later stage investments. In the fund, the investors put money in what is essentially slideware ("here's our genius portfolio strategy for Fund XXXVII"). Same for many Series A deals. But for later deals, there is a real business, a going concern that is worth something, so the analogy doesn't work there.
BTW, another way to answer Peter's question is to think of it in terms of pre-money valuation. In economic terms a slideware business is worth zero (no, really: your idea isn't worth anything, because (a) if it's a good fundable idea, there are four or five other businesses starting up at the same time doing the same thing, and (b) the reason the investor is talking to you is that he already wants to invest in the space you think you're inventing -- see slides for Fund XXXVII). So the pre-money valuation (which ends up as a share of the proceeds in the math) is a tangible way to think of the value of experience and expertise. Investors contribute $3m of cash and you contribute $2m of knowhow and experience for a $5m postmoney deal. If it sells for $3m, they get their cash back and you get to keep your knowhow.
Posted by: Dave Jilk | Aug 25, 2004 7:41:11 PM
As mentioned above, the two "partners" need to be clear as to what they're really aiming for...
Inventors/founders think that you're investing in their idea, and are happy with a base on balls, as that a decent chunk of change and things end up much better for them than whiffing on a swing for the fences
VC has multiple shots at swinging for the fences and needs to average out at something around a double to make up for the whiffs.. it doesn't seem that the VCs make this clear to founders or that founders really understand this (things would likely go badly and have less chance of success if entrepreneurs knew this...)
its not evil, or anything, just the incentives and needs of the different parties... one more reason to stay as far away from getting VC investments as possible, and why its great to be a VC general partner (and usually ok to be a limited partner)
Posted by: hey | Aug 26, 2004 12:21:52 PM
Fred,
One thing to remember with the PPs is that it is only relevant in an acquisition exit. In an IPO the term is moot. So it further ratchets up the entrepreneurs incentive to "go big or go home." You and I both know a company very well where there is no way that the mgmt will manage the business for a trade sale because the preference stack is too high. They are going for IPO or will go out of business. Thankfully it looks like they will get the IPO, but the early investors took a huge amount of dilution. And we had to reload the mgmt team with new options because of it, but the early investors did not get reloaded. So Brad's argument of the PP creating a "flat spot" on the curve is true, but I think the biggest misalignment between investors and mgmt is the dramatic difference in the return profiles between an acquisition exit and an IPO when done at the exact same valuation. And it really affects how mgmt decides to run the business.
Because I learned the business from you, I'm pre-disposed to PPs as well. But I'm also a lot more sensitive to the complications and misalignments it can create if the business turns out to not be a viable IPO candidate.
Posted by: Dan Malven | Sep 2, 2004 11:28:21 AM
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