DEVIL IN THE DETAILS
While celebrating big valuations in good times comes easy, investment deals come with strict clauses that can hurt if startups need to raise more funding at a lower valuation in a down market. When a startup raises capital from a venture capital investor in lieu of equity, the investor is issued preferred stock, which is different from the common stock held by founders and employees. Preferred stock implies that the investor has certain rights above and beyond those of common-stock holders. Primary among these are liquidation preference and anti-dilution rights.
1. LIQUIDATION PREFERENCE
Liquidation preference, as important as valuation for a venture capitalist, ensures the investor is paid first in the event of a liquidation, acquisition, sale of assets or bankruptcy.
As part of the negotiation on liquidation preference, the investor is entitled to a multiple on their original investment. The market standard for that is 1x, meant to protect the investment, but it can go to 2x, or two times the investment.
Liquidation preference is of two types: Participating and nonparticipating.
Under participating liquidation preference, also called “double dip,“ VCs get their money back first in the event of an exit and the remaining proceeds are divided among all shareholders, including the VCs, on a share-forshare basis. Under the nonparticipating model, VCs can convert their preferred shares into ordinary shares or exercise liquidation preference, whichever gives them better returns.
So if a company is sold for $50 million and a VC had invested $10 million in it for a 25% stake, a 2x participating liquidation preference deal will fetch it $27.5 million–two times the investment plus 25% of the remaining $30 million.
If the deal had a 2x nonparticipating liquidation preference clause, the investor will get $20 million.
In a recent distress deal, the investors exercised the liquidation preference to recover some of their investment in the company.
The founders and employees got nothing.
2. ANTI-DILUTION RIGHTS
There are two kinds of anti-dilution rights–full ratchet and weighted average
FULL RATCHET ANTI-DILUTION
Let’s say an investor paid $2 per share for a 10% stake in a company in a Series A funding round.
If the company raises capital from new investors in a Series B round at $1 per share, the Series A investor holds the right to convert the value of its shares to $1 per share and double its number of shares. A full ratchet anti-dilution is usually not preferred because founders end up diluting more than they should have to.
WEIGHTED AVERAGE ANTI-DILUTION
The weighted average anti-dilution method issues fewer free shares to the Series A investor. This is arrived at by adding the shares held by the Series A investor to the shares held by the management and coming up with a weighted average price per share. This new price per share would be slightly lower than the price paid by the Series A investor in the first round and allow the company to issue fewer free shares. It also eases the path for new investors to take stake in the company.
3. HOW VALUATION WORKS ACROSS STAGES
Venture capital investments happen across stages in the following order
1) SeedAngel Prove the team and concept in terms of product market fit
2) Series A Build the product, get initial customers
3) Series B Start getting customers and build traction across the market
4) Series C and beyond Scale the business, establish market leadership and reach or build a path to profitability
When assessing a startup for series A funding, a VC will try to estimate what the valuation could be at exit. “We try to predict how large the exit can be and then back-calculate, trying to risk-weight the returns,“ said a partner at a VC firm managing over $600 million.
VCs look to invest in startups that can return value equivalent to the size of their entire fund. This is because if a VC firm managing $150 million invests in 15-20 companies, only 2-3 can be expected to achieve this. The other investments are likely to be either written off or give mediocre and no returns.
This is why venture capital is increasingly becoming a business of hunting elephants, or big outcomes.
In series A deals, there is typically a 2035% dilution for an investment of $3-5 million. Let’s say a venture capital firm invests $5 million in a startup at series A with a post-money valuation of $20 million. This would give the VC a 25% stake in the company.
The assessment criteria initially will be the size of the market that a startup is chasing and the strength of its team. In later rounds, additional factors will weigh in, such as weather the startup has been able to grow into a market leader.
For simplicity, let us assume that the VC will not invest in any follow-on rounds and the startup only raises primary capital. Also that the VC estimates the company could reach a valuation of $1 billion, for which it will need to raise $150 million in capital, after which it can exit.This stake will get diluted to about 15% as the company raises more money. At a billion-dollar valuation, this means the shares of the series A investor will be worth over $150 million.
Why are some of the world’s smartest inves tors willing to value companies with no rev enue and huge losses at billions of dollars? They know they have nothing to lose.
Over the years, these so-called risk investors have drawn up defenses and armed themselves with legal clauses to protect their money, making megasized valuations possible. In the event of a downturn, it is the investee companies that are likely to burn.
While tricky clauses such as `liquidation preference’ and `anti-dilution rights’ are not new, it is clear that the valuations of internet firms are not directly comparable to that of publicly listed companies. This is because of the special rights that venture capital (VC) investors in privately held tech companies can exercise.
“VCs can invest at any valuation because the contracts can get you back to the valuation they want,“ quipped Yashish Dahiya, cofounder and CEO of Policybazaar that is valued at over Rs 1,200 crore following a VC investment earlier this year. Dahiya, who has negotiated four rounds of funding, said liquidation preference and anti-dilution rights are non-negotiables.
Liquidation preference–a standard term in all private internet financing deals–means that when a company is sold the investors get their capital back first, before the employees or founders get paid. Anti-dilution rights protect investors if a company issues shares at a lower price than in preceding rounds.
For instance, online retailer Flipkart’s valuation was pegged at $11 billion in December 2014 when it had raised total capital of $ 2.5 billion; so its value should fall below $2.5 billion for investors to lose any money.
It is this protection that gives investors comfort to sink large amounts in companies at eye-popping valuations.“Investors in Unicorn (billion-dollar) financings have significantly more downside protection than public company common stock investors,“ Silicon Valley law firm Fenwick & West said earlier this year after studying the terms of 37 US tech companies that are valued at over $1 billion. “These protections are especially strong in the event of an acquisition.“
While these clauses do not make much of a difference when a company is sold at a higher valuation, if the value falls as compared with previous funding rounds, then these become material.These clauses have become the norm when deals are negotiated. “Liquidation preference and anti-dilution is standard for any venture capital funding,“ said Priyanka Roy, partner at law firm IndusLaw.
The nature of liquidation preference depends on the stage of a company.Investors in early-stage companies typically are satisfied protecting the capital invested. In larger investments, typically of over $100 million, minimum return expectations are built into the liquidation preference clause.
In later-stage deals, the internal rate of return IRR, or return requirement, stipulation comes into play as the company effectively gets closer to a public listing of its shares. “It changes with every deal as some people may say 2x (two times the investment) or others may ask for 30%, depending on valuations and deal size,“ said Roy, whose firm has advised Snapdeal, Ola and Quikr on their fundraising.
Such clauses have come into effect in mature markets. When US-based Box priced its IPO at $14 per share, below the $20 per share at which TPG and Coatue Management had invested in it during its last private funding round, the online storage firm had to issue additional shares to these investors to make up for their losses. This happened because the investors were guaranteed at least a 10% discount to the IPO price as part of the investment agreement.
While IPOs of Indian Unicorns are a few years away, contracts signed in a bull market could turn on the companies during a slowdown.
“As companies get larger, liquidation preference becomes more relevant, especially in companies which do not generate cash,“ said a venture capital investor who declined to be identified.“If these companies need follow-on rounds it does lead to more harsh terms on them.“
As companies remain private longer and keep raising larger rounds of funding, liquidation preferences keep piling on top of each other. These rights work as investors usually subscribe to instruments like compulsorily convertible preference shares (CCPS).
So, for instance, CCPS holders of Zomato, which include venture capital firms Sequoia Capital and Vy Capital, will be entitled to a “minimum return“ if the company is sold, ahead of normal equity shareholders including cofounder Deepinder Goyal and the employees, according to majority shareholder Info Edge’s 2014-15 annual report.
Investors also recognise liquidation preference when they account for possible gains. So Quikr’s valuation increased from $240 million in March 2014, when Swedish investment firm Kinnevik first invested, to $900 million in April 2015. According to Kinnivek’s public filing for the quarter ended March 2015, though the implied value indicates that it is sitting on unrealised profits of 95% on total investment made in Quikr, according to fair value this is just 15%. This is because it takes into account the liquidation preference, according to the filing.
“These clauses are a matter of fact, so it doesn’t matter if you raise Rs 150 crore or Rs 500 crore. What matters is what valuation you can exit at and if you can reach IPO valuation target,“ said Dahiya of Policybazaar.
If only all Indian entrepreneurs are as pragmatic.