Writing minority cheques in the eye of the SVB storm

The tech world is still reacting – at time of writing – to the run on and failure of Silicon Valley Bank, the banker to something like half the venture-capital-backed tech and life sciences companies in the US, and plenty more of them in the UK and elsewhere.  If the H2 2022 slow-down in venture capital investing had not fed through into deal terms already, watching $42 billion be withdrawn (or attempts made to do so) from SVB in a single day may well have locked in a new mindset for investors writing minority cheques that may be set to last for much of the rest of the 2020s.

On that topic, here is a ‘top 5’ for themes that may emerge from here…

1. Investor due diligence

Long gone are the days when a company with enough interest from investors could expect to sail through due diligence without being asked too many tough questions (and could optimise for investors giving them an easier ride in DD).  Founders should expect to see from here a great deal more rigour when it comes to financial, commercial and legal due diligence.

That is not because investors were particularly lax in sunnier times, as a professional investor why would you not run thorough due diligence if you could.  The point is that on the very hottest deals in town it may not have been commercially possible to run a full DD process if you as an investor wanted to be in on the ticket.  We would add, however, that this seems to have been more of a feature of deals in the US rather than the UK.

On the subject of legal DD, we expect to see a return to investors wanting to have examined the historic movements in the share capital, the group structure, the banking and finance arrangements, the key commercial contracts, the IP portfolio, compliance with data protection type legislation, and more.  The point is, however, who is going to pay for it?  DD can be expensive.

When it comes to financial DD, in the wake of the collapse of SVB, we expect to see a great deal more focus about where funds are going to be deposited and diversified, and who has control of the accounts.

We wrote in January this year about a likely sea change taking place in due diligence for tech.  Our views on changes to the commercial drivers to diligence have not changed much since then.

2. Valuation

Just about the whole of the venture tech industry in the UK, US and elsewhere is still working through the crash in tech valuations that happened in or after the summer of 2022.

There are a great many issues to wash through still, with some companies who raised at 2020/1 prices having or about to go through ‘down rounds’ and solvent restructurings of their cap tables (if not looking to merge or cash out by way of a fire sale to a larger competitor).

The VC funds who invested in those companies at peak valuations have the unenviable stick or twist type choice, whether to continue to back those companies and pour in more funds or abandon those poor souls to the storm and look to invest now in a new portfolio at what we all hope is the bottom of the market.  From what we at HLaw see, the VCs to their credit seem to generally be adopting the former approach (although see below as to on what terms).

3. Valuation adjustments

VC term sheets have always had in them price adjustment-type mechanisms.  The classic bull-run series A term sheet had in it the 1x non-participating convertible preference, a broad based weighted average anti-dilution ratchet, warranties given by the investee company and the lightest of touch leaver provisions.

In a market where there has been a drastic reduction in the amount of capital being deployed, there has been a return of investment terms not seen unless by exception for a decade or so: 1x+ liquidation preferences, coupons on the preference layer, anti-dilution ratchets diverting from the broad based formulation (that factors in prior rounds and the option pool), more aggressive warranty protection (with personal liability for the founders again the norm), step in rights at board level, more involvement in and even elements of control of the investee company’s financial operations, provisions getting into what can happen in emergency funding scenarios, harsher leaver provisions, and so on.

The above are not terms that VCs insist upon so as to punish management and the company side generally, or to unfairly take advantage of the market conditions.  By and large, these are terms that are introduced so that the risk inherent in a much more uncertain market can be priced in to the deal.

A lot of that uncertainty relates to whether companies will be able to raise the next round at a higher valuation and what the valuation might be at exit.

4. Future funding rounds and exit

Getting to the next funding round has always been of the utmost importance to founders, but it has not been as important as it is right now since the banking crisis of 2008.  Some companies that raised at 2020/1 valuations have sought to execute bridge rounds using convertible debt (or even venture debt, with SVB previously a leading player in that market).

We hope that for many of those the bridge will hold fast, and they will get to the next round.  Nevertheless, for some of those companies, the problem of trying to find a lead investor to write the next cheque at a higher valuation than the one before will need to be solved.  A convertible bridge round (where the convertible investors have rights of redemption until they convert) may not solve that issue.

The same point arises when it comes to exit: with an end to stratospheric valuations and with the big tech companies laying off staff and cutting costs, who exactly is going to buy the investee company and allow the investors to realise a gain.  A key concern is whether what is on offer will exceed the value of the prior funding round.

When it comes to fire sales, management and those at the foot of the preference stack will be looking anxiously at the equity value on offer and whether it provides any return to them at all.  If the exit price does not exceed the top of the preference layers, then the only deal on offer for management may be an acqui-hire into the safety of the buyer (and perhaps a salary bump with it).

But founders beware there also if the investee company has raised EIS and VCT funds: there may be a secondary threshold for the buyer’s offer to beat, which is the level at which the proceeds of the sale would exceed what the investor would otherwise be entitled to reclaim through loss relief.   On the smallest of exits there exists a zone of potential conflict between the interests of management (looking for a new home with a buyer) and investors (with the value of the return needing to beat the available EIS and VCT loss relief).

Understanding areas of potential conflict (economic or otherwise) between the names on the cap table is more important than ever.

5. Names on the cap table

It is now of paramount importance for investors to understand the motivations of who else is on the cap table and invested in the project, who is willing perhaps to lead the next round or when the time comes to open up doors to new investors who might be in a position to do so on the next round.

Conversely, the last 18 months or so have seen a constant flow of issues for companies (and work for law firms like us) advising companies who have minority investors on their cap tables who may have become subject to sanction in some way or who may offend the national security type legislation that has proliferated in recent years (here in the UK, the National Security and Investment Act 2021 came into effect on 4 January 2022).

To the point above, the prudent investor is now looking at their co-investors to check that their very presence on the cap table is not perhaps going to one day stymie the journey to exit in some way.

If some of the above sounds rather negative, then we can remind ourselves of the VC’s adage that the best companies are founded, and the highest returns for funds are generated, in times of crisis.  Or as Churchill said, “Never let a good crisis go to waste.”

This piece was written by Henry Humphreys with input from Natalya Vilyavina.  It does not necessarily reflect the view of Humphreys Law and other lawyers at this firm.  Most of the above will not be news to well-managed institutional investors.  Market conditions continue to fluctuate.

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 and is not to be relied upon.  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.

Humphreys Law