A VC in Vacationland

Right Whale (Photo credit: Joseph Wu Origami)

In recent months,I have had two startups faced with the decision of deciding whether to take dumb money. No, not Uncle Frank's friends and family round check, although that one can be a problem as well, but mostly over bad feelings if the startup fails. 

No, I mean money with strings attached. Strings attached to convertible notes or preferred stock rounds can come in a variety of flavors. The ones I have had to deal with recently are supra pro rata rights and unqualified financing conversions in convertible notes. And why the Right Whale to the left, you ask? Dealing with these terms can be a whale of a problem for the entrepreneur in later financings.

Supra pro rata rights are basically the right to invest in the next funding round, regardless of who leads it or whether other investors would welcome them. In the case of a convertible note, it would allow an investor to buy a certain percentage of preferred stock or invest a certain amount of money, regardless of valuation and the desire of new investors to limit participation. They are often attempted when a new VC firm finds a hot investment and wants to be guaranteed that they can invest in the next round. It is a rare term, one that can irritate the next round of investors, sometimes so much that the new investors can try and make the supra pro rata rights go away before they invest. This can be costly and make the entrepreneur give up additional ownership to satisfy the rights before financing, or have a sugar daddy who can pay off the earlier investors.

Unqualified financing clauses are usually inserted by investors who want their money back if there is a down round (meaning the valuation of the company is below the previous valuation) in the next tranche of funding. In this case, the legal clause says that the holders of the note have the right to ask for their money back if the valuation drops from say, $5 million to $4 million. The VC looking to finance the down round could then see their money go right back out the door to previous investors, rather than help grow the company. VC's would generally ask the entrepreneur to clean this obligation up as well prior to new funding, meaning the entrepreneur would have to find some way to buy off the holder. Since entrepreneurs rarely have millions in the bank, the buy off can turn out to be giving a significant share of the company to the earlier note holders to clean up the obligation prior to new funding.

There are numerous other variations lawyers and lenders have thought up which we will address later. The bottom line is that unless your are desperate, never agree to these kind of rights in a financing round.