Waze’s $1BN sale to Google was the hot topic in Tel Aviv in the last month. At the beach and in coffee shops, people were busy celebrating the startup nation’s newest success story and trying to guesstimate the enormous returns to the VCs and founders involved.
But not all “exits” have happy endings like Waze. Founders specifically are exposed to material dilutions along the road and quite often end up receiving insignificant payouts in “exits” which are otherwise good deals to investors. The recent Delaware Bloodhound case, briefly discussed below, may change this and the way boards review and approve transactions that adversely affect founders.
Some statistics first. Startup success stories (e.g., Waze), are somewhat misleading because in retrospect, success seems inevitable. However, as the famous angel investor David Rose noted — VCs invest in one out of every 400 startups they screen. In fact, only 1,500 startups successfully obtain funding in the U.S. each year. Even worse, the rule of thumb in Silicon Valley (and probably in Tel Aviv as well) is that out of these funded startups, less than 10%-15% will become successful companies.
Naturally, entrepreneurs are extremely excited when VCs decide to invest and almost always accept the industry’s standard terms for such investments. These terms ensure that the VCs are paid prior to the founders, management and employees. Consequently, VCs are typically issued preferred shares that accrue annual dividends and which entitle their holders to receive the original investment plus these dividends when the company is sold – prior to any payments to the founders and employees.
The requirement that VCs be paid first sometimes means that founders and employees receive no consideration in an otherwise successful “exit”. This is especially true in cases where the founders have been pushed out along the road.
In the recent case of Bloodhound, a Delaware Court specifically addressed claims made by the company’s founders regarding unfair dilution.
Bloodhound is a developer of web based anti-fraud software that was founded in the mid-1990′s. The Bloodhound plaintiffs are five software developers, including Bloodhound’s founder, who contended that their years of hard work laid the foundation for the company’s success. The five plaintiffs held common stock of the company. They claim that after the company raised initial financing and came under the control of the VCs, the VCs financed the company through self-interested and highly dilutive stock issuances. Consequently, in 2011 when the company was sold for $82.5 million, the plaintiffs discovered that while the VCs and current management received significant returns, the plaintiffs received almost nothing due to their minimal ownership. The plaintiffs claimed that they did not learn about the dilutive issuances and their diluted position (less than 1% overall) until the sale of the company and that the VC rounds were unfair self-interested transactions. The VCs counter-claimed that they acted in good faith.
The Delaware Chancery Court found that the plaintiffs’ claim that the VCs had favored themselves to the detriment of the plaintiffs could indeed be a viable claim. The case was therefore upheld and will be considered by the court.
If Bloodhound’s plaintiffs are successful in their lawsuit, the case could change current practices. It might require boards that take VC money to consider the founders and their interests before raising the funds. This could cause boards to be less receptive to investment rounds that involve founder’s dilution.