The current economic climate is challenging for privately held companies seeking to raise growth capital. Several factors have contributed to the recent decline in fundraising, including high interest rates, limited access to capital, a decline in valuation metrics and an unfavorable outlook for exits.
Given this market environment, companies seeking to attract new capital have increasingly had to conduct down rounds, i.e. equity financings at lower company valuations than in previous rounds. Our Goodwin deal database shows that the percentage of markdowns has increased steadily for six quarters (see chart).
Down rounds appear set to continue to increase in the near future, as companies that could delay an equity funding round in the current market by leveraging existing liquidity from previous financings or accessing short-term bridge capital may soon have no choice but to capitulate and seek additional investor capital at a low valuation.
In this environment, it is not surprising that the conditions for growth financing have become more favorable for investors. Below, we examine some terms that growth stock investors have been searching for in the current market, both to close valuation gaps between companies and investors and to correct potential mismatches between new and existing investors.
Consent rights: improving investor control
Preferred investors typically receive protective provisions, also known as veto or blocking rights, that make certain company actions dependent on the approval of preferred shareholders voting as a group. In the current environment, investors are seeking greater control over governance and operational matters compared to previous years. They often desire exclusive investor-level rights to approve proposals related to specific strategic actions, as well as additional board-level approval rights on operational matters.
This may be due in part to the challenge investors have faced in the past when trying to influence management during previous downturns, even if they held significant stakes. Many growth investors are now looking to shift the power dynamics surrounding new financing. By increasing their say in operational matters—particularly the power to approve or veto annual budgets, hiring and firing of executives, and changes in executive compensation—investors can improve their ability to direct a company on the critical aspects of its business to focus on planning during times of economic uncertainty.
Expanded consent rights can also help close potential gaps in expectations between a company’s new investors and its existing investors. New investors generally prioritize a company’s long-term performance and sustainable profitability, while existing investors who may have invested in a previous round at a higher valuation may be more interested in the company’s growth prospects and eye an exit in the near term. These protections can provide new investors with additional peace of mind by preventing companies from pursuing strategic opportunities that may not be optimal over the entire lifecycle of their investment.
Pay-to-play provisions: incentivize investor engagement
Pay-to-play provisions encourage a company’s existing investors to continue investing in the company, especially during an economic downturn. They provide investors with carrots and sticks by punishing investors who do not participate in new rounds (typically by converting their preferred shares into common shares) or rewarding those who do (typically by issuing a senior class of shares). preferred shares).
Consequently, such pay-to-play provisions help maintain investor unity and company momentum amid uncertainty and address potential mismatches between new and existing investors by ensuring that all investors at the capitalization table have a strong incentive to to continue to participate in future financing rounds.
While pay-to-play provisions remain relatively rare, we have seen a significant increase in usage in recent venture capital financings: from less than 1.0% in 2021 to 2.7% in 2022 and up to 4 .5% in 2023 (previous year). .
Financial protection: Shielding exit returns
The following terms can provide greater certainty around investor returns, helping them protect their downside risk on exit and increase their potential to achieve upside on positive exit returns. As a result, investors may be more willing to provide financing at higher valuations, allowing companies to avoid devaluations or at least mitigate the negative impact on valuations.
Participation rights
Investors are increasingly demanding “participating preferred shares” in financing rounds. Unlike “convertible preferred stock,” which is more typical, shares of participating preferred stock entitle investors to receive both a liquidation preference and their pro rata share of the return based on conversion, in addition to shares of the company’s common stock. The structure of this security allows investors to protect their primary investment upon exit and receive additional proceeds based on their shareholding in the company.
While participating preferred shares are not the type of securities predominantly issued in growth capital financings, they are more common in today’s relatively investor-friendly market.
Liquidation preferences
Investors are also increasingly able to negotiate higher value in their liquidation preference. This took the form of “senior” liquidation preferences, which prefer to return invested capital to the investor over existing shareholders of the company, as well as liquidation preference “multipliers,” which are potentially greater than 1x the investor’s original investment.
Both enhancements to an investor’s liquidation preference result in greater downside risk protection for investors by ensuring that the investor receives the first dollars spent or additional guaranteed returns over and above their initial investment in a low-return exit, in priority over others shareholders. These protections can provide additional comfort to investors if they accept a higher valuation of the company in return.
Cumulative Dividends
Investors are also increasingly demanding cumulative dividends in connection with their growth investments. Cumulative dividends accrue over time and, upon exit, are paid in priority over dividends paid to other shareholders in the company. Thus, cumulative dividends provide “sideways” protection and increase the probability of a payout in cases where exit returns are relatively flat.
Although these terms are becoming more common, we note that when preferred shares are converted (or deemed to be) into common shares, investors are still relatively rare in having the right to convert the accrued portion of cumulative dividends into common shares (in other words). , only the investment amount is converted).
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In today’s difficult fundraising environment, companies can avoid significant deterioration in their valuation by providing investors with additional protections, including in the form of negotiated consent rights and structural features of their securities. Investors will continue to take advantage of their lead in this market and should remain informed and flexible to ensure they understand their options and receive the best deal available to protect their investments.
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