Top 5 Venture Capital Equity Terms Start-Ups May Face During COVID-19 & Economic Crisis
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The last recession led to several fundamental changes in angel and venture capital financing terms, some of which persisted through the last economic expansion. Below are the top 5 terms that startups may face in the wake of what increasingly appears to be economic turbulence, at the least, and a recession or depression, at worst.
- “Down Rounds”—Most start-ups have what are called “broad-based weighted average” anti-dilution provisions in their corporate charters. These provisions give investors an adjustment to the number of shares that they would get if they convert their preferred stock to common stock at exit. They kick in if a company raises money at a lower valuation (or price per share) than in the last round. From 2008-2010, Silicon Valley companies endured several recapitalizations and down rounds. These can be complicated and often accompany several other terms, some of which are set forth below. Following the economies recovery in 2010, there were only a limited number of down rounds in Louisiana. If the economy continues to fall and does not recover quickly, there will likely be an increase in down rounds in the future.
- “Recaps” or “Recapitalizations”—A “recap” or “recapitalization” occurs when a new investor (or group of investors) is willing to continue funding a company through turbulent times but requires some adjustment to the capital structure of the company. For example, I have seen rounds where all other rounds of preferred stock were required to agree to convert their shares into common stock, thereby giving the investor who continued to fund the company during the recession the only preferred stock and a liquidation preference over all other investors. Generally, the investor continuing to fund the company would require a conversion by the preferred shareholders and an amendment to the corporate charter to create a new class of preferred. This can be negotiated. In some cases, the company might create shadow series of preferred instead.
- “Pay to Play” provisions—Pay-to-play provisions give key investor rights only to those investors who exercise their pro-rata rights to participate in a current or future round. For example, only investors who purchase their pro-rata share in each new round might be given anti-dilution rights, preemptive rights (the right to purchase pro-rata share in future rounds), or certain other rights if they participate. The mechanics and extent of this can vary. For an investor, caution must be given if these are part of the round because it makes the decision about follow-on rounds potentially more complicated. For startups with angel, seed or VCs that they view as valuable, it can also affect the balance of power among investors in later rounds.
- PIK/Dividends—Many down rounds result in dividends being payable “in kind” (referred to as a “PIK Dividend”). This means that the investors receive additional shares at the dividend rate. During the last recession, there were a number of rounds across the country in which companies and investors switched from non-cumulative dividends (PIK or regular) to cumulative (sometimes compounding) dividends.
- Valuation Caps and Convertible Notes/SAFEs—Prior to the last recession, very few deals had valuation caps. Valuation caps became much more common during the last recession as a downside protection to investors when a rebound might occur in the economy and valuations. In some circles, they have become “market” or “standard.” Companies that must raise a bridge round between equity rounds to weather the storm may be asked to give up on valuation caps in the next several months that are very low and much lower than what has been market in the months leading up to this crisis.
In addition to the legal impact that various terms in recessions have on companies, founders, and other investors, the modeling of those impacts on the cap table can be time-consuming and difficult. Fortunately, we have several tools and models to make this easier on management and can help provide guidance to those companies unfortunate enough to deal with any of these issues.
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Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal