Opaque Financial Contracting and Toxic Term Sheets in Venture Capital

• DOI: http://doi.org/10.1111/jacf.12160
• Published date: 01 March 2016
• Date: 01 March 2016

In This Issue: Risk Management

Risk Management—the Revealing Hand 8Robert S. Kaplan, Harvard Business School,

and Anette Mikes, HEC Lausanne

Bankers Trust and the Birth of Modern Risk Management 19 Gene D. Guill, GPS Risk Management Advisors, LLC

University of Texas Roundtable

Financing and Managing Energy Investments in a Low-Price Environment

30 Marshall Adkins, Raymond James; Greg Beard, Apollo

Global Management; Bernard Clark, Haynes and Boone;

Gene Shepherd, Brigham Resources; and George Vaughan,

ConocoPhillips. Moderated by Sheridan Titman, University of

Texas McCombs School of Business.

Why FX Risk Management Is Broken—and What Boards Need to Know to Fix It 46 Håkan Jankensgård, Lund University, Alf Alviniussen,

Lars Oxelheim, University of Agder, and

Research Institute of Industrial Economics

Derivatives: Understanding Their Usefulness and Their Role in the Financial Crisis 62 Bruce Tuckman, New York University Stern School

of Business

Opaque Financial Contracting and Toxic Term Sheets in Venture Capital 72 Keith C. Brown and Kenneth W. Wiles, University of Texas

McCombs School of Business

Three Approaches to Risk Management—and How and Why

Swedish Companies Use Them

86 Niklas Amberg and Richard Friberg, Stockholm

School of Economics

Are U.S. Companies Really Holding That Much Cash—And If So, Why? 95 Mar c Zenner, Evan Junek, and Ram Chivukula,

J.P. Morgan

Seeking Capital Abroad: Motivations, Process, and Suggestions for Success 104 Greg Bell, University of Dallas, and Abdul A. Rasheed,

University of Texas at Arlington

The Beliefs of Central Bankers About Ination and the Business Cycle—

and Some Reasons to Question the Faith

114 Brian Kantor, Investec Wealth and Investment

VOLUME 28 | NUMBER 1 | WINTER 2016

APPLIED CORPORATE FINANCE

Journal of

72 Journal of Applied Corporate Finance • Volume 28 Number 1 Winter 2016

Opaque Financial Contracting and Toxic Term Sheets

in Venture Capital

* We are grateful for the comments and contributions of Bill Gurley (Benchmark) and

Jordan Thomas (Croft & Bender) in the development of this study. The authors remain

solely responsible for any errors or omissions in the analysis.

1. Douglas Macmillan, 2015, “Snapchat Raises Another $500 Million from Inves-

tors,” The Wall Street Journal, May 29.

2. Douglas MacMillan and Kirsten Grind, 2015, “Fidelity Marks Down Value of Snap-

chat Stake by 25%,” The Wall Street Journal, November 10.

3. Keith C. Brown and Kenneth W. Wiles, 2015, “In Search of Unicorns: Private IPOs

and the Changing Markets for Private Equity Investments and Corporate Control,” Jour-

nal of Applied Corporate Finance 27, no. 3, 34-48.

4. See Rolfe Winkler, 2015, “Bill Gurley: ‘All These Private Valuations are Fake,’”

Money Watch, October 20.

O

n May 29, 2015, e Wall Street Journal reported

that “the demand to own private shares in Snap-

chat, Inc. has become so erce that its newest

investors (including Alibaba Group Holdings)

are willing to receive second-rate stock in exchange for their

money.”1 e security position was considered second-rate

because it came in the form of common equity rather than

preferred stock, which provides investors with stronger rights

than those aorded common shareholders. e funding round

was raised at a post-money valuation (that is, the pre-funding

value of the rm plus the newly invested capital) of $16 billion,

which represented a 60% increase from the company’s prior

round, which was also raised through the issuance of common

stock. By September 2015, however, capital market conditions

had worsened, forcing Fidelity Investments, another common

stockholder of Snapchat shares, to write down its investment

by 25% amid concerns about the inated valuations of private

companies.2 By contrast, earlier-stage providers of nancial

capital, such as Benchmark and Institutional Venture Part-

ners, had invested in preferred stock, which was specically

designed to protect them against adverse market events.

In a recent article in this journal, we documented the

dramatic increase in private IPO transactions (PIPOs) and the

“unicorns”—privately held companies with market valuations

of $1.0 billion or more—that such transactions have helped

to create.3 As we discussed, a primary benet of PIPOs is

that they allow companies to remain private longer, which

may permit them to avoid the organizational and governance

problems that are said to be endemic to publicly traded compa-

nies. But by keeping companies private longer, these PIPO

transactions may also have the potential to reduce the value

of these private companies by shielding them from the disci-

plining oversight imposed by a broader base of institutional

and individual investors, financial analysts, and govern-

ment agencies. In addition, achieving unicorn status is now

considered to be such an important event for many market

participants—if only for the public relations, marketing, and

recruiting benets the moniker is perceived to bestow—that

companies appear to be pursuing it as a goal in itself. In fact,

we showed that more than one-quarter (38 out of 142) of the

unicorn rms in our sample were valued at exactly $1 billion,

suggesting valuation outcomes that were likely manufactured

to clear that specic hurdle.

In our analysis, we sounded a cautionary note with respect

to this aspect of the rapidly evolving PIPO funding process.

In particular, we suggested that in their quest to reach unicorn

status, managers at some companies may have the incentive

(or otherwise feel pressured) to manipulate the market valua-

tion by acquiescing to complicated and onerous nancing

conditions that enable them to attract a sucient amount of

new capital. ese complex contracting terms, which include

such devices as ratchet agreements and preference payments,

are invariably imposed as a way to eliminate most or all of the

new investor’s downside exposure to subsequent market price

movements. However, this protection provided to new investors

can come at the expense of materially negative eects that get

shifted to other stakeholders—existing investors, entrepreneurs,

and employees—who may not even know the terms exist or

fully understand the impact of the stipulations on any benets

they may receive in the event that the company eventually

becomes successful. In addition, in exchange for receiving terms

that eliminate much of their downside risk, the participants in

this new funding round may be willing to accept higher valua-

tions than would be justied by the fundamental economic

activity of the rm. Indeed, Bill Gurley, Managing Partner at

Benchmark, oered a blunt assessment of this current state of

aairs, stating that “all these private valuations are fake.”4

Of course, inated valuations in the present increase the risk

that future capital-raising eorts will be transacted at valuation

levels that are lower than those obtained in previous funding

rounds. And such “down rounds” can have negative conse-

quences that go well beyond the immediate perception that the

present worth of the company has declined. For example, the

execution of a down round can trigger anti-dilution provisions

by Keith C. Brown and Kenneth W. Wiles, University of Texas,

McCombs School of Business*