Startups Ratchet Up the Risk With Share Promises; “There will be a time when this bull market ends, and when it does these ratchets will be very painful”

Startups Ratchet Up the Risk With Share Promises

Some Early Investors Get Guaranteed Return on Money

TELIS DEMOS and DOUGLAS MACMILLAN

Dec. 25, 2013 5:24 p.m. ET

As the battle for financing heats up, some startups are making big promises to their early investors: a guaranteed return on their money when the company goes public. These small companies are pledging to investors that their shares will go public at a certain price, often much higher than their current value. If the price doesn’t meet the target, the companies will agree to give the investors more shares to make up the difference.These so-called ratchet provisions have typically been rare but are becoming increasingly common, according to several investors and entrepreneurs. As companies opt to stay private longer, the perceived risks for investors increases, prompting them to demand extra protection. Companies say they are happy to oblige, in the belief that their market value will continue to rise, rendering the guarantees moot.

But making any sort of promise ahead of an IPO is a big gamble for companies, and so far it has come back to haunt a handful of them. In the past two years at least three companies have disclosed that these provisions were triggered. In each case, the shares in the companies dropped on their first trading day. Two are still trading below their IPO prices.

“You’re putting yourself at risk here by telling an investor we will take the company public and the price at list will be X,” said Tim Harris, partner at Silicon Valley law firm Morrison Foerster. “That’s a crapshoot.”

That was true of video-advertising company Tremor Video Inc., which doled out additional shares to existing investors when the time came to go public. The New York company priced its offering at $10 a share in June, below the $13.997 level it had promised investors who bought in at $9.3314 a share. Tremor disclosed the agreement in a regulatory filing.

“In every negotiation there is always an element of give and take, and in some funding rounds a term regarding ratchet provisions may serve everyone’s best interest,” said Todd Sloan, chief financial officer at Tremor. Mr. Sloan declined to discuss in detail Tremor’s decision to offer such a deal, but said he didn’t believe the deal with early investors affected the company’s valuation or its initial stock price.

Tremor’s stock fell 15% on its first day of trading on June 27. It is now down 47% from its IPO price, closing at $5.27 on Tuesday as the company struggles to meet some analysts’ expectations for revenue growth.

Tim Keating, chief executive of Keating Capital Inc., KIPO +0.84% said he has negotiated such deals in about half of his pre-IPO investments, including in privacy software companyLifeLock Inc. LOCK +4.14% and Jumptap Inc., a mobile-advertising company that was acquired this year. He said the guarantees have enabled him to turn a profit on some investments.

Demanding a guaranteed IPO price is “the only way we can protect ourselves,” he said. Keating Capital is a publicly listed fund that buys private shares in companies just before their IPOs, hoping to profit when they go public or get acquired. “How can you invest in a company with no revenue at a multibillion-dollar valuation?…It sends shivers down my spine.”

LifeLock shares, which first traded in 2012, initially declined when the company went public, though have since recovered and are trading above their initial price.

Such guarantees also could serve as a potential warning for IPO investors. And the companies that had these clauses triggered have disclosed it in their IPO filings.

In 2009, Chegg Inc. CHGG -0.60% raised $55 million from private investors. It said in its IPO filing that these investors were guaranteed an IPO price of about $26.30, or double their original investment. It promised later investors an IPO price of about $25.85, a return of 75%. A final round of investors was guaranteed $12, which would have allowed them to break even.

Chegg, which rents out textbooks and provides other student services, went public in November at $12.50. That satisfied the last group of investors. But the company also distributed 11.7 million more shares, or about 14% of the shares outstanding after the IPO, to the previous two groups, according to the filing.

Chegg shares fell 23% to $9.68 in their opening trading session, the biggest first-day fall in 2013 for a U.S.-listed IPO, according to research firm Dealogic.

Representatives for Chegg and LifeLock declined to comment. A spokesman for Millennial Media Inc., MM -0.99% which agreed to acquire Jumptap, didn’t reply to a request for comment.

Companies might agree to such deals when they are asking investors to bet on them for longer time horizons, said Roy Bahat, a venture capitalist at Bloomberg Beta, a fund backed by Bloomberg LP.

“In a world where pre-IPO funding happens more often because companies choose to go public later, you’ll have plenty of companies that want or need late-stage funding but have less leverage,” he said.

On the other hand, some investors warn that entrepreneurs also may be tempted to treat the ratchet term as a negotiating chip to get a higher valuation.

Landing funding at a multibillion-dollar price tag is a way to get noticed. Some may be willing to grant investors special terms to get a lofty valuation.

That is a mistake, said Neeraj Agrawal, general partner at venture-capital firm Battery Ventures, which makes long-term, early stage investments.

“There will be a time when this bull market ends, and when it does these ratchets will be very painful,” he said.