The second quarter of 2003 saw the first increase in venture capital investing since the bubble burst and the first increase in early stage investment in three years, according to the PricewaterhouseCoopers/Thomson Venture Economics/National Venture Capital Association MoneyTree™ Survey. According to Thomson Venture Economics and the National Venture Capital Association, the second quarter of 2003 also witnessed a slight increase in venture-backed M&A activity, after two quarters of decline.
As we look forward to venture capital returning to sustainable and historic levels, we wanted to pause and reflect on current trends in deal terms and lessons learned from our experiences in representing traditional venture funds, SBICs, mezzanine funds and corporations in their venture investing.
Deal Terms: Companies receiving venture capital can expect to continue to see investor-friendly deal terms, including: senior status as to prior rounds; liquidation preferences of 1.5 to 3 times the original investment amount plus participation rights; full-ratchet anti-dilution; mandatory redemption (possibly at a multiple of the original investment amount); and cumulative dividends.
Bridge Financings: The bridge financing, intended to take the cash strapped company either to the next full round of venture investment or alternatively to a liquidity event or wind-up, has become a familiar fixture in the life cycle of a venture-backed company. Bridge financing terms typically include: all company assets as collateral; conversion into the next equity round, often at a discount to the valuation for the round; warrants with respect to the equity sold in the next round, often at a nominal strike price; and penalty provisions that in one form or another permit recovery of a multiple of the bridge financing amount or conversion into a substantial portion of the equity of the company a lower valuation), including the insider down round where existing investors provide the funding, has certainly become familiar to many. Companies and investors have learned that it may be important to document efforts to obtain funding on the best terms available from new investors; appoint one or more independent directors to approve the terms and conditions of the down round as being fair and reasonable under the circumstances; offer participation rights to prior investors who will be severely diluted or otherwise lose rights, and take other steps to minimize the legal and practical pitfalls of the down round.
Pay-to-Play Techniques: Many down rounds are closed on the condition that existing series of preferred stock suffer the loss of rights or the more drastic conversion to common stock. Where existing investors put together the down round, they often impose structures that spare them from the effects of these changes to prior rounds. Some of these structures present legal and practical difficulties where different holders of the same series of preferred stock are treated differently based on their willingness to participate in a new round in the absence of a road map to this result in the documentation of the prior round.
Management Carve Outs: In companies with layers of senior preferences and liquidation multiples, management stock options often have no value. Particularly where management is much needed to take the company to profitability, a liquidity event or even an orderly wind-up, investors have been creating management carve-outs (essentially bonus plans), allocating as much as 10-15% of the proceeds of a future liquidity event or liquidation to management.
DragAlong: Some have experienced the inability (for practical or legal reasons) to sell a company due to opposition from earlier round investors and other stockholders with no prospect of receiving proceeds from the sale. This may force later round investors to either pay the resulting "blackmail" or forego the sale and either provide further funding or shut-down the company. As a result, later round investors have discovered the importance of the drag-along, allowing them to force other investors and stockholders to cooperate and go along with a sale that they approve.
Shut-Down Costs: The only thing worse than shutting down the company and writing off the investment is the prospect of being forced to contribute more cash to fund shut down costs. The fear of unpaid wage claims, obligations to return foreign workers to their home countries, the obligation to disgorge payments received on bridge debt prior to a bankruptcy and even the need to preserve relationships and reputations have forced some investors to fund shut-down costs and ensure an orderly dissolution. Investors have learned to turn off the lights and send the employees home before the cash runs out, and to otherwise manage the death spiral to avoid these difficulties.
Desperate times have called for some desperate measures. There is still a lot of money out there to be invested. Funds are becoming more selective, and there is a return to fundamentals in assessing which companies will be funded. Venture investors have returned to expecting solid business models with realistic and achievable goals and top management teams. The challenge will be to figure-out what this all means for deal terms and investment management as the funding pendulum swings back to the middle.