Unless you’ve been stranded on a desert island lately, you’ll know that fundraising as a Founder is a lot harder this year.
Venture capitalists are more cautious about deploying cash amid falling public equity prices. Some startups find it harder to make money in the face of macroeconomic headwinds. And no one knows how long the turbulence will last. Sheet metal hats, everyone.
It is therefore logical that the conditions of venture capital agreements also change. In the tech boom era, terms tended to give founders more control and incentives. Now things are a little more difficult.
“It comes down more to what I would say is normal in the long run,” says Mike Labriola, partner at law firm Wilson Sonsini. But, he adds: “I would say I’ve seen more of what I call ‘predatory condition sheets’ in the last six months than I’ve seen in the last decade.”
So how are the term sheets – the documents that set investment conditions between startups and their backers – changing? And what should founders pay attention to?
Valuations are falling and everyone wants to avoid a drop
The company valuation is perhaps the most important thing in a term sheet. The 10 investors and lawyers Sifted spoke to for this article said these valuations were lower than last year across the board.
But what companies want to avoid is rising at a lower valuation than in a previous cycle – a bear cycle. When this happens, not only are the stakes of founders and existing investors worth less, but their ownership is also reduced. It can also take a toll on founder and employee morale and a company’s market perception.
As a result, founders and investors are getting creative. Some are announcing “extensions”: raising more money on the same terms as last time. Others raise via convertible notes: raise debt that converts into equity at a valuation to be determined later. Sifted appreciated the new names – Series A+, Series B2, Pre-Series A – that PR created for these sneaky rounds.
Other investors tell Sifted that they’ve started seeing a few rounds structured in tranches, where the investor hands over chunks of the total money as the startup hits certain performance goals.
Negotiating other term sheet clauses can also be a way for investors to feel protected enough to invest while avoiding a downside. This can include trading on liquidation preference – more on that later.
Later-stage companies are more likely to have to negotiate terms or give investors more protection when the business isn’t performing well, according to Mike Turner, a partner at law firm Latham & Watkins.
Early-stage companies – which are further removed from the turmoil of public procurement – simply have a harder time closing deals, “but that doesn’t necessarily translate to changing the terms of the deal outside of the market. Evaluation”.
One thing that changed in the early stages, says colleague Shing Lo (also a partner), is that secondaries — the founders’ ability to take money off the table — don’t happen in Series A like they do. were last year.
In the boom era of 2021, many successful founders took large amounts of money off the table in early rounds. Johnny Boufarhat, founder of virtual event start-up Hopin earned over £100m by selling some of his shares in the company.
Liquidation preference clauses are one area where termsheets are seeing a big change, market participants told Sifted. These clauses stipulate the returns that investors obtain in the event of the sale, merger or bankruptcy of the company.
Wilson Sonsini’s Labriola says he’s starting to see a shift in whether liquidation preferences are pari passu — where all shareholders have equal priority in getting exit proceeds — or senior, in which case investors are paid in order from the most recent to the oldest (“First in, last out”). The latter is bad news for angels and early-stage VCs.
Labriola says more condition sheets in the UK have been pari passu in recent years, but he now sees senior liquidation preferences taking over.
The term sheets also establish a liquidation preference multiple, which states how much an investor gets back as a multiple of their original investment amount. It’s usually 1x, which means investors get their investment back in full before someone else gets paid in the event of something like a sale.
Higher multiples can be particularly painful for founders and employees who may end up with little or nothing in a sale or liquidation. Fortunately, attorneys tell Sifted that they don’t see too much of a change from the 1x standard, except in cases where a business isn’t performing well. A higher multiple may also be something investors can ask for in exchange for not touching the valuation, thus avoiding a dreaded downside.
Usually, these clauses are non-participatory, which means that investors receive an amount equal to what they invested, multiplied by X (if the company is doing well). But they do not receive a share of the additional profits, if they exist.
Some lawyers say they are now seeing more participation clauses, meaning investors get their money back plus a share of other proceeds in the event of a liquidation.
Claire Webster, legal director at OMERS Ventures, says she sees things changing around liquidation preferences.
“I don’t know if that’s a sign that people are taking advantage of the market or if it’s a function of inflation and rising interest rates, which means a 1x drop isn’t not very good,” she says.
What types of investors are there?
Northzone partner Michiel Kotting says most of the predatory terms emerging in the market are not from established venture capitalists, but from other investors who might not be traditional funders. These investors seek to structure trades not to protect themselves but to create a return.
Often these investors lock founders into exclusivity when negotiating a term sheet, so they can’t talk to other investors.
“They’re using that exclusivity and the fact that the company is running out of money to extort value from them,” Kotting says. “I try to warn the companies in my portfolio – understand who you are dealing with and understand how serious they are.”
Latham & Watkins’ Turner notes that there are more private equity investors investing in later scales asking for terms that VCs typically wouldn’t offer.
These can include charging interest on investments – which unsurprisingly rose from 6-8% last year to a maximum of 12% now – or redemption rights. The latter gives investors the right to sell their shares back to a company in the event of poor performance.
“[PE] investors perceive financial returns very differently. They don’t usually support founders, they support companies. They don’t support the technology, they support the economy,” Turner says.
Wilson Sonsini’s Labriola says one thing works in favor of founders: venture capital is a reputation-based industry. And word will spread if VCs go too hard on companies with their terms.
So what can founders do to avoid being fooled?
Northzone’s Kotting says founders should talk to people they trust to get a second opinion on a deal — something he does with many non-Northzone portfolio companies.
He also says that a downround may be preferable to extensions or convertible notes if they involve handing a lot of control to a new investor. It may be best to work with existing investors “creating incentives for everyone to share the pain,” he says.
Webster of OMERS Ventures says founders need to “understand what they’re asking for and what they’re getting. You can’t just look at the appraisal and assume it’s a standard deal. You need to understand what is going to happen best case and worst case. »
But amid all the pessimism, she sees one thing changing on the terms and conditions sheets the industry can look forward to: the diversity and inclusion provisions. These may require companies to implement D&I policies or communicate D&I metrics.
“It’s a good positive in the midst of dark times,” she said.
Eleanor Warnock is associate editor of Sifted and co-host of The subdued podcastand writes Turn up, a weekly newsletter on VC. She tweets from @misssaxbys
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