16 min read · May 13, 2020
Venture Funds are Doing Damage Control and Getting More Aggressive on Key Provisions
While certain states may be opening parts of their respective economies, we’re nowhere close to back to normal. More large companies are suspending guidance or even forecasting layoffs later in the year, and while we can debate whether VCs are “open for business” or not, there are no signs that fundraising will return to pre-covid levels any time soon. The market for startups and funding before the pandemic was incredibly founder friendly, and many investors were already predicting a pullback and lamenting frothy valuations, related to both an abundance of capital and more investors chasing fewer great deals.
While few, if any, had “pandemic” on their “What Will Cause the Next Recession” bingo card, it’s clear that terms not seen since the dot-com bubble and the recession caused by the financial crisis are back with a vengeance. If they are writing checks, many funds are already aggressively changing behavior. This article is meant to examine the advice investors are giving their current portfolio companies, the ways in which terms are materially changing for founders raising now, how they work in practice, and what to expect going forward.
When uncertainty started to build around the economic effects of the pandemic, venture capital funds big and small, late and early, began to do damage control. Sequoia released their patented “Batten Down the Hatches” memo, presciently, as they had done in the crisis of 08. This one identifies the pandemic as the Black Swan of 2020, and warns founders to prepare. The Sand Hill Road stalwart warned founders that a new normal was coming, and they needed to prepare. What is the new normal? In a world full of a record amount of dry powder, fear and uncertainty are the main drivers of investor habits. There is cash out there, but it’s going to come with a higher cost. We’ll talk more about those terms in a minute, but the first thing investors have to do is ensure the safety of those already in the boat. While some funds may take advantage of the new environment to go back to over-confident (perceived or otherwise) founders and renegotiate term sheets or pull deals all together, Priority #1 for every fund is circling the wagons. Investors had already been warning founders to raise a longer runway in anticipation of a recession. Now, importantly, funds are putting their own investments on life support before looking for new deals. Unfortunately, it’s important to remember that not all verticals are created equal, and some sectors will fare far worse than others. In particular, those in consumer and travel are likely to be hit hard. We’ll talk more about this further below.
So what does portfolio triage look like in practice? There are three main areas for concern.
How much cash on hand does your company have, relative to your burn? Were you about to raise a new round? Do you have sixty days of runway left? If so, this is a difficult time. Unless you’re uniquely well positioned to continue to gain revenue (one of my favorite phrases in venture: customer funding is non-dilutive), you need to do damage control as a founder and figure out how long you have before you need more money. Luckily, the WeWork IPO debacle had already shifted focus back to cash flow positivity from growth at all costs, so hopefully you weren’t planning on buying a superbowl commercial or any other aggressive (read: expensive) customer acquisition initiatives. If you need more cash, you better have a heart to heart with your lead investor, or the VC on your Board. You’ll need to acknowledge the fact that no, you are not impervious to this, and yes, you have a plan. Now is also the time to lean on investors who have seen a crisis before. While there are dramatically more funds now than there were pre-08 recession, many well established funds have a playbook for downturns, and you should learn it.
Good investors will be willing to work with founders, and will financially support those who have a shot at coming out of this. While you may not be able to connect with new investors right now, if you’re in a good position and realistic as a founder, you may find success with an inside round. If you won the PPP lottery, and many startups did, hopefully you can run the business until we can see the light at the other end of the tunnel. More on that later as well. If you’re a life sciences company or have a social impact message, you may also want to look into applying for non-dilutive grants to extend your runway beyond the short term. Venture debt may also be a possibility, and many shops are very familiar with the SBA lending process already.
Unfortunately for founders, the job of a venture fund is literally to pick winners and losers, so if you don’t have a clear path out of this, you may be left out in the cold and run out of cash. It may sound harsh, but now is the time to be realistic and proactive.
How do you prove to investors that you have a plan? You act. Some changes are easier than others, and the new normal has definitely created new opportunities to go directly to customers (who, conveniently, are stuck in their houses in front of screens). However, the path that seems most common is a reduction in your overhead and headcount. Every day seems to bring a fresh round of layoffs, from companies big and small. While the VC community has been incredibly proactive about connecting newly unemployed talent with opportunities, the current environment means a reduction in new projects, which means a reduction in employees. If you’re interested, find more information on available candidates here or add yourself to the pool if you find yourself on the wrong end of layoffs recently.
If you do find yourself in that situation as a former startup employee, know that you’re in good company. Public companies are not immune, and again, some industries have been hit harder than others. Uber recently laid of 14% off its workforce, or 3,700 people. They’ve also indicated that they’re not done yet. As Bloomberg points out, “this sort of painful day is becoming commonplace. Tech companies have eliminated more than 38,000 jobs in the past two months, according to Layoffs.fyi, which tracks the job market. Lyft Inc., the main alternative to Uber in North America, said last week it was dismissing 17% of staff, furloughing more and reducing salaries. Their longtime peer in the sharing economy, Airbnb Inc., said Tuesday the company was cutting a quarter of its workforce.”
Additionally, the days of open floor plans and stocked kitchens may be coming to an end, as remote work was gaining traction and acceptability before the pandemic and the trend doesn’t seem to be slowing down. Office space and rent were traditionally cost drivers for many startups. In the past decade, in fact, tech firms had come to dominate the commercial real estate space as tenants, bringing costs up with them. Curb, a real estate blog, explains that “in the top 25 tech cities…the cost-per-square foot for office space has risen 59 percent between 2000 and 2018, from an average of $199 per square foot to $316. That’s much [faster] than the country at large, which only rose 26 percent during the same period, from $197 to $248. In addition, 15 of the top 20 markets for new construction are tech markets, suggesting some relationship between industry demand and new office space.”
That trend may be permanently reversed, but will obviously vary by company, and industry. Github was famously one of the first companies to scale and execute with a remote-first culture, due to the unique nature of their product and autonomous work processes. Now larger companies are following suit. Just yesterday Jack Dorsey announced that Twitter will move to allow its employees to work remotely “forever.” This could significantly reduce overhead and may be encouraged by some investors, while others will want teams face to face. Apple, for example, is allowing employees to return to campus in phases over the next few months.
This was a term thrown around lightly in the bubbly atmosphere of 2019, but now it really needs to mean something. If you’re lucky enough to have cash on hand and a market poised to grow, now is the time to get creative as a founder. Here’s a fantastic list of ways very successful companies hacked their way to scale.
One of the best examples is the AirBnB Craigslist hack. “AirBnB is now famous for being the place where you can score affordable accommodation almost anywhere you travel, but in the early days, they needed to build their userbase, customer base, and reputation. The founders realized that people who were looking for alternative accommodation often searched on Craigslist, so they offered an option for AirBnB accommodation providers to copy their listing to Craiglist with one click, verify the information, and post. The result? Immediate access to a large market of target users.” This cost almost nothing and enabled scale.
The bottom line: Get creative. Again, customer funding is non-dilutive.
If you raised in the first two months of the year, you’re lucky, smart, or both. I recently wrote a post on preferred shares, a term you’re probably familiar with as a venture backed founder. That article pointed out the biggest difference between the rights associated with common stock (which founders, employees and everyone else commonly hold), and preferred stock, which is what venture funds will seek. Liquidation preferences determine what happens if things go south. There are other provisions designed to protect investors, which we’ll explore here. Pre-covid, the economy had been humming along for such an extended period of time that many of the more aggressive terms had fallen out of fashion, were unnecessary, or would prevent a fund from putting together a competitive term sheet.
One of the interesting things about law school is that much of what you learn is essentially the “car crash” version. You are trained on worst case outcomes with intense consequences and unusual results. Then you get to the real world, and life is mostly just settlements and contracts. If you studied VC, what this means is that you learn a bunch of super aggressive terms, and then never see them again. In light of the current pandemic, however, lots of unusual things are happening and investors are getting more aggressive if they’re writing checks. The following terms are some you might want to get familiar with if you’re raising money or investing yourself. I should note that I haven’t done a deal (yet) that includes terms this aggressive, but I’ve heard of them popping up in term sheets more frequently from other investors.
Venture capital investors are balancing two main goals at all times: downside minimization and upside participation. If I’m going to get burned, I want to know how badly. If things are going well, I want as much of the pie as I can get. That brings us to the legal terms that investors use to achieve some of these goals. In the current environment, investors are thinking more about the downside than the upside, particularly if they’re going along with a founder’s valuation. I’ve spoken with several investors who say they’re seeing these provisions come back at levels not seen since the recession and the dot com crash.
As we’ve discussed, a defining feature of venture investing is the liquidation preferences, and they are not created equal. Double dipping is a great example. More commonly known as “participating preferred,” these provisions became rare in boom times as founders leveraged multiple funds and term sheets to get friendlier terms. Double dipping refers to participating preferred stock which entitles a holder to a liquidation preference and also to participate in the residual value, or the rest of the money. The alternative is known as “non-participating preferred.” Chris Grew, a Partner in Orrick, Herrington & Sutcliffe’s London office, summarizes the reference well. Some investors will “include a participating liquidation preference that permits the VC to receive their money back first in a trade sale (M&A event) or liquidation of the company, with the balance of the proceeds being divided amongst the holders of ordinary shares and preferred shares on a share-for-share basis. The participating preference is often referred to as a “double dip” because the VC investor receives their money back and then gets a share of the remaining proceeds.”
Typically, an investor would have to pick between their liquidation preference, usually a set amount equal to (or a multiple of) their original investment, or convert their shares to common and get that amount. Here’s a great example of how the math works out from Mark MacLeod at StartupCFO:
Capital raised: $ 10M
Ownership of investors: 40%
Exit price: $ 30M
“In this scenario, if your investors convert to common, they would get $12m (40% of $30M). This is barely above a return of capital. Not the worst outcome for them, but not great. If however, they had participating prefs then they would get $18M ($10M cost + $8M — 40% of $20M). So, even though they own 40% of the company they would get 60% of the sale price. The situation is even worse if there is a multiple liquidation pref (i.e. >1x cost + participation in whatever is left). Generally we would do the math on an as-converted basis and decide to get the amount due to them as a proportion of the overall equity. The caveat here is that generally if you’re liquidating a company and you’re earlier down in the stack (an early investor), there won’t be much left by the time you’re owed.”
Aside from the obvious, why is this bad? Well, it can also result in what’s called a liquidation overhang. A company is in liquidation overhang when the value of the company doesn’t reach the dollar amount investors put into it. Because of liquidation preference, those holding preferred stock (investors) will have to be paid before those holding common stock (employees). As you can probably guess, when investors are being aggressive with liquidation preferences, they can eat up the returns due to other investors, and of course the founders and employees. You need to speak with a good attorney and weigh the pros and cons of valuations and aggressive terms, which we’ll talk more about in a second.
An anti-dilution clause is a provision in a stock-purchase agreement that many investors demand in order to prevent the value of their equity stake from diminishing when new shares are issued to other investors at a lower price later on. This is achieved by retroactively modifying the purchase price of shares to parity with subsequent (lower value) share issuances so that the first purchase ends up buying more shares than it did originally. In effect, the anti-dilution provision creates a situation in which a shareholder remains in control of the same percentage of the company regardless of future stock issuances made at a lower value than the value at which he purchased his shares. A more aggressive version of this is the Pay to Play provision. Rather than giving the investor the option to maintain their pro rata, a pay to play provision can force previous investors to give up liquidation preferences and other rights if they DON’T maintain their share.
“Pay-to-play” is a term used for a corporate policy established as a condition to a shareholders’ preferred share purchase that requires that purchaser to make future, pro rata, purchases in subsequent investment rounds. If the shareholder subject to a “pay-to-play” provision ignores it, he will lose the protections associated with his preferred shares such as liquidation preference and anti-dilution provisions.
As a founder, you may have bigger fish to fry but should still be concerned about how your investors are working together, and who comes into your next round and maintains positions on your cap table. As an investor, particularly at the early stage, this should worry you a bit. Venture fund dynamics require (or at least heavily suggest) investors to allocate certain amounts to new deals and follow-on funding, and terms you’ve negotiated guarantee you a spot at the table if things are going well down the road. This is typically frowned upon, because one of the fundamental aspects of venture capital is relationship building and collaboration. Pay to play provisions force earlier investors back to the table, an especially tall order when things are tight.
So what happens if you raise a round at your preferred valuation with confident investors and the recovery is more swoosh than V? You may find yourself in the unenviable position of raising a down round. Some investors would rather sit on their hands now and wait than invest in this market and face this prospect later on, but it is already happening to some companies.
This report from Bloomberg Law summarizes the mechanics of cram downs and unusual terms in tough times. “A down round financing is a capital raise that is based on a company valuation that is lower than the company’s valuation in its prior financing round. As a result of the lower valuation, the equity outstanding immediately prior to the down round will suffer dilution. A “cram down” is a term that is often used to describe a down round financing in which existing investors lead a new financing that includes terms that may be severely dilutive to non- participating investors and that may include other features, such as forced conversions and “pay-to-play” mechanisms, that may have the perceived effect of punishing non- participating stockholders. In a severe cram down, existing stockholders who do not participate in the round may end up with little or no meaningful ownership stake in the company. In addition to further consolidating ownership of the company, investors willing to participate in a cram down may often also receive ancillary deal terms and preferred stock rights and preferences (such as super-priority liquidation preferences, “drag along” rights and special voting rights) that are superior to the prior rounds.”
The article starts off with an explanation that when things are good, investors play nice together, but when times are tough, investors get aggressive and take advantage of opportunities. Sound familiar? The article is from 2009. Seed investors who did deals recently at inflated valuations are particularly vulnerable to these terms.
It should be noted that Term Sheets are a series of trade offs, from the valuation all the way down to IPO Registration rights, so these terms aren’t necessarily independent of eachother. They function as a series of levers and switches that investors can pull, depending on the timing, the company and founder, and the other investors at the table. A term not discussed here that fits into this category is “drag along” provisions, which can compel founders and other shareholders to go along with big decisions, like selling the company. This article covers a lot of ground so I won’t get into it at length, but there are also many investors who gave up certain control rights via amendments to comply with provisions in the Paycheck Protection Program (PPP) to make their portfolio companies eligible for loans. It will be interesting to see how this plays out over time, as many investors and professionals are voicing some confusion about the ever-changing repayment and forgiveness requirements around these loans. Maybe another article on that down the road.
I recently heard a venture panelist with over two decades’ experience say they thought top line startup valuations could come down 20–30% over the next six months, depending on the road to recovery. “Because with other investors departing the market, deal terms are getting better, the competition is less keen, [many investors] can do more due diligence and there are a lot of companies being built that have great growth prospects and are going to survive this global pandemic,” Danny Crichton detailed on Extra Crunch after calling around to his sources. “It’s the VC equivalent of buy (actually) low and sell high.” If, as previously mentioned, we don’t bounce back as quickly as some are predicting, that seems likely.
In some verticals the downward trend is apparent. Lime, the ubiquitous bike-share-turned-scooter startup, is one of the first unicorn victims. According to the Information, “Uber is in talks to lead a $170 million financing in scooter rental firm Lime, whose business has dropped sharply amid the coronavirus pandemic, executives at the startup told investors last week. The potential deal would value Lime on paper at $510 million, after the proposed cash infusion, a 79% drop from its previous valuation.” Lime (and other ride and scooter sharing startups) has obviously been hit hard by the pandemic, along with travel and hospitality companies. Airbnb is probably the starkest example of change in economic prospects from 2019 to 2020. At the end of last year, the company was preparing to IPO. Then the pandemic struck, bookings dried up, and now hosts who overextended themselves to leverage the platform are looking for help and answers. Travel will come back. However, it’s going to be a long time. According to TechCrunch and other sources Airbnb raised a fresh round of debt in the form of a $1B term loan, which is better than a down round from a valuation perspective. The “term loan looks more clearly targeted at dealing with immediate negative impacts caused by COVID-19. Although, once again, Airbnb’s statement seeks to paint an upbeat picture of travel in a post-pandemic future, without the company being able to specify exactly when such a time might arrive.” Venture debt may gain market share as companies look for sources of funding that don’t hurt previous investors (unless of course you count seniority.) Where valuations don’t seem to be dropping are delivery (especially grocery) and healthcare (especially telemedicine).
On that note, the Information also reports that “Instacart, the grocery delivery company whose business has surged amid Covid-19 lockdowns, is in talks to raise several hundred million dollars from existing and new investors, according to two people with knowledge of the situation. The deal would put the company’s pre-money valuation at between $12 billion and $14 billion, one of these people said, an increase of at least 50% over Instacart’s valuation during its last financing in late 2018.”
It seems in the current climate the only certainty is change, as many investors are also establishing bright lines for expiring term sheets and valuations. If you received one in early April and haven’t held your first close, don’t be surprised if investors come back to you looking to renegotiate. How can investors and founders navigate in the current climate? Keep yourself healthy, have a plan, and speak with your advisors honestly and frequently.
This too shall pass. Until then, read that Term Sheet carefully.
