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Terms of Engagement: New Rules for Negotiating the Deal

Jun 2, 2023

Setting the Stage

The venture capital (VC) industry saw record numbers for investment, fundraising and exits (including IPOs) during COVID-19. The competition for deals of all sizes was fierce and, in most cases, companies had the upper hand over VCs when it came to negotiating terms and valuations. Many companies were receiving multiple term sheets and certainly had negotiating leverage. However, now it appears that the pendulum has swayed in a different direction. The volume of VC investments has been declining since Q2 2022 and has continued into Q1 2023. Companies from seed stage to later stage are certainly experiencing more difficulty raising funding rounds in 2023 and it now looks like the negotiating leverage is firmly in the hands of the VCs.

Record fundraising the past few years coupled with a slowdown in transaction volume has resulted in a significant amount of dry powder on the sidelines. However, it appears that VCs are taking a very cautious and conservative approach to investing in today’s uncertain economy. Now is a time of a “flight to quality.” Better companies are finding capital, while marginal companies are experiencing difficulty in fundraising. VCs are looking for companies that could be considered disruptive and exhibit a somewhat clear path to profitability and a possible exit.
Many VCs are presently at a “tipping point” in their fund’s lifecycle. The funds are of the age where they need to create liquidity through exits and return some capital to the limited partners (LPs). However, exit volume for VC-backed companies is way down and the IPO markets have slowed down considerably. Many later-stage VC-backed companies would have used the IPO market to create liquidity for their investors, but at present that is not a viable option. The VCs have been reluctant to continue to invest in these later-stage companies due to the uncertainty surrounding the timing and valuation for exits.

2023 Might Be the Year of the Down Round

Many technology companies raised capital over the last few years at quite frothy valuations. Now with the market cooling and the valuations beginning to contract, many companies needing to raise capital could be faced with down rounds. These down rounds will certainly change the look of the cap table and will also create further dilution for the founders and the early investors. Equity holders are diluted when a company issues more shares and decreases their ownership percentage. As one can see, one of the risks of raising capital at too high a valuation is that market forces and poor company performance can lead to future down rounds and future difficulty supporting this valuation in subsequent rounds.

We fully expect to see down round protection clauses or anti-dilution clauses become a more common element in VC term sheets. With a down round protection clause, a valuation adjustment is included so that investors are protected from the negative valuation effect of a down round. 

Other terms that one would expect to see in a VC term sheet are liquidation preference, participation and drag along rights to name a few. These terms are going to be written in a way to protect the investor and also help to provide the investor with the greatest possible return. With the slowdown in the VC market, the capital providers definitely have the leverage when negotiating deal terms. Hence, most term sheets today are much more investor than company friendly.

Board Seats/Board Rights Are Non-Negotiable

As part of any term sheet, VCs require some level of board representation. Most VCs will require at least one board seat and possibly two. VCs come in all shapes and sizes and bring different levels of value to a portfolio company. Companies should select the VC that brings the most value in addition to the financial terms of the transaction. The VC should be able to provide mentoring to the founder and management team; strategic advice; and network resources for people, customers, suppliers, etc.

Final Thought

Remember, a signed term sheet is not the end, but merely the beginning of the relationship between the founders and the VC. This relationship built on mutual trust hopefully will lead to a future exit that will fairly compensate both the VC and the founders.

The contents of this article were the result of a  panel discussion moderated by Alan Wink at the Emerging Tech Venture Summit  in San Jose on May 10 and May 11,  2023.


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Alan Wink

Mr. Wink assists clients with capital budgeting, capital structuring and capital sourcing. He has worked with many tech and life science companies on developing the appropriate capital structure for their position in the business life cycle.

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