As the COVID-19 pandemic spread from Asia to the rest of the world at the beginning of 2020, global venture capital (VC) funding dropped dramatically—by about 20% since December 2019 according to Startup Genome. While the longer-term effects of the pandemic on startups’ ability to raise money cannot be fully grasped yet, it is likely that this downward trend will continue. Furthermore, though many venture rounds in Q1 2020 benefitted from optimistic beliefs in a V-shaped economic recovery, deals that get done over the next several quarters may reflect pressures resulting from what most now predict to be a longer and more painful path.
Before turning to what those new terms might look like, it is worth noting some of the current challenges faced by emerging growth companies (EGCs) and their investors:
- Lack of Sufficient Investment Capital. While many sources report record amounts of “dry powder” in the VC industry, the general consensus is that, given anticipated challenges in new fund raising and the potential pull-back of corporate VC investments, there may still be insufficient capital to fund collective EGC needs.
- Attention Focused on Existing Investments. In addition to requiring committed capital for existing investments, EGC investors may be required to be more involved in many of those existing investments, resulting in less bandwidth for evaluating new opportunities.
- Novel Difficulties in the Investment Process. While technologies like Zoom and Microsoft Teams have emerged as useful alternative communication tools in recent months, many EGC investors may struggle to abandon their historical reliance on face-to-face meetings and site visits as key diligence items. EGC investors may likewise require more lead-time to diligence deals, resulting in a slower pace of investments.
- Uncertainty in Public Markets. Though many EGCs focus locally, the strength or weakness of public markets invariably affects the market for EGC investments. Accordingly, to the extent that public markets remain volatile, there is a high likelihood of a trickle-down effect applicable to EGC investments.
With all these challenges, among others, it is unsurprising that both the data and anecdotal accounts suggest that “market” for EGC investment deal terms may, at least temporarily, be shifting. In particular, market participants and their advisors are increasingly noting:
- Lower Valuations. Several industry reports, including the Pitchbook Q1 2020 US VC Valuations Report, have noted an overall drop in valuations for most segments of EGC investment market.
- “Tranched” Deals. In the face of economic uncertainty, investors may investments in “tranches” based on the achievement of one or more predetermined milestones. This feature, while useful for investors in hedging risk, puts companies in positions of uncertainty with respect to their available capital.
- Pay-to-Play Provisions. Investors may require “pay-to-play” provisions in new investments, particularly “down round” investments. Management and common stockholders may actually support these provisions, both to “clean up” the cap table and to reduce the overall liquidation preference overhang. Existing investors that are financially incapable of participating would, of course, be less enthusiastic.
- Increased Control Mechanisms and Exit Options. Given the increased importance for many investors in managing investment risk and finding liquidity, investors may seek greater control not only over day-to-day operations normally left to management, but also to company sale processes. Investors near the end of their fund lives may even require redemption provisions, forcing the company to further manage cash on hand.
- Liquidation Multiples and Price Protections. Whereas more robust economic times have made 1X non-participating preferences and noncumulative dividends mostly the norm, there may be an increasing trend toward liquidation preference multiples. Similarly, relatively uncommon features such as full rachet antidilution protection or warrant coverage could be on the rise.
- Alternative Financing Structures. As valuations become less predictable or access to traditional capital less reliable, even later-stage EGCs may look to turn to alternative structures such as convertible debt, SAFEs or initial coin offerings.
In all, just as COVID-19 brought into our common lexicon new terms like “flattening the curve” and “herd immunity”, so too is the economic uncertainty caused by the pandemic is likely to introduce new terms into EGC investments. The real question—for which answers will be revealed only over time—is what it will all look like when the face mask finally comes off.