Negotiating with Venture Capitalists Now

Valuations of top-tier companies are falling, it's taking longer to get funded, and the terms are tougher

By Tom Taulli

The past few years have been relatively easy for founders of startups to raise venture capital. VCs were willing to take bets on new markets—and make large investments. Bear in mind, I say "relatively easy" because only a tiny fraction of companies seeking venture funding actually get it. But with the looming global recession and the implosion of the financial markets, the VC game has suddenly become even more challenging. So what should founders expect in this new environment? Let's take a look.

Valuations will plunge. This is perhaps the most obvious impact. It's a good bet that valuations of top-tier companies have fallen 30% or more over the past couple months. As for those companies that have already received VC rounds, we will see more so-called "down rounds." This is when a funding comes in at a lower price than the earlier round. In such financings, the founders could see their equity stakes easily reduced by 50% or more. If a company is in a distressed situation—and has run out of capital—the financing could mean the founders lose all their equity.

I looked at law firm Fenwick & West's venture-capital surveys for 2002 (after the dot-com bust) to try to predict what's next. The down rounds, as a percentage of all financings, ranged from 57% to 68%. What were the percentages for 2008? The statistics I looked at only go into the second quarter—so they still reflect the benign funding environment. They range from only 13% to 19%. Of course, if the VC marketplace freezes again, there could be a notable increase in down rounds.

It will take twice as long to get funded. Even in normal times, it can easily take six months to get a VC round. But this time frame is likely to get much longer. For early-stage deals, from seed to Series B, I suspect it will take a year to put together a round. This is why VCs are encouraging their portfolio companies to take large reductions in their cost structures.

Tougher Terms. As I've noted in my series on term sheets (BusinessWeek.com, 8/22/08) key provisions—like liquidation preferences and anti-dilution rights—can have a major impact on your company. Unfortunately, expect these terms to get even rougher.

First, a liquidation preference is triggered when there is a major event, such as an acquisition, sale of much of a company's assets, or even bankruptcy. If a VC has a 1X liquidation preference, then it will receive its whole investment back before all other shareholders. (A 2X preference means that the VC will get twice its investment back before any other shareholder gets anything.)

The Fenwick survey for 2008 shows that most of the deals were between 1X and 2X. But, looking back at 2002, it was not uncommon to have more than 20% of deals between 2X and 3X. That's a hefty concession for a founder to give away.

Sharply Lower Valuations Ahead

Next, there is the anti-dilution clause, which provides more stock to existing shareholders when there is a down round. There are two approaches: the "full ratchet" and the "narrow weighted average calculation." (I explain what these terms mean in my term-sheet series.) The "weighted-average" is the most onerous. According to Fenwick, most deals for this year had a weighted-average calculation. However, back in 2002, it was typical for more than 20% of deals to have full-ratchets.

Finally, a VC term sheet is likely to have "drag-along" rights. This means that minority investors must agree to the future sale of the company. Thus, if a VC has strong liquidation preferences, this option may be quite attractive. Of course, it could mean that the founders wind up with little or nothing.

Unless your company is growing quickly and seemingly immune from the recession, then the odds are strong that your next venture round will see a sharp reduction in valuation (30% of more), a 2X to 3X liquidation preference, and perhaps even a full-ratchet.

Going into Hibernation

In other words, founders have some tough decisions to make if they were considering raising venture capital. It may make sense to scale down a business into hibernation mode. Or another option is to find a buyer. Because if VCs have strong investor-friendly terms, a company may need to achieve high valuation hurdles to get a decent return for the founders.

Tom Taulli is a noted finance author and blogger.