Unless you’ve been stranded on a desert island recently, you’ll know that it’s much harder to raise money as a founder this year.
Venture capitalists are more cautious about deploying cash amid plummeting public share prices. Some startups are having a harder time making money in the face of macroeconomic headwinds. And nobody knows how long the turbulence will last. Tin hats, all of them.
So it makes sense that the terms of venture capital deals are also changing. In times of technological boom, the terms leaned towards giving founders more control and incentives. Now things are a little more difficult.
“It’s getting back to more of what I would say is long-term normal,” says Mike Labriola, a partner at the Wilson Sonsini law firm. But he adds: “I’d say I’ve seen more of what I call ‘predatory term sheets’ in the last six months than I have in the last decade.”
So what are term sheets like? the documents that set investment terms between startups and their backers – Changing? And what should founders keep in mind?
Valuations are falling and everyone wants to avoid a bearish round
Perhaps the most important thing on a term sheet is the valuation of the company. All 10 investors and lawyers Sifted spoke with for this article said those valuations are lower than last year across the board.
But what companies want to avoid is going up to a lower valuation than a previous round: a round down. When this happens, not only are the holdings of founders and existing investors worth less, but their ownership is also reduced. It can also be a blow to the morale of founders and employees and the market perception of a company.
As a result, founders and investors are getting creative. Some are announcing “extensions”: raising more money on the same terms as last time. Others are rising through convertible notes: Obtaining debt that is converted into capital at a valuation to be determined later. Sifted has enjoyed the novelty names (Series A+, Series B2, pre-Series A) that PR has come up with for these tricky rounds.
Other investors tell Sifted that they have started to see some rounds structured as tranches, where the investor gives up parts of the total money as the startup hits certain performance targets.
Negotiating other clauses in the term sheet can also be a way for investors to feel they have enough protection to invest and still avoid a round to the downside. That may include negotiating on settlement preference; more on that later.
Late-stage companies are more likely to have to negotiate terms or provide more investor protection when the company isn’t performing well, says Mike Turner, a partner at the law firm Latham & Watkins.
Early-stage companies, which are further removed from the public market turmoil, simply have a harder time closing deals, “but it doesn’t necessarily translate to changing the terms of the deal as well as the valuation.”
One thing that has changed in earlier stages, says his colleague Shing Lo (also a partner), is that high schools – the founders’ ability to get some money off the table – it’s not happening in Serie A like it did last year.
In the boom times of 2021, many successful founders took large amounts of cash off the table in the early rounds. Virtual Events Startup Hopin Founder Johnny Boufarhat won over £100 million by selling some of their shares in the company.
Settlement Preferences
Settlement preference clauses are one area where term sheets are seeing a lot of change, market participants tell Sifted. These clauses stipulate the returns that investors obtain in the event of a sale, merger or if the company goes bankrupt.
Wilson Sonsini’s Labriola says he’s starting to see some change in whether liquidation preferences are pari passu, where all shareholders have equal priority when taking exit earnings, or senior, in which case investors are paid in order. from newest to oldest (“First in, last”). The latest is bad news for angels and early-stage venture capitalists.
Labriola says more UK terms of reference went pari passu in recent years, but he is now seeing senior settlement preferences take over.
The term sheets also establish a liquidation preference multiple, which stipulates how much an investor receives as a multiple of their original investment amount. This is usually 1x, meaning that investors are paid back in full before anyone else is paid in the case of something like a sale.
Higher multiples can be particularly painful for founders and employees who may be left with nothing or almost nothing in a sale or liquidation. Fortunately, lawyers tell Sifted they’re not seeing too many changes to the 1x standard, except in cases where a company isn’t doing well. A higher multiple may also be something investors can ask for in exchange for not touching the valuation, thus avoiding a dreaded round down.
Generally, these clauses are non-participating, which means that investors get money equal to what they invested, multiplied by X (if the company does well). But they don’t get a slice of the extra revenue, if it exists at all.
Some lawyers say they are now seeing more participation clauses, meaning investors get their money back plus a portion of the other proceeds in the event of liquidation.
Claire Webster, chief legal officer at OMERS Ventures, says she’s seeing changes in settlement preferences.
“I’m not sure 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 very good anymore.” , He says.
What kind of investors are out there?
Northzone partner Michiel Kotting says that most of the predatory terms emerging in the market are not the work of established venture capital firms, but of other investors who might not be traditional start-up backers. These investors seek to structure deals not to protect themselves, but to generate a return.
Often these investors lock the founders in exclusivity when negotiating a term sheet, so they can’t talk to other investors.
“They’re using this exclusivity and the fact that the company is running out of money to basically extort money from them,” says Kotting. “I’m trying to put my portfolio companies on notice: understand who you’re dealing with and understand how serious they are.”
Turner of Latham & Watkins points out that there are more private equity investors investing in later-stage raises asking for terms that venture capitalists would not normally come up with.
Those may include charging interest on investments, which unsurprisingly rose from 6-8% last year to as high as 12% now, or redemption fees. The latter gives investors the rights to sell their shares back to a company in the event that it fails.
“[PE] Investors think about financial returns very differently. They usually do not endorse the founders, but rather the companies. They’re not supporting the technology, they’re supporting the economy,” says Turner.
Wilson Sonsini’s Labriola says that one thing works in founders’ favor: VC is an industry built on reputation. And word will spread if VCs are too harsh on companies with their terms.
So what can founders do to not get screwed?
Northzone’s Kotting says founders should talk to people they trust to get a second opinion on a deal, something he’s doing with many non-Northzone portfolio companies.
He also says a down round may be preferable to extensions or convertible notes if they involve handing over too much control to a new investor. It may be preferable to work with existing investors “creating incentives for everyone to share in the pain,” he says.
OMERS Ventures’ Webster says founders need to “understand what they’re asking for and what they’re getting. You can’t just look at the valuation and assume it’s a standard deal. He must understand what will happen in the best case and in the worst case.”
But amid all the doom and gloom, she’s seeing a change to term sheets that the industry can be happy about: diversity and inclusion provisions. Those may require companies to implement D&I policies or report D&I metrics.
“It’s a very positive thing in the midst of some dark times,” she says.
Eleanor Warnock is Deputy Editor of Sifted and co-host of The Sifted Podcastand writes round up, a weekly newsletter about VC. She tweets from @misssaxbys
