January 11th, 2021
Managing the Effects of High Power Incentives on the Behavior of Entrepreneurs
At the age of 24, American entrepreneur, Ryan Blair sold his first company (SkyPipeline) for twenty-five million dollars. Since he owned 25% of the company, Blair anticipated a big payout from the sale. To Blair’s unfortunate surprise, he learned that he was not projected make any money from it. Blair was enraged when he learned this was not a mistake but a consequence of the venture capital contracts he signed, specifically the anti-dilution and liquidation provisions they contained. In response, Blair threatened to tarnish the company’s reputation and withhold his vote to approve the transaction (his vote was required for the sale to proceed under California law). Following Blair’s outburst, the company’s board of directors agreed to distribute some of the sale’s profits to Blair however, the amount they agreed to was still low relative to his equity ownership in the company. This scenario illustrates how many entrepreneurs react to the application of high-power incentives.
Investors impose high power incentives to transfer considerable risk to from themselves to a start-up’s founders and management (which I collectively refer to as “executives”).Two particularly onerous high-power incentives are full anti-dilution rights and multiple liquidation preferences (similar to those in Blair’s venture capital contracts). Inexperienced entrepreneurs like 24 year-old Blair, often do not appreciate the effects they can have until their application is triggered. Thus, despite initially agreeing to these provisions, executives often feel they were treated unfairly by investors when the effects of high-power incentives take place. As a result, disgruntled entrepreneurs retaliate and engage in strategic behaviors to deliberately harm the company which may harm a start-up.
The behaviors of executives are significant to a start-up success and this is recognized by venture capitalists, many of whom attribute the failures (of portfolio companies) they observe to shortcomings in senior management and founders. However, despite the negative effects that high-power incentives can have, they are still commonplace in venture capital contracts. Since venture capitalists still request these terms, I provide suggestions to supplement anti-dilution terms and liquidation preference or otherwise to mitigate their negative effects. I begin by describing each term and the interests they signify.
Anti-dilution rights are triggered when securities are issued at a price lower than the investor’s conversion price. The most dilutive variation of this term is a full anti-dilution right, which adjust the investor’s conversion price to the absolute lowest price at which subsequent stock is issued. This provision enables the preferred stockholder to obtain enough shares to maintain their original equity position in the company by disproportionately diluting common shareholders or other investors who do not invest on a pro-rata basis.
(b) Multiple liquidation preferences
Preferred shareholders receive some money on liquidation of the company before anything is paid out to other shareholders. Liquidation preferences may be triggered on a company’s bankruptcy or wind-up. A multiple liquidation preference provides the investor with a right to receive between one-and-a-half and three times the liquidation price (the original purchase price plus any accrued and unpaid dividends).
2. Interests Underling the Provisions
A venture capitalist’s main method of mitigating the risk of their investment is the valuation of an investee company. However, as venture capitalists often recognize that entrepreneurial over-optimism can result in an exaggerated valuation of the company. Full anti-dilution rights and multiple liquidation preferences are triggered in unanticipated, non-ideal circumstances. Effectively, these terms provide the investor with “downside” protection, mitigating the risks of their investments. With this in mind, I conclude this post by outlining some ways to circumvent the perverse implications of these provisions while satisfying the interests of an investor who may request them.
(2) Staging investments: this reduces the amount of capital at risk at any given time and enables the venture capitalist to get more information about the business and management of a corporation before hazarding the full amount of anticipated investments.
2. Managing expectations
The strategic and retaliatory behavior I noted is closely correlated with deviations from the executives original expectations. If either an anti-dilution right or liquidation preference must be used, a start-up’s executives fully should understand their implications along with the real possibility that they will take effect, from the outset.
3. Considerations to limit the severity of anti-dilution rights:
(1) capping the dilution produced by them (for instance, at the point at which it becomes clear that management would have no meaningful stake in the business);
(2) adding a sunset clause so that this right is only effective for a limited time following the investment;
(3) making the right affected by the company’s achievement of certain milestones which themselves ameliorate the risks faced by an investor (i.e. Producing commercial product, generating certain gross revenue etc.), in these circumstances, the anti-dilution right can be affected by altering the formula used to adjust the conversion ratio or even by getting rid of the right all together; and
(4) rather than adjusting the conversion provision to the lowest price given to a subsequent purchaser, consider substituting for a weighted averaging “narrow-based” or “broad-based” formula.
(a) “broad-based” formula: gives the venture capitalist a conversion ratio that reflects a per share price equal to the weighted average purchase price of all subsequently issued and outstanding shares. 
(b) “narrow-based” formula: only takes into account the pricing of the shares being adjusted (usually just the venture capitalist’s preferred shares), along with all subsequently issued shares.
4. Considerations to limit the severity of multiple liquidation preferences:
(1) capping the returns on preferred shares so that if the company is a modest success, venture capitalists do better by converting preferred shares to common shares than they would by relying on the operation of their liquidation preference; or
(2) a viable compromise might be that the preference operates only against the start-up’s executives. This will leave the investments of other common stock holders (like the executives’ families and friends), proportionally intact.
(3) Liquidation preferences should not:
 Kim Orlesy, “The Difference Between Success and Wisdom With Ryan Blair” (2016), online https://www.kimorlesky.com/blog/author/kim-orlesky
 Ryan Blair, “Nothing to Lose, Everything to Gain: How I Went from Gang Member to Multimillionaire Entrepreneur” Portfolio/Penguin (2013).
 M. Gorman and W. A. Sahlman, “What Do Venture Capitalists Do?” (1989) 4 J. Bus Venturing 231 at 238.
 Well Kenton, “Anti-Dilution Provision” Investopedia (2019), online: <https://www.investopedia.com/terms/a/anti-dilutionprovision.asp>
 Bryce C. Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practices, 3rd ed (Canada: LexisNexis Canada Inc, 2018) at p. 416.
 Deepak Malhotra, “How to Negotiate with VCs” (2013) Harvard Business Review, online: <https://hbr.org/2013/05/how-to-negotiate-with-vcs>
 Supra note 5 at p. 419.
 Ibid at p. 357.
 Ibid at p. 364.
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Blog posts are by students at the Business Venture Clinic. Student bios appear under each post.