Bill Gurley’s post last week sparked a multitude of conversations around the current funding environment, and what it could mean for the future of VC. Veterans throughout the industry weighed in with their opinions, along with what they believe Gurley may have left out.
1/ Now w/ 2 nights sleep to digest @bgurley's post, 1 (of many) takeaways is potentially big % of preferred shares may, in fact, be common.— Semil (@semil) April 22, 2016
2/ Some may find out by surprise their preferred shares are now common, impacting early shareholders & potentially washing away any returns.— Semil (@semil) April 22, 2016
The post has started some interesting discussions in regard to how new deals with 'dirty terms' could negatively affect existing investors. As companies venture into the chilly fundraising environment, there will be investors looking to add specific terms to subsequent rounds, securing a picturesque valuation but adding in dubious liquidation preferences and ratchets. The addition of these terms often makes it difficult for existing investors to realize their investment, as they are bumped further down the liquidation ladder.
@semil no question many firms/investors have "booked" gains that will evaporate upon modest exit post dirty round— Michael Carney (@mcarney) April 22, 2016
One way early investors can negate this is to sell a portion of their shares when a new round is raised, providing them with liquidity when it's available. An interesting signaling conflict arises in this case, however. When an investor looks to sell off their position, it can be seen as a lack of confidence in the future of the company. Why would you cash out now if you could realize larger gains in the future, after all?
Moreover, if an investor does liquidate early, it could hurt the firm’s brand and reputation with founders, potentially causing deal flow to suffer in the future. All that said, amid an exit environment like today's, opportunities to liquidate and realize an investment are few and far between. Since these venture investors hold a fiduciary duty to their LPs, it may seem prudent to cash out when the chance comes.
The conversation will undoubtedly continue and morph into many more interesting blog posts and discussions. One thing is for sure—the flurry of investment activity over the last couple years and the current VC environment we’ve found ourselves in has, and will, force investors to make difficult choices moving forward.