The one thing going up? Down rounds.
The market is improving. But the environment remains tough And deal terms are getting tougher.
Should your terms get tougher too? In short, is it time to get medieval to protect yourself?
Some investors think if you can, you should. You’re a capitalist, not an ATM. Maybe you have a strategic rationale for some of your investments. But your reason for being, is to make money. (That’s true even if you’re a CVC – CVCs have a much better chance of weathering CVC cycles if they’re generating returns.) Why shouldn’t you get the best, most aggressive terms that the market will bear?
- Increase the liquidation multiple on your new investment. In good times, the liquidation preference is 1x. If the company is sold, you get 1x your investment back, before junior securities gets paid. When companies are struggling to raise capital, some investors will push the liquidation preference higher, to 2x, maybe more.
- Participating preferred. In good times, you get preferred stock. When companies are struggling, some investors will push to get participating preferred stock. This gives the holder additional proceeds, on top of their liquidation preference, before converting into common shares – even where the proceeds on sale are above the total amount of investment in the company. Participating preferred gets to “double dip.” Even George Costanza knows that isn’t cool.
- Get ratchet. No, not that kind of ratchet. Full ratchet. In good times, you may use a “weighted average” formula that protects you if money subsequently comes in at a lower valuation. When companies are struggling, some investors may force them to accept the dreaded “full ratchet” formula. This gives the investor the ability to adjust their valuation to match the pricing of any down round – even if it’s for very modest total dollars.
- Go pay to play. In good times, this doesn’t fly. But when companies are struggling, some investors will force the hand of other existing investors by wiping them out if they don’t put in new money.
The VC market has been kicked in the teeth over the last 3 quarters. And use of aggressive measures went up.
Pay to play is up seven-fold (though still small in absolute numbers.) Participating preferred more than doubled in Q1 2023, appearing in 16% of deals, though it has settled back to closer to historical norms of 6-8% of deals. So, you can get aggressive terms (at least for challenged companies).
But should you?
Our take? We’re capitalists too. Our entire business is advising institutional LPs on optimizing their private investments, and in some cases we manage their portfolios outright. We understand that there are valid reasons to consider getting aggressive. They punish – perhaps fairly – “free rider” investors who might otherwise be content to sit tight while other investors stick their necks out and put in fresh capital to keep a company afloat. And they may ultimately be required to attract new money at all.
But our belief: life is long.
We’re not in business to extract the last drop of blood from the stone to get a short term win, at the expense of a long term win.
Deal structure considerations are highly situation-specific. So we won’t paint with too broad a brush and say that we never use aggressive terms. But our focus is on helping the investors we advise not only optimize their returns, but also to be a sought-after partner for investees and investors.
That’s the long term win. We believe it will ultimately deliver greater financial returns over the long haul, by allowing us to attract the highest-quality portfolio companies to invest in; and investor syndicates to invest with.
Aggressive terms like these are euphemistically called “structured” terms. They’re less euphemistically called “dirty” (even by some of the biggest players in VC.) And dirty terms can leave a dirty taste.
They may poison relationships with investors on the receiving end of a pay to play round. They may wipe out founders whose equity is deeply underwater. (And we’re depending upon those founders to create value.) They may force a company to sell or go public before they’re ready, to untangle a thicket of preferences on the cap table. And they may create bad optics for later investors, because they suggest that the company has been in a distressed state and that elbows were swinging in the boardroom.
So we use dirty terms very sparingly.
We’re focused on the long term win.
And going medieval, in our view, is usually a short term win – if it’s a win at all.