It is clear that we live in dangerous times. For example, only yesterday my wife threatened to give us all haircuts. But she's not the only one knocking at the door brandishing sharp implements. Now, it may be said that over the last few years, the market has been rather founder-friendly and valuations and other terms for good and great companies have been, well, very good and pretty great. Anyone who has been paying attention in the last few weeks, will have seen or heard of more aggressive terms being imposed in funding rounds for both "good"and formerly "great" companies. Much, of course, in the name of Covid-19. So the question begs itself: is what we are seeing a much needed re-balancing of bargaining leverage resulting in a more equitable allocation of risk between founders and investors or are we seeing opportunistic value grabbing by newly-empowered investors?
Here a few thoughts....
1. Valuations: Reasonable up rounds are being turned into flat rounds before the ink on the term sheet is dry, down rounds abound, but so do convoluted warrant structures aimed at maintaining "headline" valuations while giving investors additional equity. The reasonableness of all of these propositions, of course, depends on the exact circumstances of the portfolio company. Is there a direct and disproportionate negative Covid impact on the company? If so, it is difficult to argue against a valuation haircut."The situation is only temporary", the company might cry, but, of course, nobody knows how long the impact will be felt, and it is that uncertainty that is the legitimate driver of lower valuations. Compare that to the company that is trading in line with plan despite Covid, having effectively implemented Covid mitigation measures, but is (bad timing!) in the middle of fundraising, and the situation is far less clear. Is it a real feeling of uncertainty that is driving behaviour there or is Covid simply a convenient excuse to cut the valuation as the round is about to be inked - something that would (with good reason) be considered bad behaviour in normal times?
2. Anti-Dilution: The mere utterance of the words "full ratchet" is usually enough to catapult both founders and early investors across the first four stages of grief (denial, anger, bargaining, depression), but, unlike in grief, should there ever be acceptance? There was, for certain, a time when full ratchets were more common than they have been in recent years, but in practice they were extremely rarely exercised in full. And no wonder: they are extremely damaging to the founders, management and, cry me a river, early investors. Venture capital investing is, of course, about backing companies that will be successful and doing so at the right price. A full ratchet aims to all but eliminate risk on the second variable and it is difficult to see how that can ever be considered a fair allocation of risk - Covid or no Covid.
3. Liquidation Preferences: When is 20% never 20%? When you're a founder or early investor and have (multiple?!?) participating liquidation preferences sitting in front of you. A one-time non-participating liquidation preference - simple, straightforward downside protection - has been the staple for years, but it is not surprising to see some investors brandishing term sheets with multiple and/or participating liquidation preferences these days. If this is the difference between life and death for the company, it's a bitter pill that may be wise to swallow, but be in no doubt that this is just another way of hacking away at the valuation of the company and the same considerations as to reasonableness mentioned above with respect to valuations apply here. There should also be no doubt that whatever liquidation preference is agreed will set a strong precedent for future rounds, so a calculation based only on the current round ("oh it's only another $5m off the top before we are all filling our pockets pro rata") is likely to miss the full picture.