By: John W. Dorris, January-February 2003, BizAZ
THE SIGNAL FROM THE investment community is telling: Backing a startup or early stage company presents markedly greater risk these days. With the slow economy and fewer opportunities to liquidate a position with an acceptable return, venture capitalists have been disinclined to fund new startups with limited operating histories, focusing instead on portfolio companies and so-called "down round'' financings. A significant amount of venture capital (VC) has been sidelined, but could be available for new venture capital funding.
Market trends have spawned increased leverage for venture capitalists. What's happening today is that venture capitalists ara extracting from entrepreneurs substantially lower pre-money valuations that, coupled with other financing terms, result in higher dilution for prior investors, founders and management.
But bargains may always be struck, even in tough market conditions that favor venture capitalists. Venture capitalists provide funding in exchange for a share in the upside, through an ownership interest in the business. Thus, for the entrepreneur seeking VC, the initial question is how much a financing round will cost him in terms of equity in the company.
Consider a hypothetical biotech company, Life Sciences, Inc. Life Sciences has obtained its initial funding from founders and angel investors, and is now looking to complete a $20 million venture round. Life Sciences is blessed with a seasoned management team as well as a business plan and market opportunity that has attracted investor interest.
Assume that, under better market conditions, Life Sciences could have obtained a $100 million pre-money valuation. In a $20 million venture round, the company would give up a 16.7% equity stake, and existing stockhlders would retain an 83.3% stake. However, in the current market, suppose Life Sciences could only achieve a $60 million pre-money valuation. For $20 million, new investors would receive 25% of the company, leaving existing stockholders with 75%. Now, here is the key: While the pre-money valuation has dropped by 40%, the ownership of existing stockholders has decreased by only 8.3%.
We generally advise a client to take on as much financing as their business plan requires when it is available -- even though the market is down -- rather than running the risk of experiencing a genuine liquidity crisis. However, if dilution is a serious concern, the company should consider stopgap measures, such as a smaller round of financing at the lower valuation, which might permit it to achieve performance milestones while waiting for market conditions to improve.
The pre-money valuation is just the beginning of the story. But things get even more interesting when you consider recent trends in other VC financing terms. These terms hearken back to a more conservative era, before the technology boom, and can seriously undermine a company's operational flexibility, or put the shackles on subsequent rounds of financing, as new investors are likely to insist on deal terms that are at least as favorable to them. When the company performs poorly or needs to look at alternative strategies, such as an acquisition of the company, these terms can be draconian from the entrepreneur's perspective.
ENHANCED LIQUIDATION PREFERENCE
In a liquidation or sale of the business, when investors have a liquidation preference, they get their money first -- that is, before founders and other holders of junior securities. His becoming more common for investors to require a liquidation preference at a multiple of the original investment, often three times or more. Investors may also require the right to "double dip" by participating on an "converted" basis in any remaining proceeds after payment of such liquidation preference. Suppose Life Sciences had obtained a $50 million valuation for a $20 million round and is considering selling the company. A preference of this size could eliminate the entire equity interest of founders and employees, unless they were able to increase the value of the company substantially.
Many investors now seek to divide a single financing into multiple parts or traunches, with subsequent funding stages at the same valuation conditioned on the achievement of certa1n performance milestones. This permits investors to test management forecasts and shield a portion of the investment from company creditors pending achievement of milestones. Not only can defining appropriate milestones be difficult, there also is significant risk that investors may dispute their achievernent if they have soured on the company's valuation, leaving the company with the impractical alternative of costly litigation to enforce its rights.
In the event of diluted issuances, such as a subsequent, "down round" financing at a lower valuation, investors would receive a downward adjustment to their conversion or exercise price. The size of the adjustment often is determined pursuant to a weighted average formula, which is based on the number of actual or fully diluted shares outstanding. Increasingly, investors are insisting on ''full ratchet" anti-dilution provisions, in which the conversion price is simply reduced to the diluted issuance price, without averaging. For founders and other equity holders with no or less favorable price protection, full ratchet provisions can dilute their interests substantially and can serve as a strong disincentive for investors in a subsequent, "down round" financing.
WORDS OF CAUTION
Preparation is crucial to the negotiation process. Company execs and entrepreneurs should have a working knowledge of common structural variations in VC financing, the import of common business terms and potential financing and strategic alternatives, the likes of which include strategic alliances, acquisitions, negotiated re-capitalization or the tactical use of bankruptcy proceedings. Early consultation with an attorney or other advisor with venture capital experience can be invaluable in preparing a successful bargaining position, avoiding pitfalls in complicated transactions and dealing with issues that could cause costly delays or a failure to close.
John W. Dorris is a co-managing partner with the law firm of Dorris & Giordano PLC. His practice encompasses a broad array of transactional matters, including securities, merger & acquisitions and real estate transactions. He may be contacted at firstname.lastname@example.org.