In its September 2002 issue, Red Herring reports, "Extortion-style funding dies an early (and timely) death."  Specifically, the magazine says that the use of the "multiple liquidation preference" mechanism is on the decline.  With the MLP, preferred investors (i.e., venture capitalists) get 100% of the proceeds of a sale of the company up to a pre-determined multiple of the preferred shareholders' investment before common shareholders (including management and employees) get a dime.  In comparison, the more traditional "partially participating preferred" mechanism allows preferred investors to get 100% of sale proceeds until they get their money back (plus a pre-determined preferred rate of return on their investment) before they participate, pro rata, with the common shareholders up to the point where the preferred investors get 2X to 4X of their investment, at which point the common shareholders get everything.

Even if the trend is back toward more "normal" term sheets, I wonder if the change is as timely as the Red Herring hopes.

It's hard to make the case that venture capitalists weren't full participants in the recent stock market bubble.  If private valuations were ridiculous, it was, in part, because venture capitalists willingly signed preferred stock purchase agreements.  But when the bubble burst, it seemd that venture capitalists, as a group, cried foul.  "We're not responsible.  We're the unwilling victims of unscrupulous management teams."  In response, new financings came to a dead halt and existing portfolio companies found that they couldn't survive unless they accepted dramatically lower valuations, full ratchet anti-dilution provisions, MLPs, and other draconian terms.  Entrepreneurs took what they could get, but I don't suspect many were (or are) happy about it.  It seems that when the going got tough, venture capitalists used their leverage to screw their management "partners."

I suspect that the early stage venture capital industry has blown its trust.  Notwithstanding term sheet trends, it may take years to recover.

Nobody expects venture capitalists to ignore their self interest.  Agency risk is real, and venture capital is, after all, a for-profit enterprise.  Liquidation preferences and anti-dilution rights have evolved because they make sense.  But, capricious, opportunistic, punitive behavior is not okay, and it does not make sense.  Unlike Wall Street, which is largely based on impersonal transactions, Sand Hill Road and its equivalents are built on very personal relationships.

In the past, I've been known to lecture entrepreneurs on how it's important to understand an investor's incentives, because that understanding allows one to predict future behavior.  I overstated the case.  As the Red Herring article illustrates, seemingly arcane structural details can result in a cascade of very difficult to predict behavior.  Ultimately, an entrepreneur needs to be able to trust his investment partners to do what's right - for them, for their limited partners, and for the company.

Not an easy job, but that's why venture capitalists are paid the big money.  Or, should I say, were paid the big money.