Tuesday, May 3, 2016

VCs and "Dirty Term Sheets"

A recent blog post by Bill Gurley, "On the Road to Recap," has been getting shared lately. It is well worth reading. The topic is the current excesses in venture capital, which appear to be in the process of deflating.

In particular, Gurley explains "dirty term sheets," which keep up the appearance of high valuation for a so-called unicorn.

There can be clauses in the terms of later-round capital raises that beggar earlier rounds, if certain contingencies come to pass. For example, the ownership percentage of those investing in the last round can go up (costing earlier investors) if the company does not make a public offering by a certain date. Such terms make valuation look higher on paper than it really is, because it is hard to make appropriate (downward) adjustments to a company's value for the presence of such contingencies. Human nature is to overlook them, as the post explains.

Gurley is saying that terms of this kind are a form of structured finance -- but for venture capital, rather than for mortgages. That is a really interesting way to think of this.

This is a likely area in which more problems will surface. Also, the post makes a persuasive case that there is pent-up demand for going public in Silicon Valley.