Businessweek in an article this past week documents some of the changes that the pain in the venture capital and start-up company sector are bringing about - particularly in investment terms being imposed on start-ups. As the economy gets worse and young companies struggle, more investments are down-rounds - or investments at lower company valuations than previous investments. And the deal terms are getting tougher. The article shows results from a survey done by Silicon Valley law firm Fenwick & West. Among the findings:
As venture capital firms retreat and finance fewer deals, the financiers that do move forward are continuing to extract tough terms from the entrepreneurs they go into business with. Of the companies that received financing, 41% of the deals contained "liquidation preferences," or provisions obligating that the most recent investors get their money back first if the company is sold or acquired. That's about the same rate as the previous two quarters.
However, many more firms that do receive liquidation preference are getting "multiple liquidation" preferences, which state that a venture firm will get back as much as two or three times the amount of capital it invested. In the fourth quarter, 23% of the companies that secured preferences negotiated a multiple preference, up from 16% in the third quarter.
Multiple liquidations preferences mean that, for example, a venture capital firm investment $1 million would get paid a multiple of their $1 million investment (up to $3 million according to the study) prior to anyone else getting paid following a sale of the company. This is a mechanism that venture capital firms use to elevate their return on investment above what they can normally earn simply from dividends on their preferred stock. It's also a safety mechanism to make sure they get paid whatever money is left if the company liquidates.
Another feature increasingly being used are "pay to play" terms:
When companies can't find new investors to bring into a company, they sometimes will try to corral a new round of financing from existing investors. Some may balk. To force all of the current investors to pony up the money, venture capitalists who are willing to play will create a provision stipulating that if others don't participate, their existing equity, which is usually in preferred stock, will convert into common stock.
So in a given venture investment, there are often several different venture groups that will fund a round of investment (say VC A, B and C). A "pay to play" provision means that if the company needs funding down the road to continue, can't find new investors and only current investor A wants to fund another round, B and C will have their preferred stock from the initial round converted into common stock and A will end up being the only holder of preferred stock - with its rights, preferences and dividends. B and C are relegated to the last-in-line status of common stockholder in the case of a sale or liquidation of the company - essentially a punishment for not participating in the latter financing round.
As 2009 drags on, we are no doubt going to see investment terms continue to tighten as venture capital firms use the downturn as an opportunity to extract additional terms and conditions that mitigate their risk and help to safeguard their investments. Start-ups will have to decide whether to try to tough it out without taking additional funding and its concomitant loss of valuation and control. In this down economy, however, they may have no choice but to accept the tougher terms in order to just survive.
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