Founders may have inadvertently given their VCs too much power to block an IPO
While some investors they lament loudly that the IPO window can’t stay closed forever, and other VCs are actually part of the problem.
Many standard VC deal terms give investors the ability to block an IPO or acquisition if they didn’t think the timing or price was right, Lowenstein Sandler partner Eric Weiner told TechCrunch. While it’s relatively unusual for investors to directly state that they have the ability to block an IPO — though it’s been seen in the past — there are very tabled deal terms that essentially allow preferred stock investors to do the same thing, he added.
Investors with preferred stock have more power than those with common stock and have a say, and usually a vote, when a company is about to take an event that would dilute their shares or convert them into common stock. The IPO process does both of these things. “It’s not easy to come out publicly,” Weiner said. “A lot of things have to line up.”
Ryan Hinkle, CEO of Insight Partners, said that before a company can go public, its preferred stock investors — especially those setting the terms in the latest round — must want an IPO. In a good market, investors and founders are likely to agree on the right time to go public. Today a founder can be okay with going below their startup’s last valuation. But their investors have to be okay with that too.
“Any preferences on that stock go away, you no longer have 1x liquidation preference, you have no named right on the board when you convert to common stock,” Hinkle said of what happens to VC stock after an IPO. “The last capital raise, if you’re not on top of it, the last investor basically has to want the IPO or it’s not going to happen.”
A 1x liquidation preference means that the investor receives the first estimates of the repayment of the investment money in the event of a redemption, before any other investor. It’s a common term for late-stage investors who agree to pay higher prices for their stake to boost a startup’s valuation. The term preferred by most investors (especially early stages) is pari passu – which grants all shareholders an equal share.
Such high royalties are likely to be a hang-up for many startups raising rounds in 2021. When startups hit high valuations in 2021, they may not have realized how much power they were giving their late-stage investors if the market cooled. which it did.
“People mess up and to the right, with a God-given right,” Hinkle said. “We have the right to life, liberty and the pursuit of happiness. We don’t have the right above and to the right.”
Alan Vaksman, founding partner of Launchbay Capital, agreed. He added that there is always much more friction between investors and startups over the decision to IPO than investors would like to admit. He added that not everything comes from a negative or selfish place. These investors have a fiduciary duty to their LPs to make the smartest financial decisions to bring the highest returns back to their investors. Pushing a company into an IPO when it could potentially return more capital if it waited isn’t smart.
Street markets have also changed in recent years. Hinkle said that traditionally companies should have eight quarters of strong growth and metrics before going public. While companies could get away without it in 2020 and 2021, they won’t be able to now. Waxman agreed.
“Public markets don’t care so much about your growth, but more about pure financials, good old profitability and margins,” Vaksman said.
In addition, the rise and maturation of secondary markets, where private shareholders can sell shares in company-sanctioned transactions, also plays a big role for VCs. Secondaries let them get liquidity if they need it, rather than forcing undervalued startups to go public.
Founders dealing with VCs who might drag their feet might cause tension in the boardroom, but could produce better results for the startups, their VC backers, and the VC’s underlying LPs.
“While a year ago I would have guessed we would be closer to normal than now, SVB has thrown a big wrench into the world, heightened tensions in the Middle East, these times of uncertainty introduce fear, doubt and risk,” Hinkle said. . “I wouldn’t expect a boom in IPOs this calendar year.”
