VCs Get Paid Back First

I read an article this morning in DealBook titled “In Venture Capital Deals, Not Every Founder Will be a Zuckerberg“.  Go ahead and give it a read.  I actually like the Deal Professor very much and think he usually writes good stuff.  But this time he missed a few things.

My first reaction was “no kidding” and that was just to the title of the article.  I hope that does not need much explanation.  Here are a few other thoughts:

1.  The article states “When venture capitalists invest, they typically demand preferred shares that accrue a yearly dividend of about 8 percent. The dividend goes unpaid until the company is sold. In a sale, the original amount and the interest all come due. It must be paid out before the common shares, which are typically held by the founders and other employees.”   What this describes are “cumulative dividends” where the dividends actually accrue over time.  This is RARE in VC deals.  Most deals are done with non-cumulative dividends that are NEVER paid.  Huge difference!

2.  The article also states that “But venture capital investments are structured to ensure that the venture capitalists are paid before founders and employees.”  And to this I think “yeah, that makes sense.”  If the VCs invest say $18 million in a company, and assuming that the employees have been getting paid for their work, then it makes sense that the first $18 million available on a sale transaction would go back to the investors to repay their investment.  It is ONLY once the VC’s liquidation preference is cleared that the common stock held by founders and employees is worth anything.  And I think that makes 100% sense. Yeah, I am a VC so you might think I am biased, but it really does make sense.

The legal case that the Deal Professor writes about is one of the fringe cases where actions by the board of the company may be called into question for breach of fiduciary duty to common stock holders, who, in this case, included founders who had been let go many years prior.  Fiduciary duty law is well settled, and, no, directors cannot approve dilutive financings without regard to common shareholder interests.

It will be interesting to see how this legal case plays out.