In the premiere episode of the new HBO drama, Silicon Valley, six tech geeks who live together in an “incubator” space in Palo Alto, CA, are hoping to make it big. One of them, an incredibly bright, but socially awkward programmer, has created an app with a powerful compression algorithm that could reap billions and potentially change the very nature of the entertainment business. Suddenly he becomes embroiled in a bidding war, with one potential offer going as high as $10 million, sending him off to a clinic with a panic attack.

We have seen this story play out again and again. An entrepreneur hatches an idea, then looks for independent sources of funding to grow and scale the business. Yet, despite the many headlines about soaring multiples, the road to riches isn’t so simple.  Blame the practice of independent venture capital (VC) firms dedicating a lot of focus and energy on “exit strategies” as the first and foremost question in structuring an investment, a practice that could actually be undermining instead of fostering entrepreneurship.  I would argue that moving towards more “evergreen” structures for capitalizing new enterprises would help everyone regain momentum.

Looking from a Brazilian market perspective and drawing from my experience as a legal adviser active in São Paulo, the VC scene here since its early beginnings in the mid-nineties offered a few first-hand experiences in negotiating exit provisions on behalf of “buy side” and “sell side” clients, as well as later participating in some of the ensuing “exit”. 

There are three main categories of independent VC-sponsored deals from the perspective of exit strategies and their dynamics: At one end of the spectrum lie a fair number of companies that do not take off after they’re seeded and quickly die of natural causes; on the other extreme, we find the precious few that do according to plan or better, making everybody happy and rich.  In between are the handful of entities that end up “getting by” after scoring an infusion of venture capital, performing more or less to the satisfaction of their founders – but hardly living up to the expectations of the VC’s managers and investors.

It is invariably in these “middle of the road” scenarios where exit clauses come into play and at their roughest, cause a lot of stress to those involved, if not significant avoidable losses.

Stepping back to look at the individual cases, the broad backstories tend to be very similar to the one now being depicted on TV: the target firm survives its start-up phase with the VC’s capital injection but, for any number of reasons, does not reach the stage where it can raise capital on its own merits by the time the VC’s liquidation deadline approached.  Nevertheless, in the eyes of its founders, it still has a great future – provided that they can be entrusted with more capital, time and some good people.

All these elements, of course, are in very short supply with the VC partner; investors are impatient to cash out and look for greener pastures and no performance fees are likely to materialize out of the deal.  As tension mounts and the relationship between entrepreneur and investor sour, the readiest solution for the VC is to make use of its exit prerogatives and to try to forcibly sell out, usually at a significant discount, to a “strategic” buyer (oftentimes the original entrepreneurs, if they can find the necessary funding).

Less often, the parties might agree to muster the cash needed to liquidate the venture if no buyers are found. And finally, there is bankruptcy as the path of last resort.  If the VC was able to extract “minimum return” guarantees from the entrepreneur as part of its exit package before closing, there would be some collateral damage and additional costs arising from ensuing litigation, assuming the entrepreneur was worth the trouble in the first place.

In hindsight, I’ve wondered: couldn’t those involved have overcome the fighting and directed all the money, time and energy spent on negotiating and resisting a forced exit to help the company get over the hill, or find new investors? Surprisingly, looking back at the fiduciary duties, contractual structures and the layout of the economic incentives set out from the start, the answer was a very clear “no.” Why so, then?

My guess is that local VC fund regulations[1], by-laws and economic incentive structures were originally crafted to mimic imported models, designed to work in developed economies and typically carried pre-established liquidation dates.  As such, the much deeper capital markets and an abundance of strategic buyers at the ready coupled with functional bankruptcy laws, made it theoretically possible to spin off, recapitalize or terminate investments before the end of a fund’s pre-set investment period, with relatively little residual value destroyed in the process.

Maybe more importantly, the prevailing very high local capital costs associated with the extra liquidity risks of venture capital investing caused the risk premium demanded by independent VC’s to be very high and the capital commitments very low, all of which had a direct impact on the type of deals (and exit clauses) the VC managers had to work with.

As a result, most of the VC funding offered to start-ups in Brazil ended up being attractive only to those entrepreneurs that had difficulties raising capital elsewhere and were led to believe that having the “quality stamp” of a local VC partner helping with governance, intelligence and visibility would facilitate their access to markets, thus compensating for the extra price imbedded in the steep exit conditions. The result of that combination fell short of everybody’s expectations and depressed the industry as a whole.

On the other hand, opportunities apparently continued to exist for other types of VCs entering the game with fewer constraints, such as private family offices, aka “Corporate Venture Capital” (CVC’s). Curiously, there’s an interesting piece of academic research supporting the thesis that CVCs on average do better than independent VCs because they generally have more money and time to do better, and are less constrained by exit preoccupations[2].

If the above considerations are correct, one may conclude the conventional VC’s “exit first” approach appears to have some negative impact on entrepreneurship and that making VC structures more “evergreen” could help rebalance the equation.

TV depictions of startup life aside, investors should also believe that this different tack will work to their benefit so that they may feel confident to deploy more capital and worry less about short-term returns and exit strategies – and ultimately, lead independent VC managers to agree and change their compensation models accordingly.  

Camillo Sicherle is an Attorney of Law in São Paulo, Brazil.

 


[1] Note: most local IVC sponsored vehicles are regulated by and registered with the Brazilian SEC (CVM: Comissão de Valores Mobiliários,) as a matter of mandatory portfolio allocation rules applicable to local institutional buyers.
[2]Investment, Duration, and Exit Strategies for Corporate and Independent Venture Capital-backed Start-ups”, by Bin Guo, Yun Lou and David Pérez-Castrillo, Barcelona GSE Working Paper Series, WP # 602, January 2012.