“Whoever has the Gold, (Once Again) Makes the Rules”: VC Deal Terms Likely to be More Investor Favorable
July 13, 2020
It’s no shocker that the Coronavirus pandemic has slowed down venture capital investment dramatically, with 2020 now on pace to be well below the high levels of the past couple of years. According to Pitchbook, VC deal flow through June 28 fell to just 4,675 funding rounds as compared with 6,357 in the first half of last year. But a drop in dealmaking volume may not be the pandemic’s only impact on the VC market. In the immediate aftermath of the dot com meltdown in 2001 and the financial crisis in 2008, VCs were able to negotiate for more favorable terms to protect their investment as a result of lower investment supply and the leverage that comes with it. It stands to reason that we will see the same phenomenon now, with the pendulum swinging back in favor of VCs. Consequently, companies and their founders need to understand these pro-investor terms so that they could at least try to minimize their severity and make good dealmaking decisions overall. This blog post will review several of the deal terms most likely to be targeted by VCs in reaction to new market realities.
Investors may seek to enhance their liquidation preference rights in two ways: preference multiple and participation.
In a normal, reasonably competitive market, such as existed the last several years, liquidation preference multiples have settled at one. On a sale of the company, the VC would first get its money back. Simple and fair. It’s also consistent with what liquidation preference is intended to be, namely downside protection. In a disappointing ultimate strategic outcome for the company, the investor arguably should get the amount of its investment back, plus accrued and unpaid dividends, before the common holders receive anything.
Investors are likely now to negotiate for some multiple of their investment, i.e., 1.5x, 2x, 3x, etc., on the theory that the deterioration of the risk/reward profile means that the investor should receive a higher reward upon exit to compensate for the greater risk.
Investors are now also likely to negotiate for participating preferred, i.e., the right to participate, after receiving their liquidation preference, in remaining proceeds with the common shareholders on a pro rata, as converted basis. Participating preferred is often referred to pejoratively as a form of double-dipping, and in fact VCs rarely received it in recent years. Without it, upon a sale of the company, investors would just compare the amount of the preference against the amount they’d receive on conversion and take the higher amount. With participating preferred, they get both.
My view is that companies have the better argument here in that participating preferred goes way beyond liquidating preference’s intended purpose of providing downside protection.
A right exercisable by the investor that the investor be bought out after a certain number of years could be extremely risky to a company. Most companies will not have the cash on hand or access to debt or equity financing needed to satisfy the redemption obligation. The practical result of the redemption period expiring is a shift in leverage in favor of the investor to force either a sale of the company or a renegotiation of existing investment terms. Over the last several years, VC deals have not included redemption rights. The perceived longer path to liquidity, however, will now likely cause investors to seek redemption rights, particularly in later stage deals. They may also seek shorter periods before redemption rights become exercisable, e.g., three years rather than five or seven. One way for a company to mitigate the effect of redemption is to negotiate for deferred payment of the redemption price. Investors may also require a company to create a sinking fund to ensure adequate capital for the redemption.
Investors will almost always get protection against economic dilution in the form of anti-dilution provisions which adjust the conversion rate of the preferred into common resulting in a larger number of common shares upon conversion in the event of a down round. The method of calculating the conversion price adjustment is often the subject of negotiation. In normal market conditions, most anti-dilution provisions are based on a weighted average formula which takes into account the number of shares issued in the down round relative to the number of shares outstanding, i.e., the actual dilutive effect of the round. But there are different ways of calculating shares outstanding to arrive at the weighted average adjustment. “Broad-based” anti-dilution is more founder-friendly than a “narrow-based” anti-dilution formula because it is more inclusive in terms of what is deemed outstanding resulting in less dilution than a narrow-based formula. A broad-based weighted average formula would typically include within outstanding shares not just common shares actually outstanding, but also all shares issuable on exercise of options and on conversion of convertible securities such as preferred stock. In contrast, a narrower formula might include in the calculation of outstanding shares only those shares of common that are actually outstanding (i.e., excluding shares of common issuable on conversion of options, warrants and, potentially, even the preferred stock itself). While narrow-based anti-dilution formulas are more investor-friendly, the most investor-friendly category of anti-dilution protection is “full ratchet” anti-dilution which adjusts the conversion price all the way down to the lower down round price irrespective of the actual number of additional shares issued in the down round, i.e., regardless of its dilutive effect.
With additional leverage moving their way, VCs could be expected to negotiate for greater anti-dilution protection. In most cases, I expect investors will only seek a more narrow-based version of weighted average anti-dilution protection by including fewer categories of options and convertible securities in the calculation of fully-diluted outstanding shares. In more extreme cases, they may push for a full ratchet anti-dilution feature.
VCs typically receive preemptive or pro-rata rights, i.e., the right to participate in a future round in proportion to ownership. Normally, these rights don’t generate much friction in a negotiation, with any negotiation here being typically limited to which categories of issuances would be excluded and thus outside the reach of the right. As a practical matter, preemptive rights are usually waived by investors in connection with subsequent rounds.
In the current environment, it could be expected that VCs will negotiate for the right to invest in subsequent rounds above their pro-rata ownership, perhaps 1.5x – 2x their ownership interest. This enhanced right could be valuable because it would allow investors to “load up” on successful portfolio companies in subsequent financings.
A significant portion of those rounds that will successfully close in this climate will likely be down rounds, which typically result in harmful consequences and thus a serious morale problem for founders and employee holders. Earlier preferred stock investors are protected with antidilution rights which get triggered in a downround resulting in a more favorable conversion rate and ultimately more common shares on conversion. But that comes at the expense of greater dilution to the common holders. Another consequence of a down round is that it often results in employee stock options being underwater. These events could result in a serious hit to company morale.
To combat the foregoing morale issues, VCs may seek to force earlier investors to bear the brunt of the down round by either waiving their anti-dilution rights, which would minimize the dilutive hit to the common holders, or converting their preferred shares outright into common which would remove much of the preferred stock liquidation preference stack above the common holders. Convincing previous investors to waive antidilution rights or convert is no easy task but, if successful, could greatly benefit employee holders and the new investors by reducing the amount of liquidation preference outstanding and giving the remaining preferred stockholders greater control over the company.