News & Insight
Top 5: term sheet traps in a bear market for founders
At time of writing, just about everything is going down apart from inflation and interest rates. Unemployment in the UK is still negligible, but if that too starts going up then we are into ‘stagflation’ territory. What remains to be seen is whether this is just a big dip in a frothy market, or a fundamental re-set of an era super-charged by quantitative easing and cheap money.
But it’s not all doom and gloom.
In what might be the third ‘once in a generation’ crisis in tech not yet three years into this decade, the coffers of the worlds’ VC funds remain stuffed to bursting with cash. KPMG report that around 1,400 VC firms globally raised US $200 billion last year.
Those funds are going to have to go somewhere if not back to the LPs. But, yes, for a while at least deployment is likely going to be slower, valuations will be far less generous (and harder to justify) and term sheets more likely to have bear traps for the unwary founder.
Here are our ‘top 5’ for founders negotiating that next round right at the moment.
Anyone who is closing deals right now with a chunky uplift to the valuation is doing well. Pricing privately held and illiquid tech stocks is always as much of an art as a science, and at this moment founders may find themselves under pressure to justify that assumed increase in the face of uncertainty in the wider economy.
Which is kind of ironic because a lot of tech valuation as an exercise is about looking forward to exit and what might happen years into the future after having disrupted and conquered a particular market. Founder teams closing at a flat valuation will be facing greater dilution than they had planned, and the maths going forward may not be so rosy when it comes to predicting likely returns for them at exit.
If you are looking at a down round, then the results can be unpleasant – the anti-dilution ratchet in the articles of association that you thought you’d never have to think about? That’s going to apply. Hopefully it’s of the broad based weighted average variety and not a full ratchet.
Whatever the valuation is, the new money going in is likely to be as a new share class with at least a 1x preferred return. Where the leverage in negotiations has tilted towards the investors from the founder side, expect to see pressure on that 1x to go up, and expect to see more of – the ‘double dip’ variety – preferred participating.
See our guide to understanding liquidation preferences, HERE.
2. So maybe do a bridge round?
If you can’t agree a valuation, then maybe kick the pricing can down the road and structure a convertible bridge round. You might be looking at a chunky discount given market uncertainties, but at least you aren’t yet pricing the funds.
Having a cap to the conversion needs to be thought through – is the cap signalling pricing to the new investors for the next round? And, if you don’t have a floor price, then if the next round is a major down round then your easy-going convertible funds are going to operate like a full ratchet.
Be careful too since raising the next round at a flat valuation will trigger the loans converting at a discount, which in turn may trigger the anti-dilution rights and unpleasantness for founders and existing shareholders.
Building a bridge usually only works if it’s a bridge to somewhere – if there is real uncertainty as to the prospects of raising that next round then the bridge may well collapse, or it won’t get built in the first place.
3. How are those returns at exit looking?
You may already have anti-dilution provisions in the articles. You may be asked to include them on this round. Investors being asked to pay high valuations for high-risk bets on technology plays have unsurprisingly sought to back off the risk by including machinery in the investment documents to re-base their investment if the investee company later raises funds at a lower price. The only way to fully get across how that might happen is to model it out in Excel – the algebra is intense and differs depending on the type of ratchet.
And if you are going to the trouble of building a model, you may as well line it up against prospective returns on a trade sale, or a scaling back to wait for winter’s end, or even a winding up.
If there just isn’t going to be enough equity on the table to keep management incentivised, then growth shares or other forms of management incentive schemes can be looked at. If you are at series B + stage then these discussions are important, not least because the founders will likely have lost control of the board. As such, they may be unable to block an exit where the drag along mechanic is used to force a sale at a time that is not of their choosing.
Some of generation millennial who eschewed the well-worn path of becoming investment bankers or accountants or lawyers to go be a CEO of a cool tech venture might be thinking wistfully about what it must be like to not have to lose sleep over running out of cash and laying off staff.
4. Focus on leaver provisions
With more leverage in negotiations, expect to see investors asking for more robust leaver and vesting provisions – in recent years, the West-Coast-US-influenced super-light-touch leaver provisions have been all the rage as VCs have chased after the hottest companies.
We think you will now see more thought given to leaver scenarios and vesting periods lengthening. If the rule of thumb is that vesting is the flip side to the hockey stick valuation chart, then if valuations are going to stay flat for a while at best, then presumably vesting periods will extend out accordingly.
Check out our comprehensive guide to negotiating leaver and vesting provisions, HERE.
On the subject of leavers, closing out a round at a flat valuation or a down round – and with chunky layers added to the top of the preference stack – may well put the ordinary shareholders and the employee option holders under water for all but a really significant exit. If they have been hanging on and taking a below market salary because of those options, then be careful that closing the round does not trigger an exodus of the talent.
5. Signing up for warranties personally
In recent years, so too has the ubiquitous 1x salary personal liability under the warranties been regularly dis-applied for the best companies. The VC textbook says that they don’t want to spend significant costs on PE style due diligence and so they need the founder’s ‘feet to the fire’ when populating the disclosure letter.
Claims against founders under the warranties are rare, but – again – with more leverage in negotiations, investors will have more scope to insist that the founders are on the hook and perhaps further insist that liability is on a joint and several basis.
If you are giving those warranties, then be careful around those that go to the business plan and any projections within. Some guidance HERE from us on the business plan warranties from back in 2019 that is as relevant today as it was back then.
This piece was written by Henry Humphreys, with assistance from Jamie Crocker. Investors sitting on the other side of the table may well have views that differ from those put forward above!
All the thoughts and commentary that HLaw publishes on this website, including those set out above, are subject to the terms and conditions of use of this website. None of the above constitutes legal advice. Much of the above will no doubt fall out of date and conflict with future law and practice one day. None of the above should be relied upon. Always seek your own independent professional advice.