1/15: Early stage investors have gotten really creative over the past few years with the rights they’ve negotiated in their deals. But guess what? In today’s market the rights aren’t being honored like the Investors expected. A quick thread on what’s going on and why:

2/15: The issue starts with the nature of the asset class as a whole. Here are a few “facts” about VC investing:

First: The average VC investment delivers negative returns. A commonly sited statistic is that 75% of all VC backed startups don’t return capital to investors.

3/15: Second: Producing outsized returns requires finding right-hand tail companies. If you’re a typical early stage investor, you want to protect or grow your investment because the return profile of follow-ons is better than investing in a new unknown company.

4/15: Third: Many VCs aren’t capitalized properly to protect or grow their position in their winners. A typical early stage fund is structured to build a diverse portfolio to get more “shots on goal” and only write one or two additional checks into their winners at most.

5/15: These three issues have driven the early stage VC community to find creative solutions that theoretically allow them to capture the downstream return profile of their winning investments without needing to upsize their core fund or reserve more capital for follow-ons.

6/15: But in today’s environment, these creative solutions are creating downstream problems and therefore are being re-negotiated or altogether ignored. Paper rights are like paper gains --- counting on them isn’t prudent because they can go away in a puff of smoke.

7/15: One “why” behind the issue is that valuations have spiked. While some startups have simultaneously upsized the amount being raised, this isn’t uniformly true. For many rounds this means that less equity is being sold than in the past.

8/15: Historically, a startup could expect a typical early/mid-stage round to dilute investors/employees by 20-30%. An early stage lead investor is usually looking to buy 15-20% with their check, so there was usually room for pro-rata rights to be somewhat if not fully honored.

9/15: In this environment, early stage investors are encountering situations where the valuation and round size translate to 15-20% total dilution which leaves very little (if any) room for pro-rata. Existing investors want the high valuations but they also want their pro-rata!

10/15: Making this worse are side letters that preserve their pro-rata (or in many cases grant them super-pro-rata rights) even in cases where an investor falls below the “Major Investor” threshold or lets their pro-rata rights lapse for a round or two.

11/15: Many of these investors don’t have the capital to back their rights so SPVs are being raised to cover their allocations. These SPVs don’t always come through and when they do they take time to fill which makes it difficult to close the round.

12/15: And the concept of super-pro-rata is extremely challenging and in some cases quite offensive to incoming investors. Writing tiny early stage checks and then backing up the truck when a winner emerges is the opposite of conviction based investing.

13/15: Why not ask the new investor to own 10% instead of 15-20%? For funds with active investors this is a major ask because each investor can typically only oversee a portfolio of 8-12 companies. Finite portfolio size drives minimum ownership requirements.

14/15: What’s sad is that the completion of a funding round is supposed to be a celebratory event. Instead, they can feel like a wedding where the families are fighting even though the only two persons who matter want to get hitched.

15/15: TL;DR: In today’s environment it’s important to read the room. In oversubscribed situations historical rights aren’t worth the paper they’re written on. Insisting they’re honored is the VC version of a toddler not wanting to share their toys. Just don’t do it.