Buying the Next Unicorn

How Prudent Fiduciaries Negotiate Disruptive Investment Opportunities

The popular term “disruptive innovation” appears to have first been coined by Harvard Professor Clayton M. Christensen in his technology research and later book The Innovator’s Dilemma, published in 1997. To be truly “disruptive,” an innovation must transform an industry or sector. In other words, disruptive innovation doesn’t merely make incremental improvements. Rather it changes the industry fundamentally by making at least exponential improvements or even by rendering the industry’s status quo wholly obsolete. The introduction of the personal computer in the late ‘70s and early ‘80s is referenced by Prof. Christensen as a classic example of disruption.

[To read more of Sander C. Zagzebski’s thought leadership click here]

Seeking disruptive innovation­ is the focus of entire classes of professional investors, including the lion’s share of the traditional venture capital community, so few innovators will fail to label their technology or approach as “disruptive” if they can say it with a straight face. Entire emerging industries, such as artificial intelligence (AI), distributed ledger/blockchain, legal cannabis and even shared transportation (those brightly colored bicycles and electronic scooters) have all at some point been referred to as disruptive by commentators, as have virtually all of the so-called “unicorns” (a phrase coined more recently by venture capitalist Aileen Lee and defined as private venture-backed growth companies with valuations in excess of $1 billion). To be sure, many more companies claim disruption and unicorn potential than will actually achieve it, but convincing investors of it can result in a sky-high valuation and instant paper wealth, not to mention Silicon Valley street cred, for the founders.

Once a growth company reaches true unicorn status, it will often turn to a select group of major investors like SoftBank Group, large late-stage VC funds and sovereign wealth funds for financing. In the earlier days, however, the pre-unicorns will generally have to call on the usual suspects—high net-worth individuals, family offices and early stage VC/angel funds—for growth capital. If the Company is already generating buzz, it likely will be seeking a comparably high valuation for its latest funding round. So how should investors approach an exciting potentially ­disruptive opportunity?

FIRST, DON’T FORGET BASIC DUE DILIGENCE

At the risk of being boring, it is always prudent to remember that investing isn’t gambling, and losses avoided are as valuable as realized gains. Sophisticated investors, including the Walton family, Rupert Murdoch, Betsy DeVos, the Cox family, the Oppenheimer family, multi-billionaire Carlos Slim and several VCs, reportedly lost approximately $700 million in Theranos, the over-hyped biotech company valued at its peak at over $10 billion. Theranos’s young founder, Stanford dropout Elizabeth Holmes, was a ­media darling after Theranos signed a high-profile blood testing contract with Walgreens, and in 2015 she was named to Time Magazine’s Most Influential People list. In the same year she became the youngest person ever to win the Horatio Alger Award, among other accolades. Theranos also boasted a high-profile Board of Directors that included Henry Kissinger, George Shultz, Sam Nunn, Bill Frist, Gen. James Mattis, former Wells Fargo CEO William Kovacevich and famed trial lawyer David Boies. With all the excitement and attention, it was obviously easy for investors to succumb to enthusiasm too quickly.

Not all prospective investors fell for the Theranos story however. Bill Maris, then at Google Ventures, reportedly looked at Theranos and decided not to invest. “We looked at it a couple times, but there was so much hand-waving — like, ‘Look over here!’— that we couldn’t figure it out,” Maris said in an interview with Business Insider. “So, we just had someone from our life-science investment team go into Walgreens and take the test. And it wasn’t that difficult for anyone to determine that things may not be what they seem here.” Basic technical due diligence and the discipline not to get swept up in the hype probably saved Google Ventures a substantial sum.

SECOND, DON’T STOP NEGOTIATING AFTER AGREEING ON PRICE AND VALUATION

If your favorite tool is a hammer, you only tend to look for the nails. Similarly if your primary advisors are trained only in finance, they may not pay attention to the legal details once they’ve agreed on pricing and valuation terms. This can be a pricey mistake, particularly if the investment opportunity seems particularly exciting and as a result the valuation is high.

If your primary advisors are trained only in finance, they may not pay attention to the legal details once they’ve agreed on pricing and valuation terms.  This can be a pricey mistake, particularly if the investment opportunity seems particularly exciting and as a result the valuation is high.

Consider the example of Square’s initial public offering and its prior venture capital round. Approximately a year prior to its IPO, Square issued shares of Series E Preferred Stock at $15.46 per share which resulted in an approximately $6 billion valuation. When Square filed to go public, however, it priced its shares significantly less than the $15.46 per share paid by its Series E investors. While this decreased valuation and resulting dilution would ordinarily cause heartburn, Square’s Series E investors were comparably unconcerned. After all, they had included a somewhat unusual “full ratchet” anti-dilution protection provision (rather than the more typical “weighted average” anti-dilution formula) in their investment documents which not only made them completely whole, it even guaranteed them a significant return in comparison to the IPO price, all at the expense of increased dilution to the founders and earlier stage investors.

The full ratchet anti-dilution provision is still unusual in comparison to the more typical weighted average approach, but it is becoming more common particularly in high value unicorn transactions (Box is another high profile IPO in which the full ratchet anti-dilution provision was triggered). There are also other elegant ways to give investors heightened protection, such as a blocking right in the case of a lower priced IPO, participating preferred shares, in which the investors receive both (as opposed to either of) their liquidation preference and their as-converted percentage on liquidation, and increased minority protections. These types of discussions are particularly important to consider if the founders have protections of their own such as super-voting stock.

THIRD, REMEMBER THAT YOU’RE INVESTING IN PEOPLE, AND THE FOUNDERS IN PARTICULAR

In evaluating an investment, it can be tempting to get lost in the details of the financial analysis and the legal terms and conditions, and to forget that the success or failure of an investment will in large part depend on the management team’s ability and motivation to deliver. Founders in particular are often critical components of the development of the product from a technical perspective, not to mention the visionaries and the “heart and soul” of the operation. It is not unusual for savvy founders of exciting companies to bargain for their own protections, usually in the form of all or some combination of a minimum number of guaranteed Board seats, super-voting stock and employment agreements with severance provisions. Working through these issues can be tricky, as often the founders’ motivation for maintaining control is at least as emotional as it is economic, so a horse-trading approach can be counter-productive.

While often tense, experienced investors will generally find common ground with savvy founders. After all, each needs the other to make the deal successful. Investors will often permit a founder to maintain a high degree of control, and perhaps even longer term control via super-voting shares, as long as the investors have appropriate Board representation, meaningful minority protections in the form of veto rights over certain major decisions and some form of golden handcuffs (often vesting or re-vesting over some portion of the founders’ shares). In a well-crafted venture investment, the investors and the founders have a balance of power which motivates them to work together to solve problems and to grow the business.

FOURTH, YOU’RE SMARTER THAN YOU LOOK!

It can be easy to be intimidated, even subconsciously, by impressive founders, particularly if those founders have impressive technical, political or business backgrounds. Not only was Theranos’s founder being proclaimed by some as the next Steve Jobs, the company hired an impressive technical management team and recruited a Board of DC heavyweights. Bill Maris, however, still reportedly refused to invest without understanding how (or whether) the technology worked. His team’s insistence on validating the company’s claims from a technical perspective (in other words, how did the technology actually work and did it produce correct results?) uncovered the weakness in the company’s presentation.

In addition, the media hype surrounding some “disruptive” technologies or industries seems to provide air cover for business claims that otherwise would be met with a greater degree of skepticism. For example, the distributed ledger/blockchain industry gave rise to some crypto token ICOs that in hindsight appear to have been at best problematic and at worst fraudulent. In certain cases, the published disclosures relating to these deals should have failed to pass the “smell test” of reasonably prudent investment professionals. Anecdotally, the legal cannabis sector also seems to have attracted a fair number of individuals peddling farfetched investment opportunities and schemes. As with investments in non-disruptive industries or technologies, if you don’t confidently understand how the company makes money or how you make money from the investment, you are well advised to learn more or pass on the opportunity.

[For more on Greenspoon Marder LLP’s approach to Corporate Law click here]

To conclude, truly disruptive innovation opens significant opportunities for investors to make outsized or asymmetrical returns. That said, the hype surrounding disruption can often cause prudent investors to make mistakes. Balancing the excitement and enthusiasm of disruption with caution, creative downside protections and an insistence on understanding the business from a technical and financial point of view is the only prudent way to bet on the next big unicorn.

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