The last ten years have been a gold rush for tech investors and startups. VCs have raised ever-larger funds and startups have fetched mind-blowing valuations. According to CVCA, Canadian venture capital investments reached new heights in 2019 with $6.2B invested in 539 companies. Then the corona virus pandemic happened… Many startups are being hit hard by the social distancing measures adopted by public authorities to flatten the curve of COVID-19 infections. The economic impacts of the pandemic are enormous and oblige founders to navigate uncharted waters. A large number of startups who had enjoyed comparing term sheets and negotiating their juicy valuation multiple in the past years are about to discover the harsh reality of fundraising in time of economic uncertainty. Those who are getting to the end of their runway in the coming months and cannot delay their fundraising will be the most impacted. Raising an equity round during the longest-running bull market in history, which celebrated its 10th anniversary in March 2019, is a different thing than having to raise money when everybody works from home and nobody knows how long the pandemic will last, let alone how profound will the harm to the economy be. 

The best comparable to what we are going through is the financial crisis of 2008-09. The Kauffman Fellows organization went back and looked at venture capital funding during that time[1] . They found that across all rounds types (Seed to Series D), the median round size went down significantly. Startups were raising lower amounts of capital, and in some cases over 30% less. This was clearly due to market pressure as companies were going through turbulent times and VCs were more prudent with their investments. The chart below illustrates the dip in funding across all rounds in 2009. 

First Round Capital conducted a survey with founders and found that in the last two weeks, the percentage of survey respondents who reported being negatively affected by the pandemic rose from 55% to 64%.[2] According to this same survey, 47% of respondents said they had frozen hiring and 23% had made salary cuts. 25% of the respondents thought they would be raising less that what they were planning to raise prior to the pandemic. This is a large chunk of startups having to deal with increased churn, lower revenue growth, a shorter runway and a foggy path to raising their next round. It’s hard to predict how venture capital funding will be impacted in 2020 but we believe that we may be about to see down rounds (and down exits), together with less attractive terms for startups. Let’s call these down rounds “corona rounds” for the purpose of this note.

So what would a corona round mean for a startup?

Valuation. Two scenarios will likely become more common over the next few weeks and months: (i) startups having to raise a new round at a lower price per share than the one they had in their last financing round, and (ii) startups who were in the process of fundraising who now see their valuation expectations drastically change overnight. Many investors currently expect a price reset ranging between 20% and 30%. Venionaire Capital for example just published the following note on their website: “As there are more startups in desperate need of funding and less investors willing to invest, because of truly uncertain developments, we will witness valuations dropping by roughly 30% even for healthy startups or scaleups[3]. A lower valuation dilutes founders and existing investors further.

Liquidation preference and multiple. We will likely see investors moving away from pari passu liquidation preference and starting to ask for a senior liquidation preference over previous rounds. Also expect investors to ask for a more generous liquidation multiple between 1.25x and 2x. During the last financial crisis, participating preferred shares were particularly popular in the US, i.e. shares allowing preferred shareholders to receive their liquidation preference while also participating with other shareholders in what remains to be distributed. We wouldn’t be surprised to have participating preferred shares popping up on some term sheets as market conditions worsen.

Anti-dilution rights. Anti-dilution provisions protect investors against down rounds by adjusting the conversion price or rate at which preferred shares convert into common shares – therefore increasing the number of common shares the investors are entitled to upon conversion. If an investor exercises its anti-dilution rights, the adjusted conversion rate gives the investor the opportunity to convert its preferred shares into more common shares and assuming that the company does really well in the future, this investor might prefer to convert its shares to participate in the proceeds instead of receiving its liquidation preference. 

Broad-based weighted average anti-dilution has generally been the norm in VC financings as it provides a reasonable protection against dilution without being too punitive to founders and existing shareholders in down rounds. This type of anti-dilution clauses adjusts the conversion rate by taking into consideration the size and valuation of the down round as well as the startup’s total share capital. Full ratchet anti-dilution is less common in the Canadian venture capital landscape as it results into much more dilution for holders of common shares. It gives the investors the right to convert their preferred shares into common shares equal to the amount they previously invested divided by the price per share paid by new investors in the down round. 

In a recent discussion we attended with several US-based venture capitalists and lawyers, most participants agreed that full ratchet anti-dilution protection might make a comeback in corona rounds in order to provide enhanced protection to investors against potential subsequent down rounds given the current economic uncertainty. We believe some VCs could indeed start demanding that protection but startups with potential alternative financings or enough runway to wait should resist granting it and offer broad-based weighted average anti-dilution only (or at the very least, negotiate a waiver subject to preferred majority of the class). 

Preferred share dividend. To better protect their return, we have seen some investors asking for a cumulative dividend per preferred share they subscribe to of anywhere between 6% and 15% (calculated on the price per share paid in the down round), payable upon the occurrence of a liquidation, redemption or conversion as the case may be. This preferred share dividend would normally accrue and may also compound annually in addition to have priority over any other dividends paid to shareholders of other classes. A compromise founders may want to negotiate with investors is that the dividend will go away (without having to be paid to investors) upon reaching certain milestones such as raising a new round at a certain valuation or reaching a revenue threshold.

Exit/redemption rights. Put options exercisable after a certain period of time are sometimes required by some institutional investors (e.g. pension funds, governmental agencies) but rarely by VCs. In a corona round, it is possible that VCs would decide to add redemption rights to the term sheet. It is also worth noting that new players such as large institutional investors and family offices may decide to allocate more funds to venture capital in order to fill the funding gap and come in with a different set of terms and expectations than what traditional VCs would typically want. Such terms may well include redemption rights and other types of exit rights. A put option, or redemption rights, essentially gives the investor the ability to force the sale of its shares on the company after a pre-determined period of time or upon reaching a milestone. Typical timeframe is 5 to 7 years and the redemption price for the redeemable shares is often the fair market value of such shares or the greater of fair market value and the original purchase price paid by the investor. Payment for the redeemable shares can be paid in a lump sum by the company or spread over a number of months to massage the company’s cash flows. It has the benefit, for investors, of guaranteeing a potential exit avenue if things don’t go how they would want to after a certain time.

Milestone financings. Although it’s not something that has been very common in recent VC financings, investors may want to make their investment in a startup, or tranches of their investment, partly conditional on the startup meeting certain milestones such as reaching a revenue threshold, securing a patent, hiring an experienced CTO, etc. When those milestones are met by the startup, the investor needs to disburse and subscribe to more shares, as previously agreed when the down round was negotiated. If the milestones are never met though, the investor doesn’t have to invest more than what it initially invested. Milestone financings can be structured in many different ways to meet the investor’s objectives. Sometimes, the full investment will be paid on closing of the round but the terms of the investment (e.g. conversion rate, special dividend, etc) may be adjusted if milestones are met or not.  

Pay to play. Pay to play provisions penalize investors who decide not to participate in future rounds. It’s used to incentivize investors to be committed to the company’s growth by at least investing their pro rata in subsequent financing rounds. If an investor subject to pay to play provisions does not participate in further financings, penalties that might be imposed include the loss of its board representation, the loss of certain preferred shareholder rights such anti-dilution protection and pre-emptive rights, or even the conversion of its preferred shares into common shares. Pay to play is fairly rare in Canada and it remains to be seen if we will see such provisions appear on term sheets of corona rounds. Although it is mainly a “pro-company” feature that generally disadvantages investors, it can also be imposed by a lead investor taking up a large portion of a down round with the goal of managing the risk allocation of future rounds by forcing other investors to either participate or lose some of their preferred shareholders rights. Lead investors may want to push these provisions through in a distressed financing situation or in a down round where it contributes a big chunk of the financing.

Representations and warranties, due diligence and veto rights. As businesses are adapting to the new reality caused by the pandemic, their business plan and financial model will most probably be totally off by summertime. For investors investing in new companies, it will be harder to rely on the company’s financial model and to believe in the underlying assumptions and projections given the economic uncertainty in front of us. They also know that some startups, even the great ones, are anxious and more desperate to close a financing and founders might inadvertently paint a rosier picture of their business that doesn’t accurately reflect the situation they are in. Startups and founders should expect investors to require more disclosure and an extensive set of business representations and warranties in the share purchase or subscription agreement. It is possible as well that the due diligence exercise will be more exhaustive and take longer than usual. Essentially, investors will want to make sure that they are not missing anything that could adversely impact the business and, perhaps more importantly, that they understand how the company will navigate the storm and reignite growth. Finally, even if veto rights are a standard feature of venture capital financings, investors might be tempted to ask for a longer list of veto rights as they want to tighten their oversight over key business and corporate decisions.

Vesting schedule for Founders. Revisiting the vesting of founder shares and stock options is one of the things that impact the founders more personally. Investors in corona rounds may take advantage of the tough economic context to ask for a reset of the vesting schedule for founder shares and/or options. Founders who are parties to a restricted stock agreement and who had vested a large chunk of their shares will have to negotiate new vesting terms with investors as they want to make sure founders have more skin in the game. Same logic applies to stock options. On the other hand, those negotiations, if they come up, are also a good opportunity for founders and key employees to ask for their stock options to be topped up in exchange for a new vesting schedule.   

Reduced burn and management changes. It is very unlikely that startups having to raise a down round will be able to continue as if it’s business as usual. Founders should expect investors to require them to reduce their burn by cutting expenses, laying off people and/or firing less performing employees, freezing hiring and if burn is still too high, reducing salaries (often starting with executives). Investors may also want the startups with younger, inexperienced founders to bring in more experienced leaders (“who have gone through tough times before”). All these considerations won’t necessarily be set out in the term sheet but founders should expect them to come up at their first Board meeting post-corona round if they haven’t come up before. It’s a good idea to align on these matters with the new investors before closing the round.

Despite the above, we are confident that we will return to market conditions that are similar or better than those before the pandemic although nobody can realistically predict how long it will take. Startups having the luxury of healthy sales and/or a decent runway should nevertheless consider cutting back expenses as much as possible and wait to fundraise unless they can close a financing on good terms. They can look for alternatives such as MRR and SRED financing as well as emergency governmental programs. Indeed, not all startups are suffering because of COVID-19. Companies offering technologies making it easier for employees to work remotely, telehealth and food delivery, for example, are having some of their best months ever. But they’re the lucky ones… For all the other startups who are adversely impacted by the downturn and need to fundraise in the coming months, know that VCs have a lot of dry powder to play with and need to deploy it despite the pandemic. Getting funded, even in these difficult times, is possible but will require founders to manage their valuation expectations and adjust to the new reality. A startup that was hoping to raise a $12M Series A at a valuation of $80M may still be able to close a Series A but possibly a smaller round of $7M at a valuation of $50M. Founders should be prepared to talk about how their company plans on surviving the crisis and thrive afterwards.

[1] Kauffman Fellows, This is how much harder it is to raise capital during a downturn, March 27, 2020.

[2] First Round Review, The Founder’s Field Guide for Navigating This Crisis — Advice from Recession-Era Leaders, Investors and CEOs Currently at the Helm, April 2020.