Deal terms in venture financing transactions have changed as a result of the recent economic downturn. As capital has become scarce for many start-ups and investors are increasingly skittish, terms have shifted markedly toward the investor-favorable end of the spectrum.
The venture fundraising process is now considerably longer, with more due diligence cycles and less urgency for prospective investors to commit capital. And when investors do commit to a funding round, it is often at lower pre-money valuations or in down round financings, and in most cases on terms that entrepreneurs would find unacceptable in a better market. Venture investors have the negotiating leverage in this environment.
A prime example of this shift in leverage is the venture capitalist’s renewed focus on downside protection. This mirrors what occurred in the early part of this decade shortly after the end of the Internet bubble. In recent months we have seen a resurgence of term sheets calling for preferred stock with a senior liquidation multiple (e.g., 2-3 times an investor’s initial investment), often together with “full participation” with common stock after the liquidation preference is paid out. This means that when a company is sold, the holder of preferred stock (i.e., venture investors) will be entitled to 2-3 times its initial investment before any holders of common stock (i.e., founders and employees) receive proceeds, and then will share any remaining proceeds with the common holders on a pro rata basis.
Consistent with this trend, when companies raise money in later stage, insider-led down round financings, investors are frequently requiring a senior multiple liquidation preference that is high enough to recapture the diminution in company value reflected in the down round valuation. It is important for entrepreneurs to model the distribution of proceeds across a range of assumed exit valuations so that they understand the full impact of investors’ liquidation preferences on proceeds allocation upon a change of control. Preferred stock with senior multiple liquidation preferences coupled with participation features can require exit valuations to be extremely high before common shareholders are able to meaningfully participate in the distribution of proceeds.
We are also seeing venture investors more frequently including a redemption feature as part of their investment terms. A redemption feature is a form of “guaranteed downside” protection in which an investor is able to require the company to repay its investment after a period of time (typically 5-7 years after the date of the investment), often with a built-in return. Redemption provisions rarely get triggered, either due to an intervening liquidity event, or because the company shuts down or renegotiates the provision right before the redemption feature is triggered. Nevertheless, redemption provisions offer investors the psychological comfort of knowing they can recover their investment after a fixed period of time if there has been no liquidity event. As the company approaches the redemption date, these provisions can also exert pressure on entrepreneurs to sell the company in order to avoid having to redeem preferred shareholders in the absence of a liquidation event.
In this funding environment, entrepreneurs can no longer take for granted that existing investors will “waive” their anti-dilution rights in a down round financing as they have typically done in recent years. Anti-dilution rights essentially enable investors to recapture a portion of the price they paid for their preferred stock if, after their investment, the company issues additional equity at a lower price. Over the past several years, as robust economic times gave the (often false) impression to many that liquidity events were always possible at accretive valuations, existing investors were willing to waive their anti-dilution protection as a show of support for their companies. These days, however, given the lack of visibility around when or if a company might exit, a growing number of investors are exercising their anti-dilution rights in down round financings –- to the detriment of the holders of common stock –- in order to protect their ownership percentage in the company.
Entrepreneurs should also be sensitive to the fact that down round financings can generate friction between different groups of investors, such as those that are willing to continue to financially support the company and those that are not. This friction is exacerbated where there is a “pay-to-play” provision in the company’s financing documents. We are seeing an increasing number of insider-led financings with pay-to-play provisions. Lead investors use pay-to-plays to force other investors to commit additional capital to the company or risk severe dilution and/or loss of some or all of their preferred stock rights. When non-participating investors have a voting block right, however, financings with pay-to-play provisions can lead to an investor stalemate that can delay or even prevent a funding round.
Advice to entrepreneurs
Entrepreneurs should be aware that there are ways to counteract the effects of these pro-investor provisions. Every successful start-up needs highly motivated management to build the business, and investors know this. Therefore, in circumstances where the aggregate liquidation preferences exceed the expected enterprise value of the company in any near-term sale, management can require the creation of so called “carve-out” plans. Carve-out plans set aside a specified percentage (typically around 5-10 percent) of the proceeds distributable to shareholders upon a liquidation event for management. Because carve-out plans are contractual obligations that get paid out of liquidation proceeds prior to any shareholder distributions, they remain in effect regardless of the liquidation preferences of the preferred stock. Properly conceived, carve-out plans keep management incentivized after a down round financing by earmarking for them a meaningful portion of the proceeds paid out on a company exit.
In addition to a carve-out plan, entrepreneurs can –- and often should -– advocate for a sizeable option pool increase after a dilutive financing, even as much as 15-20 percent of the company’s post-financing fully-diluted outstanding share capitalization. An option pool increase can be coupled with a promise from investors to support an allocation of “refresh” options to management and key employees to fully or partially offset the dilution that resulted from the down round financing.
Entrepreneurs can also use down round financings as an opportunity to renegotiate their employment packages to include additional downside protections for themselves. In many cases, investors are more flexible with respect to such requests at the time of a down round financing because they realize that retention of key management through the down round financing and beyond will be a critical element to realizing any return on their investment. We therefore will look carefully at the employment agreements of senior management as part of the financing process and consider the appropriateness of including meaningful cash-based severance, accelerated equity vesting and/or post-termination continuation of benefits upon termination of employment without cause or upon a constructive termination.
Entrepreneurs who feel their companies are not properly valued by potential investors in the current economic environment can also consider alternative financing structures that meet the goals of both the company and its investors. One such structure is a convertible note and warrant financing. This type of financing offers the advantage of allowing the parties to postpone establishing a company valuation until a later date when the note converts to equity –- giving entrepreneurs the opportunity to increase the company’s enterprise value during the period in which the debt is outstanding. These financings are also cheaper and faster to close than a typical preferred stock financing. However, note and warrant financing terms have also recently become more investor-favorable, and entrepreneurs should pay close attention to provisions such as those that require a multiple of the note principal to be repaid to investors on a sale of the company, or those that give noteholders ownership of company intellectual property upon an event of default under the notes.
As entrepreneurs embark on the venture fundraising process in the current economy, they must carefully consider the financing terms they care most strongly about and be prepared to give ground on other terms. They should approach financing events recognizing that the process will require considerable time, planning and patience. Although investors will likely have negotiating leverage on deal terms, entrepreneurs have tools at their disposal to protect their own interests as well. Legal counsel that is both skilled and highly conversant with the venture financing market can be an invaluable resource to assist entrepreneurs in navigating this process.
Caine Moss is a corporate and securities partner at Wilson Sonsini Goodrich & Rosati. Caine works with software, telecommunications, life sciences and Internet companies through all stages of their growth. In addition, Caine has broad transactional experience, particularly in the areas of venture capital, public and private mergers and acquisitions, and representation of issuers and investment bankers in public equity offerings.