This article – part two of a series – examines venture financing deal terms that are more prevalent in difficult market conditions. See Part 1 of our series to learn about alternatives for averting a down round. See Part 3 of our series to learn about strategies for managing an unavoidable down round.
In a tougher financing environment, climate tech startups need to understand how market conditions impact deal terms. Startups that can secure new equity financing at an acceptable valuation may still find themselves reluctantly agreeing to more stringent and investor-favorable deal terms than are typical when capital is flowing more freely. These terms are even more common in a down round scenario.
Tranched financing structures. Investors unwilling to fund a large amount upfront may push for a tranched financing, in which the company receives only a portion of the total purchase price at the initial closing, with the remainder of the funds to be released subsequently upon the achievement of specified milestones. Tranched deals may also involve a “pay-to-play” feature (discussed in greater detail below) as an enforcement mechanism to make sure that all of the investors comply with their future funding obligations.
Enhanced investor economics.Investors have a variety of tools at their disposal to help guarantee a more generous level of return on their investment in the event of an exit (typically at the expense of common stockholders and junior series of preferred stock). When investors have more leverage, they are more likely to push for these investor-friendly economic terms, such as a multiple liquidation preference (in which investors receive a multiple of their investment before any funds go to junior series of stock or common stock, as opposed to the “1X” liquidation preference that tends to be more common in buoyant markets); participating preferred stock (which allows investors to receive both their liquidation preference as well as their pro rata share in the profits distributed to the common stock, as opposed to having to choose between one or the other); and cumulative dividends (in which dividends accrue annually on the preferred stock and the accrued amount is added to the amount of a preferred stockholder’s liquidation preference).
Aggressive protective provisions.Virtually every venture deal will involve some form of investor consent requirement with respect to company actions that could affect the rights of preferred stockholders, but the relative leverage between the parties will dictate just how much control the investors get. For example, when investors have the upper hand they may push for more granular veto rights over operational decisions, hiring and firing, future debt and equity transactions, and so on.
Pay to play. “Pay-to-play” provisions aim to incentivize existing investors to participate in new or future financing rounds by putting their existing equity on the line: if investors choose not to participate, their existing preferred stock may be forcibly converted to either common stock or a junior series of preferred stock, often at an unfavorable conversion ratio that heavily dilutes their stake. In addition to the threat of dilution, when investors are stripped of their preferred stock they often lose other valuable rights and privileges associated with the preferred stock, such as a senior liquidation preference, information rights, protective provisions, a board seat, or the right to participate in future financings. Pay-to-play provisions may be pushed by investors who are willing to step up in a challenging financing climate and want to restructure the company’s cap table to wash out any earlier investors who aren’t willing to double down on their commitment.
Super pro rata rights. Pro rata rights, which enable existing investors to maintain their stake in the company in future financings, are relatively common. Super pro rata rights, which are more common when investors have greater leverage, guarantee a particular investor the right to purchase a percentage of a future financing round that may be higher than the investor’s actual pro rata stake (for example, if an investor who holds 10% of the outstanding common stock on a fully-diluted basis gets a super pro rata right to purchase 25% of equity issued in a future financing).
FURTHER INFORMATION
For further information about these matters, please contact Samantha Rothberg at srothberg@klavenslawgroup.com or 617-502-6286, Frans Wethly at fwethly@klavenslawgroup.com or 617-502-6285, or Jonathan Klavens at jklavens@klavenslawgroup.com or 617-502-6281.
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