We live in ever-changing times with the presence of COVID-19 affecting every aspect of our business and personal lives. The world of venture capital is not exempt. The outbreak has effectively curtailed, in record time, what had been a steadily growing market opportunity for venture-backed companies and investors. Over just a few weeks, venture-backed companies have shifted from seeking new paths to growth, to seeking new paths to merely survive.
Likewise, companies must decide whether to raise money now or delay fundraising plans. Companies must make these decisions, and investors must make their investment decision, without significant time for deliberation and must consider the company’s current funding needs, any actual or potential market liquidity constraints, extended sales and payment cycles, and the economic outlook postpandemic. To assist companies and investors evaluating funding decisions in the era of COVID-19, this article addresses how investors might seek to protect their investments, as well as what terms new investors in a company may expect (or even demand) as a condition to investing, if private financing markets do not return to their activity and/or valuation levels prior to the pandemic.1 We use the term “venture” in this article to encompass both earlier-stage venture investments and later-stage investments, which are sometimes referred to as “growth” investments. Some of the potential changes to investment terms discussed in this article are more applicable to later-stage growth investments than those in early-stage companies.
Likewise, companies must decide whether to raise money now or delay fundraising plans. Companies must make these decisions, and investors must make their investment decision, without significant time for deliberation and must consider the company’s current funding needs, any actual or potential market liquidity constraints, extended sales and payment cycles, and the economic outlook postpandemic. To assist companies and investors evaluating funding decisions in the era of COVID-19, this article addresses how investors might seek to protect their investments, as well as what terms new investors in a company may expect (or even demand) as a condition to investing, if private financing markets do not return to their activity and/or valuation levels prior to the pandemic.1 We use the term “venture” in this article to encompass both earlier-stage venture investments and later-stage investments, which are sometimes referred to as “growth” investments. Some of the potential changes to investment terms discussed in this article are more applicable to later-stage growth investments than those in early-stage companies.
Enhanced Liquidation Preference Terms
In a financing environment that may favor investors, venture investors are likely to re-examine the liquidation preference granted to holders of preferred stock. We would expect the negotiation of enhanced liquidation preference rights in favor of preferred stockholders looking to “de-risk” their investment. These enhanced rights could take several forms, including (1) increasing the multiple of, or priority of, invested capital, (2) “participating preferred” terms and (3) special rights of the preferred shares in connection with an initial public offering (IPO).
Increase in the Multiple or Priority of Invested Capital
The liquidation preference of secured stockholders is generally set to an amount based on the multiple of invested capital (e.g., 1x). We would expect either to see investors request an increase in the average multiple of invested capital in liquidation preference rights for their investment or that their multiple of invested capital receive priority over pre-existing preferred stockholders. Of course, companies will be wary of high liquidation preferences as it may limit the ability of founders, employees and existing shareholders to receive proceeds in a liquidation event. Existing preferred stockholders will likewise be wary of relinquishing any liquidation preference they currently enjoy.
Participation Rights
Investors could make more requests for “participating preferred” rights, which allow an investor to receive its multiple of invested capital pursuant to the liquidation preference and the pro rata share of the distributions made to common stockholders as if the preferred stock had converted into common stock. Over the course of the past decade, participating preferred terms became less prevalent, but in a new financing environment after COVID-19, we expect to see some investors insist on participating preferred terms as a condition to their investment. Companies and existing stockholders will again seek to resist granting participating preferred stock rights, especially when coupled with multiples of invested capital greater than 1x or liquidation preferences over all existing preferred and common shares, as these terms could reduce the returns of these existing holders at exit.
Valuation Protections in Connection With IPOs
Generally, the event that triggers a preferred stock liquidation preference right is related to a sale or change in control of the company (often referred to as a “deemed liquidation event”). IPOs are not typically considered to be “deemed liquidation events.” Therefore, when a company completes an IPO, preferred stockholders are not entitled to their liquidation preference but instead are expected to convert into common shares in connection with the IPO, including pursuant to “automatic conversion” provisions in the company’s charter documents.
In light of current risks, we expect some investors will negotiate for additional protections upon an IPO. For example, to the extent that an IPO constitutes a “down round” to the prior private financing round, the new preferred shares issued in the prior private financing round would receive additional shares of common stock under a weighted average antidilution formula in favor of the new preferred shares. These “IPO down round” provisions had already become more popular investor protections in connection with later-stage financings. As another example, the new preferred shares may require that the IPO achieve a certain price per share, aggregate proceeds raised by the company and/or minimum valuation of the company for the new preferred shares to be automatically converted into common stock in connection with the IPO. Another “valuation protection” mechanism could include the shares of preferred stock converting into a number of common shares in connection with the IPO equal to the number that those preferred shares would have received in connection with a deemed liquidation event (i.e., a sale of the company).
Expanded Preferred Stock Voting Protections
Special class or series voting rights are common across all stages of venture financing. These rights grant one or more series of preferred stock, including all series of preferred stock on a combined voting basis, a special right of approval over certain company actions. Such actions generally include, among other actions, charter and bylaw amendments, creation of senior or pari passu preferred shares, common stock repurchases, change of control transactions and other terms that would materially impact the capital structure of the company.
In a market that is more favorable for investors, we expect investors in new series of preferred stock to seek greater control over venture-backed companies by demanding additional consent rights for that new series, to the detriment of existing series of preferred stock. We also expect the list of activities subject to such consent rights to expand in certain instances, such as approving company budgets and material divergences from those budgets, material financial expenditures, entering into joint ventures or other strategic collaborations, and incurring indebtedness.2
Increased Prevalence of Redemption Rights and Shorter Redemption Periods
In recent years, venture financings have not typically included a mandatory redemption of preferred stock. A redemption right allows investors to require the company to redeem their shares and can often be used as a tool for an investor to force a liquidity event. We expect redemption rights to become a more popular option for investors, particularly among later-stage growth investors, as they help investors limit their losses in underperforming investments.
To the extent a company is unsuccessful in resisting redemption rights, it will generally seek to have a longer time period between the date of the initial investment and the redemption date as well as a payment of the redemption price over time (e.g., over two or three years). Conversely, the investor’s redemption date may depend on the maturity of the fund as well as the investor’s expectations on the feasibility of a liquidity event within a stated timeframe. While the redemption period can span three to five years, and some even longer, we expect to see investors generally negotiating shorter redemption periods, particularly among later-stage companies.
As an alternative or supplement to redemption rights, investors may seek a less forceful version of a forced redemption and request that the board and management of the portfolio company initiate a sale process for the company by, for example, hiring an investment bank to engage in a “market check” for potential buyers. Companies may view these provisions as a less severe alternative to a forced redemption because it would not require a company to have cash available to consummate the redemption. Of course, a sale process in itself would require significant time and resources of a company and its management, and (if a sale is successfully completed) would preclude an IPO.
Resurgence of Pay-to-Play Provisions
A lead investor in a venture round may want to provide strong incentives for co-investors to further invest in a company. One way investors incentivize other company investors to participate in future rounds is through a so-called pay-to-play provision, which causes investors to lose preferred stock rights if they do not participate in later financing rounds. We expect to see an increase in pay-to-play provisions as part of the discussions among investors, particularly in later-stage companies but also potentially in earlier-stage companies.
Increase in Financings Coupled With Secondary Transactions
Depending on the attractiveness of the valuation to new investors, we may see an increase in venture financings utilizing a dual transaction approach, in which the investors purchase a primary equity issuance from the company in conjunction with or contingent upon a secondary purchase (i.e., a purchase from existing stockholders). This transaction structure can be beneficial to both companies and investors because it allows the investor to purchase a larger percentage of the company while enabling the company to limit the dilution of existing investors. Similarly, it permits existing investors to exit their investment, which will become increasingly important in situations where later-stage companies have put off a sale or IPO because of depressed market conditions.
Expansion in Staggered Financings
We expect to see more “staggered financings” or “financings in tranches” as a way for investors to de-risk transaction and bridge the gap between valuation disagreements. In staggered financings, companies and investors negotiate a set of funding milestones, which can be based on the development of a certain technology, satisfaction of a certain business plan or other financial projections provided during due diligence. A staggered financing would provide for the same valuation for each tranche of the investment, irrespective of a company’s changed circumstances from the milestone achievement. As a result, the investor is able to better control the valuation at which it invests because the company will have achieved the milestones that were the basis for the investor’s agreement to the valuation in the first instance.
“Washout” and “Cram Down” Financings
To survive, some companies and their investors will be forced to accept financing at premoney valuations that render preexisting equity at mere cents on the dollar of their prior value. For companies that rely heavily on talent, these transactions can create employee morale issues, and investors will have to negotiate prefinancing to combat this risk. Companies and investors may seek to combat the employee morale issues by (1) converting outstanding preferred stockholder to common stock (and thereby removing their liquidation preference and other preferred stock rights), (2) agreeing to “top-up” option grants to all or certain employees or (3) convincing existing shareholders to waive antidilution adjustments arising from the down round.
For companies that may be considering a sale in the near future, boards may wish to consider creating management incentive plans, or MIPs, which typically involve the payment of some portion of the proceeds of a sale of the company first to a defined group of employees in the company. MIPs typically only apply in the context of a sale of the company, and so it is important to consider the potential implications for the company and its stockholders for adoption of a MIP where the company may be seeking alternative paths to liquidity other than a sale (e.g., an IPO).
The Importance of Rigorous Company Process
For much of this article, we have focused on the negotiation of particular provisions that may be in the interests of investors, either existing or new, into a company that may be facing valuation challenges (whether due to COVID-19 or otherwise). Naturally, introduction of these particular provisions creates potential difficulties for companies and investors. Existing shareholders, particularly employees and other holders of common stock, will be concerned about the impact that the terms of new preferred investment may have on their holdings.
In recognition of the fiduciary duties of the company’s board of directors to all stockholders, including especially the common stockholders, the board will need to demonstrate its commitment to a strong process that has sought the best possible terms of the investment for the company while also recognizing the company’s need for additional financing. Fulfillment of fiduciary duties can be more challenging when investors participating in the down round also hold board seats in the company. In these situations, to meet their duty of loyalty, boards should rely on independent directors (possibly including a special committee composed solely of independent directors) to negotiate the financing terms on behalf of the company. The introduction of a new investor who is not an existing shareholder, and who serves as the lead negotiator for the new investor syndicate, can be another helpful way for directors to demonstrate a true arms-length good faith negotiation by all parties.
Conclusion
Venture financings are not immune from the economic impacts of COVID-19. Investors and companies must be prepared to address and negotiate new or reemerging terms as investors seek to de-risk their investments and companies seek financing alternatives in response to rapidly changing market conditions. Company boards will need to take affirmative steps in their process around these financings to ensure fulfillment of their fiduciary duties, balancing the competing interests of different stockholder and employee constituencies, in order to help the company navigate these extraordinary times.
1 This article does not attempt to forecast what will happen in the coming weeks and months, either with respect to the impact of COVID-19 generally or with respect to venture-backed companies and the behavior of their investors. It also does not purport to address the valuation issues that almost certainly will become relevant for most, if not all, venture-backed companies.
2 Note that to the extent venture investors are seeking consent rights over certain company actions, they do risk having indicia of “control” for purposes of the affiliation rules of the Small Business Administration (SBA), which may impact the ability of a portfolio company to receive SBA financing under the Paycheck Protection Program (not to mention the potential lack of available funding under PPP given strong borrower demand). Those risks are important considerations for an investor and a company but are beyond the scope of this article.
In a financing environment that may favor investors, venture investors are likely to re-examine the liquidation preference granted to holders of preferred stock. We would expect the negotiation of enhanced liquidation preference rights in favor of preferred stockholders looking to “de-risk” their investment. These enhanced rights could take several forms, including (1) increasing the multiple of, or priority of, invested capital, (2) “participating preferred” terms and (3) special rights of the preferred shares in connection with an initial public offering (IPO).
Increase in the Multiple or Priority of Invested Capital
The liquidation preference of secured stockholders is generally set to an amount based on the multiple of invested capital (e.g., 1x). We would expect either to see investors request an increase in the average multiple of invested capital in liquidation preference rights for their investment or that their multiple of invested capital receive priority over pre-existing preferred stockholders. Of course, companies will be wary of high liquidation preferences as it may limit the ability of founders, employees and existing shareholders to receive proceeds in a liquidation event. Existing preferred stockholders will likewise be wary of relinquishing any liquidation preference they currently enjoy.
Participation Rights
Investors could make more requests for “participating preferred” rights, which allow an investor to receive its multiple of invested capital pursuant to the liquidation preference and the pro rata share of the distributions made to common stockholders as if the preferred stock had converted into common stock. Over the course of the past decade, participating preferred terms became less prevalent, but in a new financing environment after COVID-19, we expect to see some investors insist on participating preferred terms as a condition to their investment. Companies and existing stockholders will again seek to resist granting participating preferred stock rights, especially when coupled with multiples of invested capital greater than 1x or liquidation preferences over all existing preferred and common shares, as these terms could reduce the returns of these existing holders at exit.
Valuation Protections in Connection With IPOs
Generally, the event that triggers a preferred stock liquidation preference right is related to a sale or change in control of the company (often referred to as a “deemed liquidation event”). IPOs are not typically considered to be “deemed liquidation events.” Therefore, when a company completes an IPO, preferred stockholders are not entitled to their liquidation preference but instead are expected to convert into common shares in connection with the IPO, including pursuant to “automatic conversion” provisions in the company’s charter documents.
In light of current risks, we expect some investors will negotiate for additional protections upon an IPO. For example, to the extent that an IPO constitutes a “down round” to the prior private financing round, the new preferred shares issued in the prior private financing round would receive additional shares of common stock under a weighted average antidilution formula in favor of the new preferred shares. These “IPO down round” provisions had already become more popular investor protections in connection with later-stage financings. As another example, the new preferred shares may require that the IPO achieve a certain price per share, aggregate proceeds raised by the company and/or minimum valuation of the company for the new preferred shares to be automatically converted into common stock in connection with the IPO. Another “valuation protection” mechanism could include the shares of preferred stock converting into a number of common shares in connection with the IPO equal to the number that those preferred shares would have received in connection with a deemed liquidation event (i.e., a sale of the company).
Expanded Preferred Stock Voting Protections
Special class or series voting rights are common across all stages of venture financing. These rights grant one or more series of preferred stock, including all series of preferred stock on a combined voting basis, a special right of approval over certain company actions. Such actions generally include, among other actions, charter and bylaw amendments, creation of senior or pari passu preferred shares, common stock repurchases, change of control transactions and other terms that would materially impact the capital structure of the company.
In a market that is more favorable for investors, we expect investors in new series of preferred stock to seek greater control over venture-backed companies by demanding additional consent rights for that new series, to the detriment of existing series of preferred stock. We also expect the list of activities subject to such consent rights to expand in certain instances, such as approving company budgets and material divergences from those budgets, material financial expenditures, entering into joint ventures or other strategic collaborations, and incurring indebtedness.2
Increased Prevalence of Redemption Rights and Shorter Redemption Periods
In recent years, venture financings have not typically included a mandatory redemption of preferred stock. A redemption right allows investors to require the company to redeem their shares and can often be used as a tool for an investor to force a liquidity event. We expect redemption rights to become a more popular option for investors, particularly among later-stage growth investors, as they help investors limit their losses in underperforming investments.
To the extent a company is unsuccessful in resisting redemption rights, it will generally seek to have a longer time period between the date of the initial investment and the redemption date as well as a payment of the redemption price over time (e.g., over two or three years). Conversely, the investor’s redemption date may depend on the maturity of the fund as well as the investor’s expectations on the feasibility of a liquidity event within a stated timeframe. While the redemption period can span three to five years, and some even longer, we expect to see investors generally negotiating shorter redemption periods, particularly among later-stage companies.
As an alternative or supplement to redemption rights, investors may seek a less forceful version of a forced redemption and request that the board and management of the portfolio company initiate a sale process for the company by, for example, hiring an investment bank to engage in a “market check” for potential buyers. Companies may view these provisions as a less severe alternative to a forced redemption because it would not require a company to have cash available to consummate the redemption. Of course, a sale process in itself would require significant time and resources of a company and its management, and (if a sale is successfully completed) would preclude an IPO.
Resurgence of Pay-to-Play Provisions
A lead investor in a venture round may want to provide strong incentives for co-investors to further invest in a company. One way investors incentivize other company investors to participate in future rounds is through a so-called pay-to-play provision, which causes investors to lose preferred stock rights if they do not participate in later financing rounds. We expect to see an increase in pay-to-play provisions as part of the discussions among investors, particularly in later-stage companies but also potentially in earlier-stage companies.
Increase in Financings Coupled With Secondary Transactions
Depending on the attractiveness of the valuation to new investors, we may see an increase in venture financings utilizing a dual transaction approach, in which the investors purchase a primary equity issuance from the company in conjunction with or contingent upon a secondary purchase (i.e., a purchase from existing stockholders). This transaction structure can be beneficial to both companies and investors because it allows the investor to purchase a larger percentage of the company while enabling the company to limit the dilution of existing investors. Similarly, it permits existing investors to exit their investment, which will become increasingly important in situations where later-stage companies have put off a sale or IPO because of depressed market conditions.
Expansion in Staggered Financings
We expect to see more “staggered financings” or “financings in tranches” as a way for investors to de-risk transaction and bridge the gap between valuation disagreements. In staggered financings, companies and investors negotiate a set of funding milestones, which can be based on the development of a certain technology, satisfaction of a certain business plan or other financial projections provided during due diligence. A staggered financing would provide for the same valuation for each tranche of the investment, irrespective of a company’s changed circumstances from the milestone achievement. As a result, the investor is able to better control the valuation at which it invests because the company will have achieved the milestones that were the basis for the investor’s agreement to the valuation in the first instance.
“Washout” and “Cram Down” Financings
To survive, some companies and their investors will be forced to accept financing at premoney valuations that render preexisting equity at mere cents on the dollar of their prior value. For companies that rely heavily on talent, these transactions can create employee morale issues, and investors will have to negotiate prefinancing to combat this risk. Companies and investors may seek to combat the employee morale issues by (1) converting outstanding preferred stockholder to common stock (and thereby removing their liquidation preference and other preferred stock rights), (2) agreeing to “top-up” option grants to all or certain employees or (3) convincing existing shareholders to waive antidilution adjustments arising from the down round.
For companies that may be considering a sale in the near future, boards may wish to consider creating management incentive plans, or MIPs, which typically involve the payment of some portion of the proceeds of a sale of the company first to a defined group of employees in the company. MIPs typically only apply in the context of a sale of the company, and so it is important to consider the potential implications for the company and its stockholders for adoption of a MIP where the company may be seeking alternative paths to liquidity other than a sale (e.g., an IPO).
The Importance of Rigorous Company Process
For much of this article, we have focused on the negotiation of particular provisions that may be in the interests of investors, either existing or new, into a company that may be facing valuation challenges (whether due to COVID-19 or otherwise). Naturally, introduction of these particular provisions creates potential difficulties for companies and investors. Existing shareholders, particularly employees and other holders of common stock, will be concerned about the impact that the terms of new preferred investment may have on their holdings.
In recognition of the fiduciary duties of the company’s board of directors to all stockholders, including especially the common stockholders, the board will need to demonstrate its commitment to a strong process that has sought the best possible terms of the investment for the company while also recognizing the company’s need for additional financing. Fulfillment of fiduciary duties can be more challenging when investors participating in the down round also hold board seats in the company. In these situations, to meet their duty of loyalty, boards should rely on independent directors (possibly including a special committee composed solely of independent directors) to negotiate the financing terms on behalf of the company. The introduction of a new investor who is not an existing shareholder, and who serves as the lead negotiator for the new investor syndicate, can be another helpful way for directors to demonstrate a true arms-length good faith negotiation by all parties.
Conclusion
Venture financings are not immune from the economic impacts of COVID-19. Investors and companies must be prepared to address and negotiate new or reemerging terms as investors seek to de-risk their investments and companies seek financing alternatives in response to rapidly changing market conditions. Company boards will need to take affirmative steps in their process around these financings to ensure fulfillment of their fiduciary duties, balancing the competing interests of different stockholder and employee constituencies, in order to help the company navigate these extraordinary times.
1 This article does not attempt to forecast what will happen in the coming weeks and months, either with respect to the impact of COVID-19 generally or with respect to venture-backed companies and the behavior of their investors. It also does not purport to address the valuation issues that almost certainly will become relevant for most, if not all, venture-backed companies.
2 Note that to the extent venture investors are seeking consent rights over certain company actions, they do risk having indicia of “control” for purposes of the affiliation rules of the Small Business Administration (SBA), which may impact the ability of a portfolio company to receive SBA financing under the Paycheck Protection Program (not to mention the potential lack of available funding under PPP given strong borrower demand). Those risks are important considerations for an investor and a company but are beyond the scope of this article.
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