Mistaking a "Premium" for a "Ratchet"

Tobias, Neil, John, Sandy…passionate folks all.

It was interesting to follow the debate in yesterday’s StartUpNorth repost of the Bloomberg News story regarding the latest Real Matters M&A activity and associated financing (see prior post “Bloomberg: Real Matters Deal Said to Set Stage for Canada’s Next Tech IPO” Mar. 17-16). According to Bloomberg:

…a C$74 million funding round it raised to help pay for the latest acquisition came with a catch — the company has to list on public markets before the end of 2016 or it will have to issue more shares to investors, the people said.

Now, if you work on either side of Bay Street, Wall Street, or Silicon Valley, this concept will not be foreign to you. When passive institutional investors (such as AGF or Fidelity) buy equity securities in late-stage private companies, such as Box or Real Matters, they are doing so in the expectation that their investment will be trading in a liquid market before too long. As managers of mutual funds, and not traditional venture capitalists, these Portfolio Managers cannot sink capital into a company that’s on the “never, never” plan.

VCs can wait for 5 or 10 years before a “liquidity” event on their portfolio of companies. That’s something that stock brokers and their clients would fire a PM for. But that doesn’t mean that traditional mutual fund PMs don’t play in-and-around the VC space. They do, and entrepreneurs / CEOs of late-stage companies love having them as shareholders.

As I highlighted in a recent — unrelated — blog post, there are several recognized benefits to taking passive institutional money: better valuations, seeded IPO buyers, and no additional Board members or veto rights (see prior post “All is not dire in sunny California” Mar. 1-16). Like everything, there’s a price to be paid for those key benefits. In the case of Real Matters, it appears that investors negotiated a normal term for such late-stage transactions: if Real Matters isn’t publicly traded by a certain date, the institution will be issued additional shares to compensate for the extended “hold period”.

This is normal. It is expected. It happens with the best Silicon Valley stories, too. Box is one example of a Valley-backed story that took late stage passive money with a ratchet. For those who don’t know the name, it was backed by Andreessen Horowitz, Bessemer Venture Partners, Draper Fisher Jurvetson, General Atlantic, Meritech Capital, Scale Venture Partners, U.S. Venture Partners. Many of which would be included on anyone’s list of the premiere VC funds on the planet today. Were they duped into agreeing to compensate late-stage passive investors with additional Box shares if things didn’t go according to plan? Not a chance.

As we all know, there are three basic reasons why Real Matters won’t be public later in 2016: i) by choice, ii) because its accounting, reporting and regulatory backbone isn’t ready for the quarterly regime of being a public company, or iii) because market conditions are lousy and the IPO window is closed. Although our Wellington Financial Fund III provided growth capital to Real Matters in 2010 and again in 2011, I have no inside knowledge about either i) or ii); although I can surmise that CEO Jason Smith wouldn’t even contemplate going public if he didn;t think his team was ready. However, as a former tech investment banker and someone who has been putting capital into innovation companies on a principal basis for more than 15 years, I can assure you that iii) is outside of his control.

That said, I think this traditional 10% penalty (or whatever it was in RM’s case) is mischaracterized, misunderstood.

It might seem florid to some, but it is little more than a normal trade-off between the buyer and the seller. On either side of the border. And I think that’s what Shopify CEO Tobias Lütke misses when he said yesterday:

Please let this be the last Canadian company that ever signs crappy terms like this. Forced to go public? I’m sure those are quality VCs.

As “quality” VCs go, there’s no debate that Andreessen, Bessemer, DFJ, GA, Meritech, Scale and USVP fit that label; they agreed to an even tougher deal than RM did. I’m concerned that Mr. Lütke doesn’t appreciate the inherent trade-off in what was negotiated (assuming Bloomberg has the theme and figures correct in the RM piece). Perhaps he didn’t get exposed to these kinds of transactions when he was raising private capital. The fact that it is believed that passive institutions bought this RM round, and not VCs, doesn’t change anything for those of us who have been around the block a while.

Near as I can tell, the passive investor group agreed to give Real Matters a higher valuation than it otherwise would, on one condition: that the company generate liquidity for their investment within a certain time horizon. If Real Matters doesn’t get them their liquidity with the specified timeline, the company will issue more common shares (I’d assume 10% more than originally agreed to).

Based upon the Bloomberg story, the new RM investors received $74 million of shares on a valuation of “more than $600 million”. For simplicity, let’s assume it was a $600M pre-money valuation at $10/share: with the covenant that RM will get the new folks liquidity in 2016. If that doesn’t happen, and the new investors receive their 10% share penalty this winter, the implied pre-money valuation of the current round would drop, in essence, to around $545.4 million. A great number, but not as good as $600 million if you are an existing RM shareholder or employee.

Now, I’m sure the new investors would have been only too happy to invest at $545 million pre-money without the penalty clause. But, if I’m Jason Smith and I think there’s a chance I might be able to launch an IPO this Fall — IPO market willing — wouldn’t I be better off to go for $600 million pre and agree to the 10% penalty?

As someone whose Fund III owns warrants in Real Matters stock, I answer an emphatic “yes” to that rhetorical question. It’s an usual win-win, in fact.

If the penalty doesn’t kick in, these institutions get liquid shares in one of Canada’s fastest-growing — and now public — tech firms. If the IPO window is shut this Fall, and the penalty shares are ultimately issued, Mr. Smith hasn’t missed a beat. He still raised the $74 million (which might not have been otherwise available), added another suite of products and services via this most recent acquisition, and drives forward with a broader, larger and mollified shareholder base.

Who doesn’t salute that deal?

MRM
(disclosure: I own Shopify shares)