Founders are increasingly turning to structured term sheets to secure cash without taking a down round, but these “investor-friendly” terms often come at the expense of early backers.
This tension between past and present investors is straining deal negotiations and adding an extra hurdle to startups navigating a bone-dry dealmaking environment.
“The fight that I’ve seen play out is: a company that’s done a seed or a Series A where the documents called for everyone being ‘pari passu’ (‘on equal footing’), and then somebody comes in with a term sheet and says, ‘No, I want to stack my preferences,’” said Don Butler, managing director at Thomvest Ventures, the venture arm of Peter Thomson’s family office.
Agreeing to those terms can burn bridges with early backers. If a new investor only agrees to a round if there’s a stacked cap table, that sets the terms for future financing—essentially creating a precedent that leaves early investors at the bottom of a stack that’s only going to grow.
But even with those risks, VCs say they’re seeing more pay-to-play provisions and bridge rounds quietly closing with liquidation preferences as high as 4x.
Cap table chaos
The dealmaking environment is becoming more investor friendly, according to PitchBook’s VC Dealmaking indicator. In Q1 2023, nearly 9% of the 899 deals recorded by Carta, a provider of cap table management software, closed with a liquidation preference above 1x. A year ago, that figure was less than 2%, according to Carta’s data.
Cumulative dividends, another investor-friendly term that means unpaid dividends accrue over time, are also on the rise, jumping from roughly 20% to 26% between 2022 and Q1 2023, according to PitchBook data.
Devin Whatley, managing partner at the Ecosystem Integrity Fund, witnessed a cap table battle in the early months of the COVID-19 pandemic after one of his portfolio companies resorted to a down round with a pay-to-play provision, which requires shareholders to participate in financing rounds to avoid losing certain rights.
“Early investors who couldn’t participate were essentially diluted from that recapitalization and they were unhappy about that,” Whatley said. “But you know, you’re in a situation where the company needs money and it’s got to attract capital at whatever terms it could get.”
Cap table disputes are making a comeback after two years of cheap and easy money. Andrea Schulz, audit partner at Grant Thornton, said that she’s seeing investors request more seats on company boards, preferential terms and more structure—including 2x and 3x liquidation preferences.
If a term sheet includes a 2x liquidation preference, that means investors will get double their initial investment when the company exits, even if the company does so at a loss or liquidates. In other words, a higher multiple can serve as insurance for a VC fund investing in a company that’s on wobbly legs.
Founders and investors alike can be incentivized to add structure rather than lower a startup’s valuation: "[Down rounds] can have knock-on effects, like demoralizing the team or having to mark down valuations on the books of investment managers,” Whatley said.
Building bridges
Aaron Fleishman, partner at enterprise software-focused VC firm Tola Capital, is seeing liquidation preference ratchet up in two places: late-stage growth deals and internal bridge rounds. In the latter case, “That’s where you’re seeing a lot of pay-to-plays, you’re seeing 3x, 4x liquidation preference and major 25% or 30% discount to the next round,” Fleishman said.
“I’m seeing it across the board in enterprise software,” he added.
Internal bridge rounds don’t require public disclosure and help get a company just to the point of profitability. But in bridge rounds, it’s more difficult for a startup to look for external sources of funding, so VCs have even more leverage when setting the terms.
Ever since startups started making cost cuts in mid-2022 to stretch out their runways, B2B software companies catering to other startups have been particularly hard-hit. “Usually the reason that anyone’s doing these bridge rounds is that they haven’t grown into their valuation,” Fleishman said.
The problem isn’t exclusive to the tech ecosystem’s worst-performing verticals. Even in climate tech, a sector that’s weathered the current downturn remarkably well so far, more structured term sheets are starting to appear.
“Great companies who are executing are still able to raise capital at all stages right now in climate tech. But where there have been stumbles on execution, the later stages are where that’s being felt,” often in the form of flat rounds and more structure, according to Shayle Kann, partner at Energy Impact Partners.
For companies that landed large enough rounds in 2021 and made some cuts to their runways when the market took a turn for the worst in 2022, they still should have some cushion, Schulz said.
“We won’t see them in crisis until late 2024,” she predicted, but noted that “we’re entering this stage where the measures they’ve put in place in cost control are starting to run out.”
Related read: Are you on top of term sheets? Take our quiz
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