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HEIDI: Welcome to The Startup Solution, I’m Heidi Roizen from Threshold Ventures.
Today I’m going to talk about a quirky but common issue that arises for venture backed startups. Most entrepreneurs don’t even realize that this quirk exists, that is, until it creates a problem for them.
At Threshold, we call this issue the investor’s ‘zone of indifference’ – and it's important for entrepreneurs to understand because it will influence how your investors evaluate, push for or against, and ultimately vote on acquisition offers. Unfortunately, it may also influence how they act as board members – even though that’s technically not supposed to happen.
So, what is a ‘zone of indifference’ and how do they come about?
As you can probably guess, a ‘zone of indifference’ is a range of outcomes, where the return to the investor will be the same, regardless of where the outcome lands. That may sound unimportant, especially if the range is small, but in reality, the range can be extremely large. In fact, I’m about to use an example where the range pencils out to be almost $200 million. And trust me, when you have an investor with that big of a ‘zone of indifference’, that will definitely influence how they behave.
A ‘zone of indifference’ is a natural by-product of the way preferred stock works. I’ve talked a lot about preferred stock in prior episodes, and I’ve put a link to a fuller description about this in the show notes. But for today' s purpose, the key point is that preferred shareholders will get all their money back, or sometimes even a multiple of that money, before the common shareholders get anything.
. . .
Most deals in venture capital today use what is called ‘non-participating preferred’ – which means that these shares do not participate in the upside of a deal. They only get whatever amount the preference represents, which is usually just the investment back, or maybe the investment plus a little interest.
Now clearly, we venture capitalists don’t just invest our money to get it back – that would be a pretty stupid business model. I mean, we appreciate the downside protection that we get with preferred shares, but of course, we also want to share in the upside of the companies that we invest in.
And that’s why those preferred shares we buy always come with something called conversion rights. Conversion rights give us the option to convert our preferred shares into common shares at our option – and we’ll take that option if we can improve our returns by doing so.
There are other forms of preferred stock, and I’ve put more detail about those in the show notes as well. But in most cases, the investor will either get one times their money back, or can convert to common, in which case they’ll get the same number of common shares that they had in preferred shares.
When an investor owns this type of preferred stock, they’ll have a choice to make when the company sells. They can either get some or maybe all of their preference back, depending on the size of the outcome, or they can convert those preferred shares into common shares, and then get their percentage of the outcome that those common shares would be entitled to. But they can’t have both – you either take your preference or convert to common.
. . .
The thing is, that for every investor, their calculation about whether it’s better to take the preference or convert to common can be different, and sometimes dramatically so. For example, some preferred shareholders may have more generous preference terms or have a senior preference to other investors. Some may have bought your shares at different prices which also impacts this calculation.
And of course, any individual investor could be holding multiple classes of shares, each with its own terms – which may even mean that they’re best off by taking the preference on some of their holdings while converting some of their other holdings to common.
The key point for today is that when they do these calculations, each investor will likely discover ranges where, even if the sale price goes up, they won’t get anything more. And that ‘zone of indifference’ is what I want to talk about next.
I’m going to use the simplest example I can think of to illustrate ‘zones of indifference’, but you’re going to learn quickly that even simple examples get complicated fast. But stay with me, because it’s important to understand how wide apart the ‘zones of indifference’ can be for two investors, even in the same company.
. . .
Let’s say you’re an entrepreneur who raised a Series A of $20 million at a $200 million post-money valuation from a firm called BigBucks Ventures. That would mean that BigBucks owns 10% of your company and has a $20 million liquidity preference.
So now, let’s calculate BigBucks Ventures ‘zone of indifference.' They’re not indifferent from a sale of zero to $20 million, since their preference would entitle them to every dollar from zero to $20 million. But once you get over $20 million, you’d have to get the deal value all the way up to over $200 million, before they’d make more money. Why? Because at over $200 million, 10% of the proceeds would be more than their $20 million preference, and so they would convert their shares to common to get the 10%. So, in this case, BigBucks’ ‘zone of indifference’ is the huge range between a $20 million outcome and a $200 million outcome because within that range, their proceeds do not change at all.
So, hold that in your head while I introduce you to a different investor in this same company, called TinyFunds. TinyFunds is the seed investor who put a million dollars in very early on, way before the Series A. Because the valuation of the company was so low then, only $10 million, their million also bought them 10% of the company. But, when BigBucks Ventures offered that $20 million pile of money at 20x valuation to what TinyFunds invested at, BigBucks also demanded that their round be senior to anything that came before it. TinyFunds agreed to this term because they still felt that overall, it was a great deal for the company, and also for them.
So now, let’s calculate TinyFunds’ 'zone of indifference.'
If the company is sold for less than $20 million, TinyFunds will get nothing, because all that money will go to BigBucks’ $20 million senior preference. So TinyFunds is technically in a ‘zone of indifference’ for deal values from zero to $20 million. And let me be clear – that doesn’t mean TinyFunds will just sit around and be indifferent about what’s happening – in fact, they’ll likely be pushing hard to not let any sale below $20 million happen precisely because they’ll be getting nothing. But in terms of a ‘zone of indifference,' between zero and $20 million, they are getting the same thing. Zero.
. . .
Now it gets interesting, because as soon as you pop above this first ‘zone of indifference’ for TinyFunds, that is, over $20 million, they are definitely not indifferent. Because in that tiny slice between $20-21 million of proceeds, TinyFunds would be getting every penny of it because of their own $1 million preference. So even though the deal in total changes by less than 5%, TinyFunds would go from a complete loss to breaking even.
But now, once you go above $21 million, TinyFunds goes back into another ‘zone of indifference.' Because as soon as you get past paying their whole million back, they won't be entitled to any additional return until the sale exceeds about $30 million. Why? Because at $30 million, BigBucks would cash in their $20 million preference, and take that money off the table, leaving $10 million in proceeds for everyone else. TinyFunds could take their $1 million preference or convert to common and get 10% of the $10 million left, or also $1 million. So, it’s a wash.
But, above $30 million, it gets very interesting for TinyFunds because they are stepping out of the ‘zone of indifference’ again. Above $30 million, they’ll be entitled to 10% of any additional proceeds, because they’ll have converted to common and own 10% of the company. So, for example, at a $200 million sale, BigBucks still gets only its $20 million preference, but TinyFunds would now get $18 million. That is, $200 million in proceeds, minus the $20 million to BigBucks, leaving $180 million for everyone else, times the 10% that TinyFunds owns.
Got that? Well done if you kept all those numbers straight. If not, we post transcripts of all our episodes, which you might find helpful to follow along. Regardless, the big takeaway is that BigBucks gets their money back in even pretty small outcomes but makes nothing else until the outcome is very large. On the other hand, TinyFunds makes nothing in pretty small outcomes, but starts making good money at what’s still a reasonably low number, $30 million. So, the two investors’ ‘zones of indifference’ are wildly different, and will definitely color how they think about any offers you the entrepreneur will get for your company.
. . .
For the sake of being comprehensive, let me also point out that once this deal gets over about $200 million, everyone will convert to common, since everyone makes more money that way. TinyFunds will still be making money, but their percentage will go down, because now BigBucks is sharing in that upside too.
As you can see, even a relatively simple deal like this is quite complex to calculate in terms of ‘zones of indifference’ and return expectations. And when there are multiple rounds with stacked preferences and different terms and prices for each round, it’s crazy hard to calculate everything out. And in addition, every time you raise more money, the calculations will change for everyone on the cap table again.
So now that you understand what a ‘zone of indifference’ is, let’s talk about the implications.
. . .
As you can imagine in the case I just laid out, a seed investor like TinyFunds is going to be highly motivated to push you – and hopefully help you – get that deal up in value, because every million over $30 million they get ten percent of, and below $20 million, it’s a complete write off to them. On the other hand, a big, later stage investor like BigBucks, well, they’re not getting anything different whether you sell for $25 million or $200 million, so if their sense is that your company is never going to be worth over $200 million, they may push you pretty hard to just get a deal done even at $25 million.
You can’t really change this after the fact if you structured your rounds this way – but by calculating an outcome analysis including the ‘zones of indifference’ for each of your investors, you’ll at least be able to understand why each of your investors may be pushing in a different direction.
And by the way, that’s all perfectly legit for non-director investors to do – because they don’t have any obligation to consider any other shareholders but themselves.
But if they also happen to be board members, that’s a whole different ballgame.
Now, I’m betting that all your investor directors are there because they negotiated for board seats when they invested. I mean sure, you may have picked their funds in part because you wanted them on your board, but still, in your docs, it will usually specify that someone from their firm will be the designated board representative from that series of preferred stock.
And yet, this is a confusing statement that even many VCs don’t understand. Because, while they may be the designated representative from that series of preferred stock, that doesn’t mean that they’re there to represent only that series of stock. As a board member, regardless of what class of shares elected that person to the board – that person’s obligation is to the company first, which means acting in the best interests of the company and its common shareholders ahead of their or any preferred shareholder’s interests.
I’m surprised at how few venture capitalists understand this, but it is, in fact, the legal construct of governance. And a board member can get in big trouble if they don’t follow it. If you want to understand more about this, and I recommend every VC and everyone who has a VC board member should want to understand this – you should take a look at what Evan Epstein has posted. Evan is the Executive Director of the Center for Business Law at UCSF, and he’s written some seminal guidance on the fiduciary duties of venture-backed directors. I’ve put links to them in the show notes, and I highly recommend you read them.
. . .
So now that you understand the investor’s ‘zone of indifference’, and the obligations of your investor board members, here are some steps you can take to mitigate the problems that these ‘zones of indifference’ can cause.
First, you should consider these implications from day one, as you raise money and structure each of your funding rounds. Senior preferences, liquidation multiples, and other fancy terms all seem like great ideas in the moment to get that headline valuation up. But while it can seem attractive to trade juicy terms in each round for a higher valuation, you’ll end up creating a shareholder base with wildly disparate ‘zones of indifference, ’ and that will likely mean more headaches for you when you try to get an acquisition offer over the finish line.
And when you do get that offer, you might find that some investors will want to hold out for a higher price, while others may push to just take a lowball deal that only covers their preferences. They’re all just acting in their own best interest. And from my experience, those positions can often differ quite a bit from what’s best for the company or its common shareholders—which usually means you and your employees.
You can at least be prepared for this by running the math on every investor’s ‘zone of indifference’ to anticipate where the likely logjams might be and figure out how to unstick those before everyone has to vote on the deal.
And by the way, when you do that, you’ll discover that you and your team, who all hold common shares, will likely be more aligned with your earlier investors, who tend to have smaller preferences and lower hurdles for converting their shares to common. It’s one of the reasons we Threshold partners give to entrepreneurs for keeping us on the board even after they’ve raised tons more money – because we tend to be more closely aligned with common shareholders in terms of which outcomes would be good or bad for us too.
. . .
And finally, speaking of investor directors, remember that while they wear two hats, one as a director and one as an investor, they must check their individual ‘zones of indifference’ at the door when they walk into that boardroom. It is their obligation to prioritize the company and all its shareholders over their own self-interest when they are operating in their board capacity. And if your investor director is not behaving that way, I’d suggest that you pull them aside and explain what you now know – maybe even share a few of Evan Epstein's posts with them. And if they’re still acting improperly, this may need the attention of the whole board, or even your legal counsel. Because letting it go could get you and your whole board in a whole lotta hot water.
I hope that by illuminating these ‘zones of indifference’, I’ve helped you gain a better understanding of how and why your investors might behave. But while all this analysis will help, there’s a whole other tail wagging that dog – and that’s the partnership and fund dynamics inside each investor’s firm, much of which is probably a black box to you. So that’s going to be the juicy topic for the next episode of the Startup Solution.
But for now, that’s it for today. Thanks for listening to this episode. And thanks to Evan Epstein of UCSF law school for being my fount of wisdom about private company governance. We hope you have enjoyed this episode, and if you have, please share it with someone who might benefit from it. I’m Heidi Roizen from Threshold Ventures.
As promised, here’s a post written by Evan Epstein about fiduciary duties of venture-backed directors. It’s a must read!
And if you want to go deep on the seminal case on this topic, the Trados case, here’s an in-depth podcast about it with Evan and Vice Chancellor J. Travis Laster of the Delaware court.
Here’s a great primer on preferred stock.
Here’s a breakdown of simple preferred versus participating preferred and how it impacts the zone of indifference.
