Changing Tides? How Investor Conservatism and Discipline Are Impacting Venture Financing Deal Terms

Published 31 July 2017 by TJ Kelly Intellectual Property Law, PC

Most of the prevailing core legal terms in seed and early-stage venture capital transactions have remained relatively stable throughout the current decade. As we survey the most recent transactions, however, we are seeing some evidence of changing tides, as investor conservatism and increased discipline seem to be finding their way into more deal terms.

For example, liquidation preferences are becoming more investor friendly. The seemingly staple "1x" preferred stock liquidation preference has been the market standard for a number of years, with preferred stockholders generally entitled to receive one times (1x) their original investment amount in preference to the holders of common stock upon a liquidity event, such as a sale of the company or sale of substantially all of its assets. Preferred stock issued to venture investors in seed and early-stage deals also has been mostly "non-participating preferred" so that upon a liquidity event, preferred stockholders are entitled to the greater of their original investment amount or the amount they would receive if they voluntarily converted into common stock prior to the liquidity event. In stark contrast, "participating preferred" stock is viewed as much more onerous for the founders and other common stockholders (i.e., the team!), because it allows preferred stockholders to receive their liquidation preference first and then also share in the liquidation proceeds with the common stockholders on an as-converted to common stock basis.

"Non-cumulative dividends," which do not accrue from year to year and are paid only as, when, and if declared by the board of directors, have been the norm for a while, as opposed to "cumulative dividends," which accrue year to year, much like interest on a promissory note. "Weighted average anti-dilution" provisions, as opposed to full ratchet anti-dilution, protect investors against future financings or issuances consummated at a price below what the investor paid, and have been market standard in almost all seed and early-stage venture deals in recent years.

Industry data out of Silicon Valley seems to support that some core deal terms are again becoming more favorable for investors, with deals that have a liquidation preference greater than 1x on the rise. According to a recent survey,1 Silicon Valley deals with a liquidation preference greater than 1x more than doubled from less than 8% of deals in 1Q 2016 to 16% of deals in 1Q 2017. Deals that included participating preferred stock were also up from about 17% of deals in 1Q 2016 to 22% in 1Q 2017. The number of deals that included a cumulative dividend remained flat at around 7-9% of deals. The overwhelming majority of deals (98%) continue to include weighted average anti-dilution price protection for investors.

While establishing founder vesting schedules is common practice either right from incorporation (as we generally recommend in our practice when there are multiple founders) or at the seed stage of investment, we are seeing more Series A investors taking a hard (read as conservative) look at founder vesting, even resetting and lengthening vesting schedules in an effort to align the interests of founders and investors.

These changes reflect a leveling off that has occurred in the venture capital industry over the past two years, exemplified by the number of seed and early-stage venture financings reaching a peak between 2014 and 2015. Many will recall that there was a lot of speculation about a venture bubble toward the end of 2015. Angel and seed stage financings, as measured by PitchBook and the National Venture Capital Association, have seen declines for eight consecutive quarters through 2Q 2017.2 If 2014 and 2015 were the "best of times," where are we today?

While there have been fewer deals across all stages of investment, the data indicates that we still have a very robust U.S. venture capital industry. In the first half of 2017, 3,876 venture-backed companies raised $37.76 billion in investment capital, with $21.78 billion invested in 1,958 companies nationwide in the second quarter alone.3 Perhaps most importantly, companies and investors should keep in mind that venture funds have raised $130 billion since 2014. This means that there is still a considerable amount of dry powder available for deployment, but investors are clearly becoming more selective in how this capital is invested.