Investment Terms
For this Antiphony Insights, we talked with Steve Goodman, a nationally-renowned corporate attorney and venture capital expert, about some of the key issues companies should consider as they pursue new financing.
As always, we hope you find this information valuable. If you have any thoughts or suggestions, please contact us at insights@antiphony.com.
Stephen M. Goodman
is a partner in the Business Transactions Practice of Morgan Lewis (www.morganlewis.com),
one of the ten largest US law firms, with nearly 1,100 lawyers in 13 offices
worldwide. Mr. Goodman is co-chairman of the Firm’s Global and Technology
Practice. His practice focuses on representing emerging growth companies
in the technology and life sciences sectors
Terms They Are a Changing
Antiphony: Times are tough for companies seeking venture capital financing. Of the private equity investments you’ve seen over the past six months, what percentage are “down rounds” where the company receives a lower valuation than their previous investment rounds?
Goodman: No question valuations are down compared to what they were two years ago at the height of the boom. One of the key reasons is comparables are down across the board -- that is the value of similar companies in the same industry. However, if you look at historic valuations from four years ago, many of the valuations we’re seeing now for in-demand, quality companies are not much different than pre-boom valuations when adjusted for inflation.
However, the reality is many emerging companies today are struggling, and as a result, they are not in strong negotiating positions with investors. Over the past six months, the majority of deals I’ve seen have been “down rounds” and 10-20% of these deals were “cram down” rounds. The deals I’ve seen that have equal valuations to their prior rounds typically have had more onerous control and liquidation preferences associated with them, which allow the company to present a retained valuation to the marketplace even though the overall terms of the deal make it less favorable to original investors.
Antiphony: What is a “cram down” round and what kind of restrictions are placed on these companies by their investors?
Goodman: When a cash-strapped company is facing the prospect of closing its doors unless it secures additional funding, the company is often left with no other option than to accept “cram down” financing. This last resort transaction essentially allows the new investors to take control of the company and its board, “cramming down” and usurping the interests of earlier investors, including founders and management.
In a “cram down” deal, troubled companies are typically forced to provide their new investors with generous concessions such as multiple liquidation preferences. Liquidation preferences guarantee investors priority distribution on the proceeds from any future corporate liquidity event and enable them to receive a favorable rate of return, sometimes as high as five times their original investment. Of course, after a “cram down” deal, one of the biggest challenges for new investors is maintaining a working relationship with earlier investors and motivating the management team, if in fact, they are going to be an integral part of the business going forward.
Antiphony: In financing rounds that are “down rounds”, how can investors restructure incentives for management in order to continue to motive them?
Goodman: “Down rounds” of financing often can change the original incentive structure for a company’s management team, as their original options may become worthless as a result of the new lower corporate valuation. As a result, investors are creating a variety of new incentive structures that include: offering cash bonuses based on future liquidity events (known as “deal carve-outs”), providing management with new stock options at a lower price or repricing their original options at a lower price.
What Private Companies Need to Know
About Corporate Governance
Jeffrey
Babin, Antiphony
(jbabin@antiphony.com)
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