Welcome back,
Today's issue will be a little different as we will analyze data from Fenwick West regarding the trends in clauses used in Silicon Valley venture capital financing rounds. This will provide an idea of what to look out for as a founder as the funding environment continues to evolve and change, given the economic circumstances.
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Onwards and upwards,
Liam
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VCs vs Founders; Financial Terms
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Background
Since the start of 2022, founders have reported an increase in predatory terms being used by venture capitalists as they attempt to limit their downside while making high-risk investments. Since 2014, founders have had great power in negotiations with venture capitalists due to the strong bull market creating pressures on investors to keep up with an increasing rate of capital deployment throughout the United States. With that capital slowing for the first time in almost a decade, we are finally seeing a return to the investment terms founders experienced in the 2000s.
Data shows that Senior Liquidation Preferences are rising, with 16% of Post-Series-A rounds including the clause in Q2 2022 compared with just 12% in Q4 2020 (a 33% increase). Furthermore, the multiples are also increasing within Liquidation Preferences. In Q4 2021, 0% of funding rounds had a Liquidation Preference with a multiple over 1. In Q2 2022, 4$ of financing rounds had this predatory Liquidation Preference.
The use of cumulative dividend clauses is on the decrease, with 5% of financing having the clause in Q1 2021 and just 2% in Q2 2022.
Ratchets saw a return in a big way, with an IPO rachet being used in Q2 2022 for the first time in two years.
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The Law
- Liquidation Preferences - These are clauses and rules about how the money will be distributed if the company is sold or goes bankrupt. When talking about a multiple, it refers to the amount of money that must be returned to a VC before the founders, employees, and others get their share. For example, if you raise $20M at a $100M valuation, then sell the company for $40M and agree to give your investor a liquidation preference with a 1.5x multiple, then the investor gets the first $30m (1.5x their investment) and the rest of the money is split based on ownership so 20% to the VC and 80% to the founders. So even though you own 80% of the company you sold for $40M, you get $8M, not $32M. Assuming you have founders and employees, you may walk away with just a few million despite owning more than the investor who makes a solid return.
- Cumulative Dividends - This is when a company agrees to pay a dividend each year, and if they can't pay that dividend, it is saved as an amount owing to the shareholder who was owed that dividend. When the company is sold or profits, that money is paid as a dividend to the shareholder.
- Ratchets - These are incredibly predatory and allow an investor to receive more shares if you try to sell or go public at a lower valuation than agreed. A simple example would be if you get $20M at a $100M valuation and then go public at $50M a simple ratch, the investor would get 20% of your company for free when you go public so that they own 40% instead of the original 20% they bought. This makes them whole since that 40% is worth the $20M they invested. More predatory versions may require you to raise your next round/go public at 2x or more above where they invested, or they get additional shares to increase their returns.
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Takeaways
The funding scene is changing, and now more than ever, founders need to be aware of the types of clauses VCs can use that may disadvantage founders. Everyone must be knowledgeable and have any agreement they sign verified by a lawyer who can adequately advise them.
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