If you’ve been stranded on a desert island lately, you know that raising money as a founder is much harder this year.
Amid falling public stock prices, VCs are more cautious about deploying cash. Some startups are having a harder time cashing in on macroeconomic headwinds. And no one knows how long this turmoil will last. Tin hats, everyone.
So it makes sense that the terms of VC deals are also changing. During the tech boom, conditions shifted to give founders more control and incentive. Now the situation is a little more difficult.
“It’s more about what I would say is natural,” says Mike Labriola, a partner at the law firm Wilson Soncini. But, he adds, “I’d say I’ve seen more what I call ‘predatory term sheets’ in the last six months than I’ve seen in the last decade.”
So how are the term papers – Documents that Determine the terms of the investment between startups and their supporters – Change? And what should founders look for?
Values are falling and everyone wants to avoid the fall
Perhaps the most important thing in a term sheet is the company’s valuation. The 10 investors and lawyers Sifted spoke to for this piece said those valuations were lower overall than last year.
But what companies want to avoid is raising valuations at a lower price than the previous round — a drawdown. When this happens, not only is the stock of existing founders and investors worth less, but their ownership is also reduced. It can also be a blow to founder and employee morale and a company’s market understanding.
As a result, founders and investors get creative. Some are announcing “development”: raising more money on the same terms as last time. Others raise through convertible notes: raising debt that converts to equity that is determined later. Sifted has enjoyed the fancy names — Series A+, Series B2, Pre-Series A — that PR has coined for these sneaky rounds.
Other investors tell Sifted that they’re starting to see multiple rounds in tranches, where the investor hands over chunks of the total money when the startup hits certain performance goals.
Negotiating other clauses in the term sheet can also be a way for investors to feel they have enough support for their investment and still avoid a downturn. This can involve negotiating the priority of liquidation – more on that below.
Later-stage companies are more likely to have to trade off terms or provide more support to investors when the company isn’t doing well, says Mike Turner, a partner at the law firm Latham & Watkins.
Early-stage companies—further removed from public market turbulence—simply find it harder to close deals, “but that doesn’t necessarily translate into changing deal terms apart from valuation.”
One thing that’s changed in the early stages, says colleague Shing Lo (also a partner), is that secondaries — the founders’ ability to take some money off the table — aren’t happening in Series A like they were last year.
During the boom of 2021, many successful founders took large amounts of cash off the table in early rounds. Johnny Bofferhut, founder of virtual events startup Hopin It earned over £100 million By selling part of your shares in the company.
Liquidation preference clauses are one area where term sheets are seeing big change, market participants told Sifted. These clauses specify the returns that investors will receive if the company is sold, merged or collapsed.
Wilson Soncini’s Labriola says he’s starting to see changes in whether liquidation preferences are equal — in which all shareholders have equal priority when it comes to receiving exit proceeds — or senior, in which investors are paid in order of most recent to oldest. (“First in, last out”). The latter is bad news for angels and early VCs.
Labriola says that in recent years there have been more term papers in the UK at par, but he is now seeing senior liquidation priorities taking over.
Term sheets also show a preferred liquidation multiple that determines how much an investor will get back as a multiple of their initial investment amount. This is usually 1x, meaning that investors get their capital back in full before others if something like a sale happens.
Higher ratios can be especially painful for founders and employees who may be left with nothing or next to nothing in a sale or liquidation. Fortunately, attorneys tell Sifted that they don’t see much change in the 1x standard, other than when a business isn’t doing well. A higher multiple could also be what investors can ask for in exchange for not touching the valuation, thus avoiding the dreaded downside.
Usually these clauses are non-contributory, meaning that the investors get money equal to what they invested multiplied by X (if the company does well). But if any, they do not receive part of the additional income.
Some lawyers say they’re now seeing tighter partnership terms, meaning investors get their money back, plus a cut of other earnings, in the event of a liquidation.
Claire Webster, head of legal at OMERS Ventures, says she’s seen things change around liquidation preferences.
“I’m not sure if it’s a sign of people abusing the market or a function of inflation and rising interest rates, which means that a one-fold reduction isn’t very good anymore,” he says.
What types of investors are there?
Northzone partner Michiel Kotting says that most of the predatory terms in the market are not the work of established VC firms, but other investors who may not be traditional startup backers. These investors are looking to structure trades not to protect themselves, but to generate returns.
Often, these investors lock the founders into a monopoly when negotiating the deal sheet, so they can’t talk to other investors.
“They’re using that monopoly and the fact that the company is running out of money to basically extort value out of them,” Cotting says. I try to warn my portfolio companies – understand who you’re dealing with and understand how serious they are.
Latham & Watkins’ Turner notes that there are more private equity investors who are investing at later scales and want terms that VCs typically don’t offer.
These could include receiving a return on investments – which has risen astonishingly from 6-8% last year to a maximum of 12% now – or redemption rights. The latter gives investors the right to sell their shares in a company if it is not performing well.
“[PE] Investors think very differently about financial returns. They usually don’t support founders, they support businesses. “They don’t support the technology, they support the economy,” Turner says.
Wilson Sonsini’s Labriola says there’s one thing in founders’ favor: VC is an industry built on reputation. And if VCs treat companies with strict terms, everything will be heard.
So what can founders do to stay out of trouble?
Northzone’s Kotting says founders should talk to people they trust to get a second opinion on a deal — something he does with many non-Northzone portfolio companies.
He also says that if a lot of control is given to the new investor, the price reduction can be preferred over the extension or convertible notes. It’s preferable to work with existing investors, he says, and “create incentives for everyone to share in the pain.”
OMERS Ventures’ Webster says founders need to “understand what they want and what they’re getting.” You can’t just look at the valuation and assume it’s a standard deal. “You have to understand what’s going to happen in the best case scenario and in the worst case scenario.”
But amid all the doom and gloom, he sees one thing in the changing term sheets that the industry can be happy about: diversity and inclusion regulations. These can require companies to implement D&I policies or report D&I metrics.
“It’s a nice positive in the middle of dark times,” he says.
Eleanor Warnock is Sifted’s deputy editor and co-host The Sifted Podcastand writes high round, a weekly newsletter on VC. He tweets from @misssaxbys