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 protected].
