The last decade has been pretty friendly to startup founders at the deal table. Term sheets got shorter and deals became less structured. Capital was abundant, the exit window wide open and the outlook strong. Who needs dilution protection when the market is steadily going up and to the right?
Now, with a more volatile market, investor money isn’t flowing as freely, and deals are going to start to look very different.
Amid the uncertainty, some VCs are likely looking to introduce language into term sheets that help de-risk their investments if market conditions continue to sour.
For someone like Steve Osborn, a member at Mintz law firm with experience in the last two startup downturns, many of these investor protections will be nothing new. However, many current venture investors and founders weren’t in this industry a decade ago and may find themselves in unfamiliar territory.
Here are some things founders should keep in mind as they look to raise in a changed market — one in which they may have less leverage.
Liquidation preference
While not all potential risk protections will prove economic in nature, many will be. One area Osborn predicted will start coming up more is liquidation preferences.
He told TechCrunch that 90% to 95% of deals he’s done over the last decade have included a standard 1x liquidation preference, meaning if a company liquidates, investors get the exact amount they invested back before a company distributes the money to common shareholders or the company founders.
“Discussion around this term, which basically have been off the table for a long time, I expect will come back in,” Osborn said. “Most rational investors in my mind will allow a cap to be at 2x to 3x.”
If an investor is looking to raise the liquidation preference to, say, 3x, that means they will get three times their initial investment before the company can distribute proceeds to other shareholders.
Founders may want to be careful with how high they go with that metric, Osborn said. If the company sells for a price lower than its last valuation, there may not be much money left for the founder or common shareholders after the investors are paid out at a higher liquidation preference.
“I would advise our companies to take a flat round or down round if needed to avoid situations like that, which are going to be much more problematic down the line,” Latif Peracha, a partner at M13, told TechCrunch.
Pay-to-play risks
Another scenario to look out for is pay-to-play. “Pay-to-play is exactly what it sounds like,” Rachel Proffitt, a partner at Cooley, said. “If you want to preserve your existing rights and preferences, or you want to earn into this new better security, you have to find some dollars in your couch cushion.”
Pay-to-play doesn’t have to be predatory or negative, but in a more volatile market, it can be. Seed and early-stage investors should be especially conscious of its potential pitfalls. If an early-stage investor gets put into a pay-to-play scenario and can’t afford to contribute to a round — which is likely as most funds aren’t set up to infinitely follow-on into portfolio companies — some of their investor rights may end up getting waived or they may find themselves losing their preferred stock options.
“If a startup needs money, and the lead investor puts pay-to-play as their term, and you are a small investor without a lot of market power, you might end up holding common stock,” Osborn said.
Anti-dilution risks
Anti-dilution terms will most likely be back on the table, too, Proffitt said. She said in the recent bull market, investors weren’t as focused on maintaining a specific slice of a company’s equity and dilution was more of a discussion at the deal table.
Many anti-dilution protections are more founder-friendly than for full-ratchet, Proffitt said, a deal term that allows backers to maintain their same ownership stake in percentage terms.
If a later financing occurs with shares priced at a lower amount than what an investor with full-ratchet rights paid for, like during a down round, the shares automatically convert to the lower price. Because of this, the company would have to give this investor supplemental shares to maintain their equity stake, despite no additional investment.
Full-ratchet was popular in the 2008 downturn, Osborn said, but he isn’t sure how often this will come up this time around.
A matter of control
Proffitt said that investors may be looking to add more provisions of governance control going forward, too. She said that in a less certain market, VCs may look to give themselves more power in the boardroom by requiring more decisions to be run through the board, like hiring or firing senior executive talent or raising certain amounts of debt.
“You are going to see investors not just thinking about dilution but operational control,” Osborn said. “When to hire and fire, salaries, loans, things that investors didn’t really care about a lot in recent years.”
While it is best to be prepared, Osborn and Proffitt aren’t sure how similar this downturn will look compared to those past. There is significantly more dry powder in the market now than in prior startup corrections, and Osborn said he thinks good companies will still be able to raise without some of these new parameters — something that didn’t happen in 2008. He added that the current volatility around inflation and pandemic pressures further makes this situation unique.
“Founder needs to be ready to capitalize on things and don’t just accept a new normal without being able to negotiate,” Osborn said.
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