Summarizing the week Jared writes, “Lewis Carroll famously said, ‘Begin at the beginning, go on to the end, and then stop.’ But that is hard advice to follow when one’s head is spinning…” It would have been just as apt if Jared had added that “here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” Because, at the end of Season 3 Pied Piper is in pretty much the same place as at the end of Season 2, and about to begin at the beginning all over again. (But at least it’s a promising place to start!)

Let me explain. First, Jared’s ploy to buy fake users comes to an inglorious end: the team discovers their “uptick” in daily active users is the product of a Bangladeshi click farm not the product gaining traction. Unfortunately, in the meantime, Erlich used the uptick to set off a wave of VC “FOMO” (fear of missing out), that culminates in an offer of $6 million in Series B funding. But Richard’s moral compass prevents him from carrying through on the fraud. He reveals the uptick was fake and tries to pitch Dinesh’s awesome (and incredibly popular) video chat app instead, but the VC’s want none of it. The same goes for Laurie who forces the sale of all of Pied Piper, including Richard’s stake, “to the highest bidder” when she finds out about the fake uptick. Shockingly, the highest bidder turns out to be Bachmanity—revitalized with $1 million from selling the Code/Rag blog to Hooli—Big Head and Erlich out-bid Gavin Belson by one dollar. Because of Raviga’s liquidation preference all the money goes to Raviga, and Pied Piper ends up back at the beginning: in Erlich’s Hacker Hostel with no money and Richard’s CEO status and equity in jeopardy, but with a really promising new technology about to take the world by storm.

And it looks like we have that stupid investment deal with Russ Hanneman to blame again! It’s the reason Richard had to sell his stake in Pied Piper and the reason Raviga walked away with all the money. For anyone who missed most of the last two seasons, Russ Hanneman came along last time Pied Piper was desperate for money, and in exchange for his pledge of a $5 million investment, he negotiated “onerous” terms. He got two of Pied Piper’s five board seats, so that when Laurie and Raviga bought Russ out, Raviga gained control of Pied Piper’s board. Russ also obtained protective provisions and restrictions, one of which let Laurie block Erlich’s sale of his shares to Russ so that she could acquire them at a rock-bottom price.

Now it appears that Russ also obtained a “drag-along” provision and a liquidation preference. A drag-along provision allows the investor to force the other shareholders to participate in the sale of the company. This means that when the investor wants to sell its shares, any other shareholders subject to the drag-along must sell a pro-rata, or equal proportion, of their shares. So if the investor sells 100% of its shares, everyone subject to a drag-along must sell-out completely too! There are a number of negotiable conditions to the exercise of a drag-along right. One is the “trigger.” Investors commonly want the provision to state that if 51% of the preferred shares approve a sale, this will trigger the drag-along forcing the founders and other common shareholders to sell. As I’ll discuss more below, these forced sales can be on terms that are very unfavorable to the founders and other common shareholders. So to help avoid being dragged into crummy deals, founders may push back against triggers that are too “easy.” Founders might want approval of a higher percentage of the preferred shares (say 2/3) to trigger the drag-along, and might even negotiate a requirement for approval of some percentage of the common shares as well (maybe 50%).

Alternatively, the drag-along provisions commonly require board approval of the sale. In fact, it looks like that is what happened with Pied Piper. Board approval was required to trigger the drag-along provision, which is why Laurie called the board meeting and needed to bully 3 board members into approving the sale. Once Richard caved and agreed to be her third vote, everyone’s shares were sold to Bachmanity. (The only wrinkle is that, as we’ve seen in other posts, when acting as a board member, Laurie has a fiduciary duty to the common shareholders. I don’t have space to go into details, but Laurie has to be careful not to harm the common shareholders in order to benefit herself.)

So if Richard (and Dinesh and Gilfoyle—to the extent they owned shares) sold their shares, why didn’t they get any money? (As Richard said, someone “gets to buy Pied Piper for $1 million and Raviga gets all of it because of their liquidation preference and I get jack s**t?”) Yes, it’s the liquidation preference, which is one of the most important terms of any VC investment. “Liquidation” usually means any sale of the company to a third party (via stock or asset sale or merger) or any other “change of control.” And a liquidation preference means that the proceeds from any sale or change of control will be distributed to the owners of the preferred stock before anything is paid to the owners of common stock.

How much do the preferred shareholders get? That depends on the amount of the preference and whether it is “participating” or “non-participating.” If the preference is 1x, the investor gets back the entire investment before anything was paid to the common shareholders, 2x, the investor gets back twice its investment, etc. Furthermore, if the preference is “participating” then the investor receives the liquidation preference and then gets a portion of the remainder as if the investor had converted the preferred shares to common shares. If the preference is straight or non-participating, the investor gets only the preference (plus any accrued dividends), and anything left over goes entirely to the common shareholders. (However, investors holding a non-participating preference also have the choice of converting their shares to common rather than taking the preference. They will exercise this option if the return is higher per common share than through the preference.)

Some simple math illustrates the principles. Say the investor put in $100 and the company sells for $200. If the investor has a 1x non-participating preference, the investor gets $100 and the common shareholders get the remaining $100. With a 1x participating preference, the investor gets $100 and then gets a share of the remaining $100—the investor “participates” with the common shareholders in splitting the remaining amount. With a 2x preference the investor gets the whole $200, and the common shareholders get nothing.

All this means that if an investor has both a drag-along provision and a liquidation preference, the investor can force a sale acceptable to the investor, but highly unfavorable to the common shareholders.

Getting back to Pied Piper, Raviga invested a significant amount of money, definitely more than $1 million. (Action Jack quickly blew it all on fancy offices, a high-powered sales team, a chef and a zen garden!) Even if Raviga only had a 1x preference, it would have been enough to deprive Richard of any money from the sale but Raviga would still have not recovered its whole investment.

Thus, Richard, Pied Piper and the team are back in the Hacker Hostel, starting at the beginning with a new negotiation of roles and equity, a new promising product, and no money to speak of. But at least they might have finally gotten rid of Russ’s onerous terms, and hopefully they are a penny wiser and more savvy about VC term sheets. And who knows, maybe next season they will run at least twice as fast!

Special thanks to corporate attorneys Stephanie Zeppa and Kevin Rogan for their feedback and insights this season!