19 Nov Heads we win, tales you lose: The VC price protection con
This is one of those “fight the good fight” columns; a spirited strike on behalf of the entrepreneur that has no chance of actually persuading anyone, or at least anyone in the venture capital community, of anything. Nevertheless, for the sake of all those entrepreneurial Davids out there looking for capital from VC goliath’s, here goes nothing.
Of the many “we do it because that’s the way it’s done” investing rules that mysteriously favor VCs over entrepreneurs, perhaps none is more deeply embossed in the fabric of the market than “price protection.” It’s the mechanism by which a venture capital investor who, having paid more for his shares than the next guy, gets some or all of the benefit of the next guy’s lower price. It’s a great scam, excuse me, scheme, that offers the venture capitalist some protection from…, well, how should I say this …, making a deal with an entrepreneur at a valuation that hindsight later suggests was, perish the thought, favorable to the entrepreneur.
If that doesn’t sound fishy, imagine a world where an ordinary investor, a mere mortal lacking the divine imprimatur of the VC, could, having purchased say 100 shares of Acme, Inc. from their broker for $50 a share on Monday, get a $1,000 refund later in the week, after the market price had dropped to $40 a share. Widespread adoption of this rule would, I dare say, make said ordinary investor’s returns look rather extraordinary. But, alas, our ordinary investor not being a VC, no one would suggest that Acme, Inc. should give him any sort of price protection to insulate him from declining valuations.
Now, having been a venture capitalist myself (and the beneficiary on more than one occasion of price protection), I can hear the wailing from my erstwhile VC colleagues even as I write these words. “We take extraordinary risks,” they howl in protest, “on deals so immature that setting any valuation is just guess work. It’s only fair that, as the valuation metrics become more visible, we should get some adjustment to reflect our beneficent willingness to invest when the metrics were so obscure.”
Yes, pity the poor VC, doing deals that mere mortals, with the possible exception of widows, orphans and investment-challenged angels, fear to tread. Why should these noble purveyors of “value added” capital be subject to the same rules as the rest of us? Why shouldn’t grateful entrepreneurs let them, in effect, re-price their investments when some combination of deal-specific or market factors makes a VC’s best guess on valuation look, sometime later, less than inspired?
Believe it or not, the argument is one that many VCs can make without even blushing. (VCs are, as entrepreneurs well know, pretty good at saying outrageous things without blushing.) But the intellectually honest VC – I knew one, once – will have to admit the argument has an Achilles heal. If giving the VC the benefit of a decline in the value of a start-up really makes sense, surely we should give the entrepreneur the benefit of an increase in the value of a start-up, right? If it’s good for the goose…..
Two-way price protection! Now, there’s a thought! If the VC gets the benefit of falling valuations, let’s give the entrepreneur the benefit of rising valuations! No VC would ever think of the term “full ratchet” the same way again! Try suggesting it to the next VC you meet. See if you can do it without blushing. If so, maybe you are on the wrong side of the table.
Recent columns by Paul A. Jones