In every bubble market, Founders raising funds put more emphasis on valuation than any other metric.
Money flows easily, and the size of funding rounds keeps increasing, which leads Founders to seek high valuations to limit their dilution.
Unfortunately, they don’t pay as much attention to term sheet language of critical clauses such as the liquidation preference and the sale rights.
Spanning from 2000 to 2013, the Trados story is a classic case study of what can go wrong when these clauses are not properly addressed.
What happened to Trados is bound to occur again when the current bubble explodes. It seems suitable for today’s Founders and (younger) Venture Capitalists to learn from the Trados case study.
Another learning is how VCs manage their portfolio companies: the Trados story encompasses the whole range of financial engineering, including down rounds, acquisitions, secondary buyouts, and exit negotiations.
Trados: The Facts
Founded in Germany in 1984, Trados is, by 2000, a $14-million software company based in Washington, DC selling desktop solutions for translating documents.
In 2000, amid the Internet Bubble frenzy, Trados decided to raise funds to accelerate growth, ahead of an Initial Public Offering planned a few years later.
Several funding rounds are realized over the next two-and-a-half years, but despite 20%+ annual growth rates, Trados fails to meet its investors’ expectations.
When Reality Hits
In 2005, although the company finally shows some progress, its financial shareholders decide to sell it to SDL, a UK-based competitor.
The price tag of $60 million was to be paid mostly in cash ($50 million), with the remainder paid in SDL shares. SLD had been listed on the London Stock Exchange since 1999.
The problem? While investors got most of their money back from that sale, common stockholders didn’t receive anything. VCs held preferred shares that protected their investment in not-so-spectacular exit scenarios.
One common stockholder consequently sued the Board of Trados for authorizing a sale in an unfair process that was detrimental to his class of shares.
An Unfair Split Of Exit Proceeds?
Trados had raised a little under $30 million in total, so the $60 million exit should have benefited to all shareholders.
How is it possible that those who owned common stock didn’t make any money?
The explanation: some shareholders had a priority right on any proceeds out of a sale, merger, or liquidation of the Company.
Trados’s investors had put money by subscribing to both participating and non-participating preferred stock. (In this case, it didn’t make a difference which type of “liquid pref” was used, as there was nothing left once the preferred amount was paid.)
How was the exit price divided?
Venture capitalists use the term “waterfall” to describe the analysis of who gets what, based on the classes of stock they own, and other contractual arrangements such as a Management Incentive Plan (MIP).
Here is the waterfall from Trados’s sale to SDL for $60 million:
As can be immediately noticed, common stockholders received nothing out of a sale valuing Trados at two times its sales forecast (the 2005 sales budget was $30 million and the first quarter had been strong.)
The amount marked “Contingency” refers to money put in escrow to cover indemnification claims. It’s not clear from the Court documents what these claims could be.
How Much Did The VC Firms Make?
As mentioned earlier, the advantage of the liquidation preference for VCs is that they have a priority right on any proceeds available to stockholders up to the preferred amount.
In some cases, this amount can exceed the nominal value of their initial investment. The expressions “1X”, “2X”, “3X” indicate how much needs to be repaid first.
In the case of Trados, VCs invested in “1X” Preferred with an 8% cumulative dividend. It means they had to make an 8% return (or Internal Rate of Return, IRR) before any money could go to the common stockholders.
To illustrate how these dividends impact proceeds, let’s take the first investment made in Trados.
In March 2000, VC firm Wachovia Capital Partners (then called First Union Capital Partners, now called Pamlico Capital) bought $5 million worth of Series A Participating Preferred Stock.
These shares came with an 8% cumulative dividend. By June 2005, when they were sold to SDL, the $5 million amount had grown to $7.5 million.
That’s a 50% increase in five years.
Preferred amount totaling $57.9 million
According to the Court’s Final Opinion dated August 16th, 2013, the total liquidation preference on the preferred stock, including accumulated dividends, amounted to $57.9 million at the time of the SDL acquisition.
Although we couldn’t reconstruct that number with the information contained in this document, let’s assume that this is the right amount.
Analyzing how much each VC firm invested and recouped from the sale, the Court concluded:
Indeed, the VC firms received $49.2 million from the sales proceed, while their preferred amount was $57.9 million.
But it is still much more than the $28.3 million they invested in total between March 2000 and August 2003. (This amount includes the stock-for-stock acquisition of Uniscape, backed by Sequoia; but excludes the secondary buyout realized by Hg in September 2000 for $2.3 million.)
Who made what? We could trace back only $35.9 million out of the total $49.2 million payout, and here is how they were divided between the VC firms:
|Preferred Stockholder||Investment in Preferred (excl. Dividends)||Allocated Merger Proceeds||Gain|
Even with some information missing, we can confirm, as did the Court, that all investors recouped their initial investment in Trados.
How About The Employees?
As far as employees are concerned, it’s a tale of two cities: leaders made money on the deal, while other employees didn’t.
Holders of common stock were most probably Trados employees who benefited from a stock option plan. Most VC-backed startups put in place such schemes to motivate and retain their best employees.
As is clear from our analysis, common shareholders didn’t get any money back from the Trados sale.
The Court document doesn’t mention it, but according to a law firm, the main plaintiff in the Trados trial — a common stockholder owning 5% of the company’s shares — is a former employee.
The (Top) Management Incentive Plan
Three managers, however, together made $7.8 million on the sale: the CEO, the CTO, and the CFO.
The CEO had been appointed mid-2004 to improve operations and negotiate a potential sale of the company — which he did quite effectively.
The CTO was Trados’s co-founder, the only one remaining in the company. His shares had little chance of having any value in a sale — he owned common stock, as Founders generally do –, so the MIP ensured he remained committed.
The last beneficiary of the MIP was the CFO, who had been hired at the end of 2003.
The Trados case is a rare window into how VCs manage their portfolio companies when things don’t go as planned.
Although the company’s revenues doubled between 2000 and 2005, this was not enough growth for VCs to make significant money on their investment.
A sale was deemed a better route to move on and spend their precious time on other deals. Thanks to their sale rights and liquidation preference, investors could time an exit that would not hurt them too badly.
A Classic VC-Related Litigation
“In Re Trados”, as the legal case is referred to, also became a classic example of how directors should manage their fiduciary duty.
The potential issue that VCs sitting on Boards of portfolio companies face is that they may be conflicted between their duty to the common stockholders, and their Limited Partners (those investing in their funds.)
It appears that the courts will only consider the Board’s fiduciary duty to the company and its common stockholders.
As Scott Kupor, managing partner at Andreessen Horowitz, puts it in his book:
In this case, the plaintiff sought to prove that the Board had not acted in the best interest of common shareholders by running an unfair process.
“In the end, the Delaware Chancery Court found that, in fact, there was not a fair process in place for the sale of Trados, yet the price was fair because the shares held no economic value. It’s a bit of a “no harm, no foul” kind of outcome—except that it took about eight years of everyone’s life, not to mention lawyers’ fees, to get there.” (Source: Woodruff Sawyer)