Since the Internet bubble burst, venture terms have gotten increasingly tough. Some of it is understandable. Financing terms are market driven. They are intended to reflect the amount of risk a private investor is taking on. As the public markets have closed tight, follow on financings have grown scarce and corporations have clamped down on IT spending, it is no surprise that venture investors are demanding more protective terms.
In light of these changes in the market, the lawyers at Fenwick & West LLP have been tracking the financing terms of those private companies they represent in the San Francisco Bay Area. They send out quarterly reports on the terms their clients have experienced and track them against the financing terms of the quarters before. It is a good snapshot of what is happening in the Valley.
Here's what Bay Area companies saw in the first quarter of this year:
- Valuations continued to tumble. 73% of all financings raised in the first quarter of this year were down rounds (i.e., the price at which stock was sold in that financing was lower than the price at which equity was sold in the previous financing). Over half of those companies going out for a second round of funding (56%) had down rounds. And if you were raising a Series D or higher, you were almost certain to have a down round (100% of the Series D financings were down, and 87% of those E or higher were down).
- Investors increasingly required participating preferred. In a steady increase since the first quarter of 2002, investors have required that their stock have participation in the event of a liquidation (i.e., in the event that a company is sold, investors first receive the amount they invested (or some multiple of that amount) and then they receive their percent of the remaining sale price as if they had converted to common stock at the time of the acquisition). 77% of those financings done in the first quarter of this year had participating preferred. That was up from 56% only a year ago.
- Most other terms remained consistent with past quarters. The vast majority of investors (83%) required weighted average antidilution protection (i.e., in the event that the company raises money in a down round, existing investors stock is adjusted as if some proportion of it had been purchased at the lower price). And about a third of the financings included redemption rights (i.e., the investors have the right at some point in the future to require the company to repurchase their shares at a specified return).
Despite increased optimism in the venture community in the first quarter of the year, follow on financing terms did not appear to reflect that optimism. I suspect that that optimism was better reflected in an increase in funding for new ventures. But I also suspect that follow on financing terms will get better in Q2 of this year. Fenwick & West concludes, "The terms of venture financings were a bit tougher overall in Q1 '03 compared to the already tough terms of Q4 '02. However, with the Nasdaq increasing 16.5% from March 1 through May 13, and with the Iraqi situation hopefully stabilizing, there are reasons for the venture capital financing environment to improve."
