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When the Tables are Turned ...
Monday, November 17, 2008

Raising venture capital in the current markets is not what it used to be. A little more than a year ago, many entrepreneurs looking for capital had little difficulty obtaining term sheets favorable to their companies. This year venture capitalists are taking much longer with their investment decisions. Yet, companies with solid technologies and strong management teams, particularly those with a track record of entrepreneurial achievement, are getting funded despite the downturn in technology investing. If one reputable venture capitalist has committed to lead a financing round, others are falling into line to complete a syndicate as well.

Also, with the pace of deals slower than a year ago, entrepreneurs and their legal and financial advisors have a much better opportunity to think through the terms and structure of financing deals. When deal activity moved more rapidly, there was a tendency to accept a cookie-cutter approach to financing terms, which may not have been appropriate for every situation. In a market where investors are not enjoying the type of returns they are used to at astronomical valuations, some of these terms will be re-examined. Questions such as how the investors’ payment on a sale of the company is calculated, the necessary approvals for replacing management, and the mechanism by which anti-dilution protection is calculated, all become very relevant for struggling companies in an uncertain market.

Entrepreneurs seeking venture capital in today’s market environment are well served to stay focused on the fundamentals: investment term sheets need to be analyzed based upon the long-term needs of a business. As a result of the uncertain market environment, some have lost sight of the fundaments and in a rush to secure a term sheet have agreed to investment terms that may prove disappointing to founders and the management team in the future. While many terms need to be thought through very carefully before agreeing to a deal, a few have become prominent points of negotiation over the last year and on which one should particularly focus in negotiating a deal:

Perhaps the most drastic example of the difference in term sheets from a year ago is in valuations. Pre-money valuations are substantially lower than they were a year ago. Some entrepreneurs, fearing that they are giving away too large a percentage of their company for the money, have focused on valuation while conceding a number of other important deal terms. However, this approach to valuations may be ill advised. It is important to remember that large changes in valuation may be less important than they appear.

Consider the following example. Assume a company has a pre-money valuation of $6 million, with a $1 million outside investment. The founders and employees will own shares worth $6 million of the post-money valuation of $7 million, or 86 percent of the company after the deal. Now, assume that the pre-money valuation was $3 million, with the same $1 million outside investment. The founders and employees will now own shares with a value of $3 million of the $4 million post-money valuation, or 75 percent of the company after the deal. Thus, even though the valuation has been halved, the percent of the company owned by founders and employees has declined only 11 percent.

If dilution is an issue, a better strategy may be to ask how much money is necessary for the company to meet its milestones. If the company can afford to raise less money, consider taking less money until after milestones have been achieved when valuations should be higher.

Liquidation Preferences
The liquidation preference is the term that specifies how the company will be divided among investors and other holders of stock on a sale or other liquidation of the business. In recent years, the negotiation has been over the extent of the “participation” feature, which allows investors to have guaranteed upside after they receive their original money back on their investment in preference to other holders of stock. Today, however, in some deals investors have been able to force companies that are desperate for funding to accept a term that requires payment to the outside investor of a certain multiple of their original investment before any money is paid to the founders and employees. Sometimes called a “pig” (i.e., preferred liquidation preference), this means that unless the company is sold for an amount greater than the aggregate liquidation preference, the founders and employees will not receive a dime when the company is sold. This term may become increasingly important if demanded by an investor who is investing significantly more money in a later round.

Investors with these preferences sometimes find themselves at odds with management and other investors. For example, assume that a company has enough cash to cover preferred preferences and that its business has significantly slowed down. The investors with these preferences may favor liquidating the company immediately rather than trying to improve the business and therefore the returns of the other investors.

Full Ratchet Anti-Dilution Protection
Anti-dilution protection allows an investor to receive additional equity in the company if it dilutes his position by selling securities with a lesser value than the securities of the investor. The full ratchet is a tool by which the investors receive additional stock at a rate calculated by using the lowest price of the dilutive securities sold by the company. The full ratchet contrasts with a more limited anti-dilution protection called the “weighted average” approach. The full ratchet means that in a down financing round founders will give up additional equity to their venture investors and will significantly dilute their ownership position.

On the one hand, some might argue that it may not make sense for an entrepreneur to expend too much energy negotiating this term. For example, if it is unlikely that the business would continue if future funding were required at a lower valuation than in the current round, this term should not prove to be too burdensome.

On the other hand, draconian terms may have unintended consequences. One of the major problems with the full rachet is that it may be triggered accidentally. For example, a company may trigger the provision by issuing securities that are not permitted carve-outs from the ratchet, such as warrants or additional options. Even if accidentally triggered, significant dilution to founders would result. Accordingly, if a full ratchet survives the negotiation, a management team would have to be very careful to guard against an issuance of securities that could trigger this provision.

Cumulative Dividends
Preferred stock usually enjoys a preference on dividends so that dividends will be paid on that class of stock prior to payment of dividends on any other stock. In the era of competitive term sheets, these dividends were usually non-cumulative, and payable only when, as and if declared by the board of directors. This meant that a holder of preferred stock would not be entitled to dividends for periods in which no dividends were declared and paid. Many more term sheets now have cumulative dividend provisions, which allow holders of preferred stock to receive a guaranteed return, which may be payable either on a liquidation of the company, in common stock upon conversion of preferred stock, or on an initial public offering.

While surprising to many who have negotiated term sheets over the last 12 to 18 months, the cumulative dividend is a provision that was quite common in recent years. The key is to negotiate the terms that govern how and when a dividend is paid, and have a good idea about how the dividend would interact with the distribution of the proceeds on a sale of the company.

Protective Provisions
With competition to obtain a term sheet growing, many investors are adding provisions that require the founders and management to obtain the investors’ consent before undertaking certain actions. While term sheets have almost always had these so-called protective provisions, many term sheets are now requiring consent to an increasing number of items. These terms, while giving peace of mind to an investor, may burden the management team by requiring them to seek investors’ approval to enter into an equipment financing arrangement or a contract with a specified value.

It is important to keep in mind that in a down market, some investors who enjoy “veto power” over certain corporate activities may be more likely to use these provisions to their advantage. For example, in exchange for agreeing to a dilute stock issuance or an increase in the option pool, some investor might demand to negotiate to get something in return for giving their consent.

The few areas mentioned here constitute just the tip of the iceberg. Negotiating a term sheet in today’s market environment involves much more than valuation. In fact, in many cases, valuation may be much less important than some of the other terms. These terms may immediately impact the ability of founders and management to achieve favorable economic terms, and they are likely to haunt the company in future rounds, as subsequent investors often demand the rights enjoyed by early investors.

Messrs. Makarechian and Smith are partners in the Palo Alto office of Brobeck, Phleger & Harrison LLP.

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