Key Points

• Prior recessions saw increased instances of investor-favorable terms.
• Founders need to weigh the benefit of receiving financing now vs. the potential chilling effect on future rounds of equity investment.

Founders strategizing how to raise capital in the midst of the ongoing COVID-19 pandemic, can look to the last Great Recession to understand investor-favorable deal terms that may be prime to make a comeback. While valuation is a critical part of negotiating a term sheet with a VC, founders should also be on the lookout for these terms:

Liquidation Preference Multiples: A typical term sheet provides that investors receive their money back first, ahead of founders and other common stock holders, in the event of an exit event (like a merger or sale of the company). Each priced equity round will increase the amount that needs to be paid back to investors first. Some investors may request a multiple (example, 2x) of their investment back before common stock receives any liquidation proceeds. Liquidation preference multiples greatly increase the "stack" that needs to be repaid to investors, and as a result, need a larger exit down the road for all stakeholders to realize meaningful upside.

Participation Rights: In most cases, once investors receive their liquidation preference, remaining proceeds from a liquidation event are then shared pro rata among holders of common stock. However, some investors may seek "participation rights" that allow them to receive their liquidation preference, and then also participate in the pro rata distribution of remaining proceeds and as a result, reducing the amount of proceeds that common stockholders will receive.

Full-Ratchet Anti-Dilution Rights: Investors will almost always receive some form of "anti-dilution" rights that protect their investment if the company issues additional shares at a lower price later on. However, there are different methods of determining how much of an impact a down round has on existing investors. For a number of years, "broad-based weighted average" formulas have prevailed, which take into account the size and amount of a down round in proportion to the rest of the company's existing capitalization. Investors concerned about future down rounds may seek "full ratchet" provisions that adjust their conversion price to be equal to the price used in the down round. The impact of full ratchet provisions is often that common stockholders experience the lion's share of the dilution from a down round.

Redemption Rights: Redemption rights have rarely made an appearance in term sheets for many years, but allow investors to require that a company repurchase their shares if an exit event or initial public offering has not occurred within a certain time period, typically around 5-6 years. This right gives investors some certainty that they have an avenue to recoup their investment if the company has not exited or reached IPO at the end of this timeframe. However, companies rarely will want (or even be able to) to devote available cash and other assets to investor redemptions.

Regional Differences: The summaries of the deal terms above reflect common practice in west coast venture capital financings, and founders negotiating term sheets with VCs based on the east coast may find that those investors have different expectations of what is market. Founders should understand that where potential investors are located may impact the substantive terms they are able to negotiate.

Additional Considerations for Early-Stage Companies: While each of the deal terms described above can place a heavy economic burden on any start-up, the impact on early-stage companies raising their first rounds is even more significant. The terms that you accept in your first priced equity round set precedents for your future fundraising, and the terms mentioned above may prove to be unsustainable. Even worse, potential investors in the future may pass on investing in the company altogether if existing terms from prior rounds are seen as too burdensome or off market.

Takeaways:

• While Founders may feel pressure to close financing rounds quickly in the current environment, they still need to be wary of accepting term sheets that include overly investor-favorable terms that could have significant negative impacts on the company's long-term outlook.
• These "red-flag" terms could set unsustainable precedents for future fundraising efforts, and even discourage potential investors from participating in future financing rounds.
• Founders should consult corporate counsel before entering into any term sheet.

Interested in learning more? Hear Natalie speak on this topic at our upcoming webinar on “Shifting Valuation: Down-rounds and Underwater Options” on Tuesday, June 23rd at 11:30 a.m. Click here to view the invitation and RSVP