Last year at this time, venture dollars flowed freely and founders could name their own terms and prices on deals.
There were stories of investors putting up money without meeting the founding team, not doing full due diligence, and agreeing to valuations far from the scope of any reality—all in an effort to not miss out on the “next big thing.”
Times obviously have changed.
Funding continues to trend downward and private valuations continue to take a beating as inflation, interest rates, geopolitical issues and public market woes have caused a pullback in the market.
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They also have caused a paradigm shift in the market back to investors, with deal terms becoming more friendly to those putting up the cash.
“Everything is changing—valuations, liquidity preferences, everything,” said Nadav Zafrir, co-founder and managing partner at Israel-based Team8. The company creates and invests in companies specializing in enterprise technologies, healthtech and fintech.
“It’s inevitable” in this market, he added.
Ch-ch-changes in the VC landscape
Like any market, the venture market is cyclical. Right now that means it is shifting back to investors in the form of lower valuations, liquidity preferences and a more natural pace of dealmaking compared to the high times of the last couple of years.
“Valuations are getting back to normal,” said Shay Michel, managing partner at Merlin Ventures. “We see this as going back to 2019 or 2020 before valuations took off. Entrepreneurs cannot be in the mindset of ‘21.”
Some of that normalizing means an increase in things such as liquidation preferences, redemption rights, ratchets and tranched financings.
Enhanced liquidation preferences guarantee an investor usually 2x or more their original investment in return and can cut into founders stakes.
Similarly, things like ratchets—an anti-dilution provision used by early investors to protect their stakes—and redemption rights, which allow investors to liquidate their stake at any time of their choosing, also protect investors sometimes at founders’ peril.
Another lever some existing investors are pulling is instituting pay-to-play rounds. These basically require existing investors to invest on a pro rata basis in current or future rounds, or lose some of their preferential rights.
Patel said he has heard that such rounds are making a comeback after being in mothballs for years because of the frothy market.
For early investors in startups—who also then invest in the succeeding rounds of portfolio companies—pay-to-play rounds only make common sense right now, Yépez said.
“I would demand it as an investor,” he said.
The trouble with a down round
Pay-to-play provisions are sometimes added to the dreaded “down round” to make sure previous investors pony up in a time of need for the startup.
However, while flat rounds are now not unheard of, down rounds have been a little more rare, according to VCs.
“I’ve not seen too many down rounds,” Patel said. “Maybe in Q3 or Q4 you may see more.”
While we have not seen many down rounds, most investors also warn against such a raise.
“They are a signal you are not delivering what is promised to your investors,” Yépez siad,
Zafrir said his best advice to startups is to avoid down rounds if at all possible. Such a round can add toxicity to the board while also hurting employees with dilution to their equity in the startup.
“CEOs should consider taking a flat round or a convertible note,” he said.
Yépez said he used convertibles during the 2008 global financial crisis when he was a founder. They are increasing in popularity right now as valuations dip.
The note works like a short-term loan to a startup, but is repaid to the investor at a later point in equity, typically at a 15% to 20% discount, and can include an interest rate between about 6% and 8%, he said.
“They just make a lot of sense right now,” he said.
‘Hysteria in the market’
The investor-friendly terms that are creeping back into the market may help new investors in a startup. However, many VCs are also more than willing to share some of the same advice they are telling their portfolio companies when it comes to not getting cornered into a bad deal.
“There is hysteria in the market right now,” Michel said. “But if you just raised $50 million last year, you should be worried about going out again this year and raising a $20 million flat round, right?”
Instead, Michel said, startups should be looking at their numbers and making good business decisions. Don’t be infatuated with the next raise, he said.
Yépez adds this is the time that will truly test what kind of investing syndicate a founder built behind their company.
“Good investors realize this is a marathon, not a sprint,” he said. “Remember, a valuation is just an interim stop. They change all the time with the market.”
This may also be a good time for founders to take a step back, breathe and put fundraising on the back burner.
“I don’t think right now is the right time to be making big decisions about your company,” Michel said.
Illustration: Dom Guzman
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