Opaque Financial Contracting and Toxic Term Sheets in Venture Capital

In a recent article in this journal, the authors documented the growing tendency of emerging growth companies to raise substantial equity while remaining privately held through private IPOs, or PIPOs. PIPO financing has created scores of “unicorn” firms—private enterprises with imputed market values of $1.0 billion or more—while allowing them to avoid the challenges of being publicly traded. But as has also been noted, the PIPO process, with its multiple financing rounds and increasingly complex terms, has almost certainly result in some inflated market valuations. Along with inflated values, the contracting process and many of the provisions that result from it often have economic consequences that are poorly understood by at least some of the participants, including the potential for significant wealth transfer between stakeholders as well as overall destruction of enterprise value. And the term sheets containing such provisions appear to become even more “opaque” and more “toxic” with each round of financing. More specifically, the liquidation preferences and ratchets often provided new investors in the later rounds of PIPOs can greatly affect the allocation of the risks and the ownership shares and, in so doing, transfer significant wealth from the entrepreneurs and other older owners. Using a numerical analysis of a representative term sheet, the authors discuss the process of financial contracting for early-stage companies, providing examples of how negotiations can go wrong and showing exactly when and where the agreed-upon conditions start to turn toxic for some of the stakeholders. The article closes with the authors’ assessment of the disincentives for entrepreneurs and early-stage investors created by this often confusing and dilutive venture capital contracting and funding process.