The recent favourable interest rate environment has led to venture capital funds being pumped full of investment pressure. The more successful the fundraising of VC funds, the greater the competition for investable start-ups. The direct consequence is that the current valuation of some young companies is simply not sustainable. The boom seems to be over for now. Investors are becoming more selective. High growth rates with an equally high burn rate are viewed critically; sustainability and a solid run rate used to be boring and are now in demand. Those who are not currently active in the AI sector are now confronted with the risk of a downturn. There are alternatives, but they should be treated with caution.
Downrounds
A downround is a financing round (usually in the form of a capital increase) based on a lower valuation than the previous or last relevant financing round. Founders are required to avoid downrounds not only for image reasons. They can also regularly trigger various so-called downward protection mechanisms, which are set out in the contracts and lead to a further dilution of the shareholders in favour of individual investors.
Structured liquidation preferences as an alternative to downround
We have observed that the current environment with regard to start-ups in need of capital generally has the following effects on the contractual documentation for financing rounds (Investment & Shareholders' Agreement, Articles of Association):
- Investors are tightening up clauses relating to downward protection, and
- The negotiations are focusing even more on regulations on liquidation preferences in favour of the lenders.
The latter in particular is increasingly appearing as an alternative to a downround. Investors are generally prepared to invest at a higher valuation if, in return, they are favoured in the context of liquidation preferences. Here, they not only want to limit their downside, but also participate disproportionately in the upside of a successful exit.
However, the existing shareholders must not lose sight of this. The disadvantage to existing shareholders as a result of a structured liquidation preference must not be (significantly) greater than the threat of a downround. Otherwise, they will not readily accept the deal. This compromise requires a customised and sometimes creative liquidation preference arrangement that transparently reflects the outcome of the parties' negotiations.
Most founders and investors are familiar with the common variants of the liquidation preference. Single or multiple liquidation preferences, each chargeable or non-chargeable, are common standards in investment documentation today. Liquidation preferences that are dynamically orientated to the respective exit valuation according to defined parameters are somewhat rarer but not at all unpopular. They are therefore rather "fluid". In practice, however, there are no limits to the structuring options for liquidation preferences.
The different variants of liquidation preferences can also be combined and supplemented as desired. In terms of contracts, the following instruments, among others, should be considered:
- Individual existing shareholders may be more burdened by a liquidation preference in favour of the investors than others (e.g. founders give up their liquidation preference disproportionately in relation to other shareholders).
- Dynamic liquidation preferences can be provided with a floor and a cap. The floor protects the downside of the investors, while the cap limits their upside and thus the burden on the other shareholders.
- Regulations can regularly be provided with a deadline, so that the favouring of investors is relativised with the passage of time.
- Regulations can also be made dependent on the achievement of milestones. This is useful in cases where an investor can be convinced of the proposed valuation if certain KPIs are met.
Founders Beware!
However, structured liquidation preferences also harbour risks. Despite all the complexity, it is important that the arrangement is transparent and sufficiently clear. Anything else will lead to misunderstandings and discussions that will burden and delay the sales process, especially shortly before the exit.
It should also be borne in mind that not all shareholders follow the negotiations in as much detail as the deal team and the lead investor in the round. Nevertheless, all shareholders must understand and accept the new regulations. The more complex the regulation, the greater the clarification effort. Regulations that are too complex almost always lead directly to dissatisfaction. Sample calculations and illustrations in particular can help here.
In addition, future investors are deterred by complex regulations on revenue distribution. The simpler and more transparent the regulations, the more likely future investors are to have confidence in the existing contract.
Conclusion
Founders are well advised to carry out a realistic and sustainably enforceable company valuation in order to minimise the risk of a future downround. If a downround is to be avoided at all costs, structured liquidation preferences can be an alternative. However, they are not the first choice. Higher negotiation costs, increased complexity and the deterrent effect on future investors are arguments against them. A balanced, transparent and comprehensible design of the financing documentation strengthens investor confidence in the long term and makes it easier to negotiate and implement the exit in the future.