One of the most controversial new funding rules hinges on "antidilution protections," executives and VCs agree. These terms can let VCs usurp or wipe out outstanding shares held by previous investors, founders and employees in order to protect or boost their stake in the company. Antidilution protections are bitter pills for proud founders, but they are particularly tough to swallow for a company formed from numerous smaller companies that might have dozens of founders. VCs agree that it is difficult to get companies to agree to financing if it erases the stakes of a large percentage of founders -- and in some cases antidilution protections sap morale and cause management defections and more turmoil for the company. "The really tough terms are coming in recapitalisation and in squeezing out old money," said Roland Van der Meer, a partner at ComVentures, a venture firm specializing in telecommunications companies. "The choice is to let them go bankrupt or sell the assets." Because the previous investors, who often have a seat on a company's board, have to approve antidilution protections, negotiations often become bitter, drawn-out affairs. As executives and VCs bargain over terms, companies often watch their cash dwindle to nothing. "It's almost guaranteed that you won't be able to raise money until you're almost out of money," said one entrepreneur who recently closed a round of financing worth more than $50m. "It's a contentious and not very gentlemanly process." Antidilution protections aren't necessarily the strictest terms that VC-backed companies must swallow. Others include: * Liquidation preferences: VCs boost the amount of money they receive if a company is sold -- in some cases requiring a return of double or triple their original investment. In the old days, they could have been guaranteed their original investment plus a cut of the proceeds. * Founder vesting: VCs require founders' stock options to vest over longer periods to ensure that key managers don't quit if the stock performs well immediately after the IPO. * Automatic conversion: VCs get a guaranteed return -- sometimes double or triple their original investment -- as soon as the company goes public, regardless of what happens to the company's stock price. Tougher rules, better management?
VCs insist that the tougher rules are not meant to penalise entrepreneurs but to help them achieve sustainable growth over the long term. The milestone approach, they say, has been particularly effective in galvanizing the management team around specific goals. "It makes the board meetings a lot more focused," said Richard Couch, chief executive of Diablo Management Group, a California-based crisis-management firm that often works with troubled start-ups. Still, entrepreneurs question the motives of VCs. Some say the pay-for-performance strategy is a clever way of disguising the fact that VCs' coffers are dwindling to dangerously low levels and they can no longer afford generous, lump-sum payments. "The downturn has affected them as much as anyone," said one chief executive, who asked to remain anonymous. Venture capitalists agree that their funds have shriveled, but some say they are eager to provide hitch-free financing -- if solid management teams create blockbuster business proposals with a clear opportunity for a return on investment in the near term. Some VCs say that if they have gut-level faith in a company's initial pitch, they don't necessarily require the entrepreneur to sign harsh contracts. "You either have faith in a company or you don't," said Warren Packard, a managing partner at Draper Fisher Jurvetson, which generally avoids the strictest rules when funding start-ups. "We're going to back those companies we think are really good and we're going to pull the plug on those we don't think are going to work out." Others wonder whether entrepreneurs' bristling reflects less on the harshness of the new rules than on the laissez-faire funding attitude of the late 1990s. "It's the same rules we used to play by," Van der Meer said. "But everyone forgot about them for a while."
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