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VC Valuations

Down rounds, structured terms and focus on profitability are making a comeback

Hallmarks of a downbeat climate, such as decreasing VC valuations and investor-protective terms, are beginning to emerge.

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In February, H1, a healthcare analytics specialist, decided to raise additional capital just months after closing a $100 million Series C at a $750 million valuation, led by Altimeter.

That turned out to be a good call. H1 received commitments from insiders for a $23 million Series C extension—at the same valuation and terms most recently agreed upon. The financing was agreed to shortly before market conditions for tech stocks and pre-IPO companies took a turn for the worse.

“Our investors told us if you had started [fundraising] later, it would have been a down round,” said Ariel Katz, H1’s co-founder and CEO.

After years of aggressively offering capital to startups with fast growth and high cash burn, VC investors have turned much more selective as the venture market’s 13-year bull market comes to a screeching halt. It is still early days, but VC deals that used to be founder-friendly at high prices have been replaced by hallmarks of a downbeat climate such as decreasing valuations and investor-protective terms.

At the same time, investors are agreeing to stepped-up prices on a few companies that are showing especially strong prospects. But even those startups often increasingly settle for deals with flat or only modest valuation increases, investors said.

In a down round, a company sells shares at a price below its previous round’s valuation, and these tend to be punitive for earlier investors, founders and employees. PitchBook data has yet to register an uptick in the number of recent down rounds, but some investors said that many more startups that need funding are now considering such unfavorable deals as an option.

 

Many companies that need to raise capital this year initially pitched investors on flat or extension rounds. But in a sign of the harsh new reality is setting in, the startups that failed to get deals done before the market soured in earnest mid-spring are now saying they are “flexible on price,” one investor who declined to be named said via an email to PitchBook News.

“The down-round conversations reflect the end of the ‘denial’ phase and the beginning of the ‘acceptance’ phase,” this investor wrote, referring to the initial disbelief many founders had about the sudden change in the fundraising environment.

“I have friends that are fundraising now—it is painful,” Katz said. Among them, he said, are strong companies with recognizable brands, but many of them raised capital last year at valuations no longer justified in light of software stocks dropping some 60% from their recent 12-month highs.

Buy-now, pay-later provider Klarna and crypto lending specialist BlockFi are reportedly raising new capital at reduced prices. But most startups in urgent need of funding are now choosing to accept disadvantageous terms to create a perception of a flat or a slightly higher round, investors say.

Your price, my terms

"[Companies] save face in terms of PR,” said venture capitalist Yoav Leitersdorf, managing partner at YL Ventures. “But in the legal docs, you’d find terms that essentially make the flat- or up-valuation irrelevant because the economics of any future distribution favor the new investors as if the round was a down round.”

These so-called structured terms can take various forms, ranging from mildly to severely punishing for founders and earlier investors.

 

Investor Mathias Schilling, a founding partner at Headline, said that investor-friendly terms are, for now, “on the softer side,” but some more onerous language is starting to make its way into select deals.

Schilling said he had seen deals done at up to 3X liquidation preference, which means that in an exit, the latest investors are guaranteed to receive as much as three times their invested capital before other shareholders get paid anything.

So-called participating-preferred terms are another provision occasionally showing up in deals, according to Chris Sugden, a managing partner at Edison Partners. Sometimes dubbed double-dip security, this entitles investors to first collect their money back and then receive their percentage ownership of the remaining funds.

In fact, it has been so many years since investor-protective provisions have been included in term sheets that some new investors are now having to learn how they work.

“They literally do not know what the terms mean,” Schilling said. “I can finally leverage the toolkit I learned 20 years ago.”

Great outliers

Meanwhile, a very select minority of exceptionally strong, late-stage companies can still raise capital without punishing terms or a valuation hit. For these deals, investors are agreeing to mild up rounds and extensions from high-priced deals done last year.

Nowadays, a company could expect to receive a bona fide up or flat round if it didn’t raise capital at an inflated valuation last year or if it’s a category leader in a large market.

Schilling said he recently met with a company seeking funding at a valuation multiple of nearly 100X annual recurring revenue. Most companies that completed deals of this magnitude are now considered highly overvalued, but this is not stopping Schilling from giving this deal serious thought. “It’s a very good company,” he said. “Probably not at 100X ARR, but we’re very tempted to do something about it.”

What’s considered a strong company is also changing.

After years of telling startups to grow at all costs, investors are now putting a premium on growth in the context of profitability, said Teddie Wardi, a managing director at Insight Partners. The priority is sometimes expressed through the Rule of 40—the notion that a company’s growth rate combined with its profit margin should be 40% or more.

“Assuming that the company [that meets the Rule of 40] is operating in an attractive market and [its] unit economics are in good order, these companies can attract financing in any market,” Wardi said.

As for H1, Katz said that with an additional $100 million in capital, the company could grow 100% faster, and if the market again prefers fast growth, they’ll seek more funding.

“But if the market values Rule of 40, cash flow-positive companies,” Katz said, “then we’ll manage towards that.”

Featured image by XH4D/Getty Images

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    Written by Marina Temkin
    Marina Temkin covered the venture capital ecosystem from 2021 to 2024, based in San Francisco. Previously with Venture Capital Journal, Marina wrote about the VC industry, and she was a reporter with Mergermarket in New York and San Francisco. She also has been a financial analyst and is a CFA charterholder. Marina received an economics degree from the University of California, Davis, and she attended the CUNY Graduate School of Journalism.
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