We are all well aware of the economic crisis, including freezing of the credit markets and turmoil in the financial sector. These events have precipitated a significant decline in venture capital investment in the fourth quarter of 2008 and through the early part of 2009. Despite the gloom, early stage companies’ need for capital has not dried up, and investments are still being made. It is essential to engage attorneys with venture capital experience as early as possible in the process who understand the current trends in the venture capital marketplace and are able to provide practical business and strategic advice in these challenging times.
Smart Business learned more from Ryan Azlein, partner at Stubbs Alderton & Markiles, LLP, about the effects of the economic conditions on venture capital financings.
Is venture capital still an option for early stage companies?
Yes, but expect a much more difficult and protracted process, with fewer interested investors and less favorable terms. Two assumptions commonly heard from venture capital firms (or VCs) these days are that (1) early stage companies should not plan any revenue growth over the next 12 to 24 months and (2) additional capital will not be available from outside sources during that same period. By necessity, many VCs are focusing increased time and financial resources to support existing portfolio companies. Further, as there are fewer ‘exit’ opportunities in the form of initial public offerings or acquisitions by other companies, VCs are planning for the need to fund even their successful portfolio companies for longer periods of time than they would have a few years ago.
Despite these trends, many VCs do have funds to put to work in new investments and see the current market downturn as an opportunity. Less competition among investors means that VCs are able to obtain more favorable terms on their investments, resulting in greater returns for the companies that are ultimately successful. Key for entrepreneurs is to identify and connect with the right funding sources.
What is the most significant effect of the economic conditions on venture financing?
Lower valuations are the most significant impact. Due to reduced competition among venture capitalists for any particular deal, a VC is likely to have an upper hand in negotiations and get a better price on its investment. Steep stock market declines mean that values for comparable public companies are significantly lower. Combined with the bleak macroeconomic outlook, it is more difficult for early stage companies to justify and negotiate higher valuations. In many cases, companies are forced to sell shares in a ‘down round’ in which the price per share in the new financing is lower than the prior round of financing. The result is even greater dilution to founders and shareholders unable or unwilling to participate in the new financing.
What are other effects on financing terms?
It is becoming more common to see a multiple liquidation preference, in which the investor receives a multiple of the original investment in any transaction resulting in liquidity prior to common shareholders receiving any proceeds. Under better conditions, the liquidation preference is unlikely to provide investors with more than their initial investment back as a preference. Further, the liquidation preference is more likely to be combined with a participation right providing for participation with the common shareholders in the remaining proceeds after payment of the liquidation preference.
Other downside protections have also become more common in the last few months, such as redemption rights and more aggressive anti-dilution rights. Redemption rights give the investor the right to require the company to repurchase its shares after a specified period of time (in the event there has not been an IPO or sale of the company). Anti-dilution rights protect the investor against future sales of stock at a lower price. VCs are now more likely to require a ‘full ratchet’ anti-dilution right, which adjusts the investor’s effective purchase price down to the lowest price at which the company sells shares in the future. Full ratchet anti-dilution rights mean potentially even greater dilution for, and essentially shift the risk of a future down round to, the founders.
VCs may also require ‘pay-to-play’ provisions as a condition to new investment in order to encourage the participation of previous investors in the new round. Prior investors who fail to participate in the new financing will have their preferred shares converted to common stock or otherwise forfeit some of their preferred rights.
In addition, new financings may necessitate a recapitalization or cram down of the shareholders not participating in the financing. The circumstances and terms of a recapitalization vary but generally relate to simplifying a capital structure or wiping out liquidation preferences in a company that has already been through several rounds of financings.
What are direct effects of these changes on founders and management?
Equity stakes in the company will be diluted. To address this and keep management adequately incented, investors may require additional equity grants, usually stock options. Another approach is to create a plan that pays a cash bonus to management upon a successful sale of the company.
RYAN AZLEIN is a partner at Stubbs Alderton & Markiles, LLP. Reach him at (818) 444-4504 or email@example.com.