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  1. 1. Practising Law Institute Corporate Law and Practice Course Handbook Series PLI Order No. B0-01DJ June, 2002 Venture Capital 2002: Getting Financing in a Changing Environment *281 TRENDS IN VENTURE CAPITAL FINANCING TERMS [FN1] Joseph W. Bartlett Copyright (c) 2002 Practising Law Institute Reprinted with permission. *283 Biographical Information Program Title: Venture Capital 2002: Getting Financing in a Changing Environment Name: Joseph W. Bartlett Position or Title: Partner Firm or Place of Business: Morrison & Foerster LLP Address: 1290 Avenue of the Americas, New York Phone: 212 468 8240 Fax: 212 468 7900 E-Mail: Primary Areas of Practice: Venture Capital/Project Finance Law School: Harvard *285 In the two years since the beginning of the market correction in Match 2000, traditional terms of venture capital financings have changed to reflect the dynamics of the evolving marketplace. This Memorandum summarizes the most significant of these terms that we are seeing in the marketplace. • Valuations. Potential revenue streams were once sufficient to support valuations of up to $100 million. Now, venture capital investors demand evidence of real revenue sources and/or impending profitability, and the absence of either of which, in both the early-stage and follow-on investment context, has resulted in (i) valuations being set at least 5 times lower and (ii) investment amounts being reduced to 60% to 75% less per investment. • Management Experience. No longer will an inexperienced, brilliant young person be able to instill confidence and convince venture capital investors to put their capital at risk. The existence of senior management that combines capital markets and relevant industry experience and a successful track record, has again become the paramount investor diligence item. The lack of available senior management talent in the marketplace has been one of the primary reasons the investment process has become so selective. *286 • Number of Investors. Before the correction, venture capital investors frequently went "solo" on a hunch, investing in companies that showed "promise" and drawing comfort from investments by the "herd," which, at the same time, was 'investing in different companies in the same market. Venture capital investors today want experienced investor groups; it will be rare in this market for a single investor to invest without other significant players providing validation or a
  2. 2. "knownlead" leading the process. • Liquidation Preferences. Liquidation preferences were once limited to the return of the original investment. Liquidation preferences now frequently run at three times the original investment (and sometimes significantly higher). Venture capital investors point to diminished exit strategies to justify this significant increase (i.e., the risk/reward profile has changed so dramatically that investors should receive a much larger reward in a liquidity event to compensate for the greater likelihood of dissolution or bankruptcy). This also enables follow-on investors who invested at a higher valuation in a previous round to increase their chances of receiving their capital back if a less than optimal exit occurs, or to achieve a more desirable ROI in today's marketplace. • Participating Preferred Without a Cap. While once difficult to obtain, investors today are succeeding in avoiding a cap on the participating preferred. Thus, in addition to the sizable liquidation preferences discussed above, investors are able to participate ("double dip") in any remaining proceeds on an "as-converted" basis *287 above the amounts designated as the liquidation preference. • "Full-Ratchet" Anti-Dilution. Although still somewhat contested by portfolio companies, full ratchet anti-dilution has become much more common. Variations on "full-ratchet" that are developing are limits on its duration; tying its duration to profitability or revenue targets; and tying its duration to the closing of a subsequent round at, for example, a 1.5x multiple, with its termination resulting in customary "weighted-average" (broad based and/or narrow) anti-dilution protection. • Greater than Pro-Rata Rights to Follow-On. Under this trend, venture capital investors are gaining a right to invest in subsequent rounds above their pro-rata ownership interests (typically 1 1/2-2 times their ownership 'interest). This right has become popular because it ensures that investors will be able to "load up" on successful portfolio companies in subsequent financings. • Convertible Debt Financing. Prior to the correction, convertible debt financing was mostly used as a stop-gap bridge financing measure that would convert into preferred stock on closing of the next preferred stock financing. Lately, bridge financing has been replaced by convertible debt financing in which the debt does not convert into equity until a liquidity event or unless investors otherwise determine. This transforms the venture capital investor into a creditor of the company, thereby giving the 'investor priority over any outstanding equity in a bankruptcy proceeding or liquidation. Note, however, that this approach *288 raises complicated valuation issues involving conversion of the debt in a liquidity event that may be years away. • Adding Warrants to Flat Valuation Rounds. Obtaining warrants 'in connection with an equity financing has become increasingly common, with warrant coverage running as high as 50%. Venture capital investors clearly appreciate this trend, but companies may also benefit because issuing warrants (rather than lowering the price of the stock) may prevent a triggering of the anti-dilution protection clauses, which typically have far mote onerous results to a company's capitalization than the issuance of warrants. • Management Retention Tools - Greater Frequency of Cram-Down Rounds/Preferred Stock Option Grants. Investors are relying on two innovative tools to overcome the common challenge of retaining management whose stock may be behind numerous rounds of expensive liquidation preferences, thereby leaving little incentive for management to remain with the company. The first tool is the cram-down round, where new investors requite that previous investors participate in the new round or face automatic conversion into common stock (See also "Pay to Play Provisions" below). Convincing previous 'investors to accept this approach is challenging but, if successful, a cram- down round greatly benefits management and new investors by reducing the amount of liquidation preferences outstanding and giving the remaining preferred stockholders greater control over the company. The second approach is the preferred stock option grant. By granting *289 preferred stock options to executives, management receives the same economic benefits available to the venture capital investors. • "Pay to Play" Provisions. In the past, these provisions were rate, and when seen, were limited either to preferred holders losing their pre-emptive rights 'in future financings or losing antidilution protection for the next financing and all future financings. Today, pay-to-play provisions are more common and frequently require the automatic conversion of "non-playing" preferred holder's shares into common stock, unless that investor participates in a later financing
  3. 3. at a lower price (and sometimes, even at a higher price). • Redemption at Investors' Option. These provisions were once not common. The longer path to liquidity has led certain venture capital investors to guarantee a liquidity event by requiring a portfolio company to repurchase a venture capital investor's stock (plus accrued dividends) after a given period time (ranging from three to seven years). Note, however, that mandatory redemption provisions may raise financing issues for a portfolio company because banks may view redemption obligations as company debt. Moreover, the ability of a portfolio company to redeem is limited by state law as well as the obvious practical realities of a portfolio company's ability to generate sufficient funds to repurchase shares. To overcome the practical risks, some venture capital *investors are requiring their portfolio companies to create a sinking fund to ensure adequate capital for the redemption. *290 • Increasing Option Pools included in Pre-Money Valuation. Venture capital investors have typically required a portfolio company to increase its option pool prior to determining the company's valuation. However, where increasing the option pool to handle up to a year of option grants was once sufficient, venture capital investors are requiring that the option pool be increased to handle up to five years of option grants, or the estimated time to liquidity. This approach shifts all dilution associated with the option pool to the founders and prior investors, and reduces the per share price of the preferred stock for the new venture capital investors. • Mandatory Cumulative Dividends. Once an afterthought, venture capital investors are now insisting on mandatory cumulative dividends. As a result, portfolio companies are agreeing to annual dividend rates of 8% to 15% that accumulate if not paid. At the investors' option, the dividend may be paid in cash or stock on conversion of the preferred stock. • Milestone Funding. Venture capital investors are "increasingly linking their investments in portfolio companies to the portfolio company achieving certain staged operational milestones. This approach reduces the risk that a creditor of the portfolio company will be able to seize or otherwise make a claim on funds provided by a venture capital investor. It also enables the venture capital investor to test the portfolio company's predictions of future operational success. Typically, milestone funding will be the only option available to distressed companies unable to obtain traditional financing. *291 • Protective Provisions. Venture capital investor approval provisions were once generally limited to approval of senior and pari passu securities, sales of the company; payment of dividends, liquidation-related actions; and changes to the terms of the investors' securities. Venture capital 'investors now are demanding rights to closely monitor "cash burn," financial condition and overall strategy. As a result, these rights now also typically include, among others, change of business, incurrence of debt over specified limit, annual budgets and variances, acquisitions of other businesses, grant of rights in technology, and appointment or termination of CEO and other senior executives. • First Refusal Rights. These rights were traditionally limited to shares proposed to be sold by employees, but have now been expanded to include shares proposed to be sold by any shareholder. This allows any investor that chooses to stay in to take advantage of any fire-sale by existing securityholders. • Co-Sale Rights. Although these rights were typically limited to shares to be sold by a founder, now investors are demanding the right to exit alongside of any shareholder that seeks to sell shares, both to discourage co-investor exits and to facilitate a partial exit. • Board Control. Once limited to influence or equal participation with founders and insiders, investors are now seeking to control boards and thereby directly direct overall strategy. *292 • Drag-Along Rights. Although sometimes seen in the few 'investments that investors previously perceived as very "risky," these rights, coupled with increased voting influence on the board of directors, allow investors to sell and limit their losses by requiring all shareholders to agree to sell the company if the Board and holders of a majority of the voting shares consent to a sale. • Founder and Management Vesting. Executive vesting periods are increasing from four (4) years to five (5) years, with slower vesting in the earlier years. The effect is to create more flexibility and more available stock if the company needs to make a change in management or suffers a departure in the management ranks and also in recognition of longer periods being required for a successful exit.
  4. 4. • Representations and Warranties. In the past, these came solely from the Company; now, to force founders to stand behind what is being said and to create the need for founders to actually diligence themselves and their business, representations and warranties are now being required from the founders, particularly with respect to intellectual property issues. *293 VENTURE CAPITAL TERM COMPARISONS OLD and NEW ------------------------------------------------------------------------------- TERM THEN ... AND, IN MANY CASES, NOW ------------------------------------------------------------------------------- Valuations: $15-$100 million $3-$10 million pre-money pre-money ------------------------------------------------------------------------------- Investment $5-$30 million $2-$15 million Amount: ------------------------------------------------------------------------------- Number of Single VC Investor At least 2 VC investors, with a Investors: 'known' lead ------------------------------------------------------------------------------- Closing Cycle: 1-2 months 3-4 months ------------------------------------------------------------------------------- Closings: Single tranche Milestone-based tranches Investment ------------------------------------------------------------------------------- Dividends: Non-mandatory, Mandatory, cumulative payable in kind non-cumulative 8% up to 0% per year per year ------------------------------------------------------------------------------- Liquidation 1X purchase price, 3X purchase price (and sometimes Preference: plus participation significantly higher), plus rights up to a 3X participation rights with no cap cap ------------------------------------------------------------------------------- Redemption: None At option of holders, after 5 years at purchase price plus accrued dividends ------------------------------------------------------------------------------- Automatic Upon Qualified IPO of Upon Qualified IPO of $75 million, Conversion: $50 million, no with at least 5X purchase price price limit
  5. 5. ------------------------------------------------------------------------------- Antidilution Standard broad-based Full ratchet adjustment for a period; Protection: weighted average then weighted average adjustment ------------------------------------------------------------------------------- Board 2VC; 2 Common; 1 Same Composition: Outsider ------------------------------------------------------------------------------- Protective Investor approval of: Investor approval of senior or pari provisions: senior and pari passu securities, sale of company, passu securities, payment of dividends, change of sale of company, rights, change of business, payment of incurrence of debt over specified dividends, limit, annual budgets and liquidation, change variances, acquisitions of other of rights businesses, grant of exclusive rights in technology, appointment or termination of CEO ------------------------------------------------------------------------------- Pre-emptive Right to maintain Right to invest up to 2X pro-rata Rights: pro-rata ownership ownership in later financings in later financings ------------------------------------------------------------------------------- Pay to Play Not often used; More common now; preferred Provisions: preferred loses automatically converts to common if anti-dilution don't participate in later protection if don't financing at lower price participate in later financing at lower price ------------------------------------------------------------------------------- First Refusal Right to purchase any Right to purchase any shares proposed Rights: shares proposed to to be sold by any shareholder. be sold by employees ------------------------------------------------------------------------------- Co-Sale Rights: Right to sell Right to sell alongside any alongside any shareholder that sells shares founder that sells shares ------------------------------------------------------------------------------- Drag-Along None Right to force all shareholders to Rights: sell company upon board and majority shareholder approval ------------------------------------------------------------------------------- Forced Sales: None Right to force board to sell company 5 years if no IPO -------------------------------------------------------------------------------
  6. 6. Founder Vesting: Standard 4-year Moving to 4-year vesting vesting with some up-front vesting ------------------------------------------------------------------------------- Representation s From company only Some reps and warranties from and founders individually re IP etc. Warranties: ------------------------------------------------------------------------------- [FN1]. Written and reprinted with the permission of Sal Vieiello, Kelley Drye & Warren, LLP. END OF DOCUMENT